Add banking stress to rising rates and recession may be baked in

Tue, 30 May 2023 21:50:12 +0000

Economists have been forecasting a US recession would happen since the Federal Reserve (Fed) started raising interest rates back in March 2022. The federal funds rate has risen almost 500 basis points since last year, as the Fed has aggressively attacked inflation.

J. Patrick Bradley, Senior Vice President – Investment Research at Brandywine Global, part of Franklin Templeton says: “On the other side of the coin, there is a sizable contingent who still assert that a soft landing remains possible.

“I am not in that camp. The exact timing of when a potential recession might begin is lacking, but a fledgling U.S. banking crisis may have shortened the timetable. Let us look at where we are in the business cycle and see if there are any recessionary signals.

“Most likely, in my view, a recession is baked in now. The U.S. has just experienced three regional bank failures. The failures of Silicon Valley Bank and Signature Bank saw a surge in discount window borrowing. Next, First Republic Bank became the latest bank to fail, earning the dubious distinction of being the second-largest bank failure in U.S. history. Now, other struggling banks, hoping to avoid the same fate, are actively seeking suitors. This turmoil and uncertainty will ripple through the economy just as the steadfast tightening of U.S. monetary policy is also manifesting in financial conditions.

“Some experts may believe the banking crisis is over, following the purchase of First Republic’s assets and deposits by JP Morgan. I am less reassured. The Fed appears to be staying the course on its rate-hiking path, putting banks and other interest-rate sensitive sectors under further strain. These potent ingredients of the Fed’s earlier hikes and recent bank failures suggest recession is likely baked into the mix.

“Tight monetary policy and failing banks further suggests a U.S. recession is baked in. The U.S. economy is slowing; financial stress is evident; credit availability is constrained by the banking failures—and likely to tighten further; leading indicators are falling; and the probability of a recession, according to some analyses, is rising.

“Whether or not the Fed quickly reverses the direction of its policy will not alter my expectation of a recession. Monetary policy operates with long and variable lags, with an emphasis on long. More banks could fail. Markets do not have confidence that the financial crisis is over. The S&P 500 regional bank index plunged nearly 28% in the days following the fall of Silicon Valley Bank (SVB) and Signature Bank. Thus far, the index has failed to recover. Furthermore, it is likely we are only beginning to see the impact of all the prior cumulative monetary tightening.

“The combination of this added stress from the banking sector in conjunction with the Fed-generated reduction in liquidity likely will magnify and accelerate the eventual outcome: A recession appears baked into the economic cake,” says Bradley.

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Covid-19 will have long lasting social and economic consequences

Wed, 24 Jun 2020 21:55:35 +0000

The pandemic has created a fertile environment for social unrest, with much depending how well governments address the crisis and the subsistence needs of their citizens.

In a recent research note, J. Patrick Bradley, Senior Vice President, Investment Research at Brandywine Global ( part of Legg Mason ) states: “There’s nothing prophetic about saying the coronavirus will change the way we live and conduct business. Unemployment will rise, and some of that increase will create permanent joblessness. Some businesses will fail, despite the efforts of monetary authorities and governments to replace the income lost and to stem the spread of the virus. We have to wonder whether or not governments will come under pressure from citizens straining under the lockdown, who have lost jobs, and have found it increasingly difficult to feed their families.”

He investigates various themes to conclude:

The coronavirus pandemic does not preordain the onset of social unrest, but it can create a fertile environment for social unrest;
Countries at risk would be those with the weakest healthcare capacity; and,
In the end, how governments address the crisis and the subsistence needs of its citizens will determine how susceptible a country is to civil unrest and even changes in governments.

No conclusion is too far-fetched

Many parts of the world have been under mandated lockdowns and the services sector has been especially hard hit, like restaurants and tourism. Only essential services have been permitted to operate. This has led to protests across the globe…tensions are rising.

Chart 1: Stringency Index

Source: Oxford COVID-19 Government Response Tracker.^[1]

Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

In most developed countries, the strength of their institutions will allow a peaceful resolution to the lockdown dissents. However, the same peaceful resolution of conflict in emerging markets (EMs) may be different, where the strength and stability of institutions and government responses to the virus crisis might prevent a resolution of protests or civil disorder. Chart 1 shows the stringency index, a measure of governmental responses to the crisis, including school closings, fiscal stimulus, and healthcare. Arguably, a higher stringency score would be an indication of aggressive country measures to stem the spread of the virus. In this chart, Peru shows the most aggressive policies, while New Zealand has the lowest—the latter has begun to slowly exit its lockdown. Aggressive policies, particularly in EMs, could contribute to social unrest and growing protests, which could exert a negative impact on a country’s economy.

Protests have arisen as a response to government policies that locked down their economies. India and Iran are just two countries where citizens have reacted. In India, migrant workers staged protests. Thus far, police in many emerging countries have been able to restrict the protests. However, as incomes are hit and workers face unemployment and an inability to feed their families—particularly within a country’s informal economy—protestors might defy their government “orders” and take to the streets. Inequality will rise. The lower income groups spend a larger portion of income on food, and rising prices will affect the poorest tiers the hardest, possibly exacerbating tensions. Finally, EM governments generally have not provided the same type of income support to their citizens that developed countries have. Further economic deterioration, could cause the protests to boil over, despite governments’ curfew efforts.

ESG factors and risk

We can use our ESG factors to identify potential areas of risk; our source of ESG risk data is Verisk Maplecroft. First, since the driving force in the current world is the coronavirus, a good place to start is with a country’s healthcare system, and then identify those countries at risk from a public health threat. Maplecroft has created a healthcare capacity index that assesses the ability of a country to react to a health crisis. That information is found in Chart 2 below, where we show healthcare capacity graphed against COVID-19 tests administered.

Chart 2: Covid-19 Tests and Healthcare Capacity

Number of Tests per 1 M Population. As of 6/8/2020

Source: Verisk Maplecroft, Wordometers, Brandywine Global. ^[1]

A low healthcare capacity risk score suggests a country is ill equipped to handle a pandemic. Latin America appears overly represented in the high-risk quadrant of the chart and includes Colombia and Peru. In Asia, Indonesia—according to this index—is also an extreme risk country. Brazil is a high-risk country, but the government’s coronavirus response has jeopardized the country’s public health. Brazil has just surpassed the U.K. for the most cases. Population density in Brazil’s favelas has enabled the spread of the virus. The rampant outbreak could raise the specter of growing social upheaval and civil unrest and pose a challenge for the government—particularly one that is generally conservative and dedicated its agenda to fiscal reform.

How does an investor make use of such information? A good question to ask is whether there a correlation between the healthcare capacity index and a country’s credit default swap (CDS), which is the relationship shown in Chart 3. A low healthcare capacity score of 0-2 suggests a higher CDS, while countries with higher capacities are rewarded with lower CDS. We don’t believe the correlation is spurious, as a country with an inability to handle a pandemic crisis should pay more for its debt. That higher cost of debt diverts fiscal support for other areas of an economy, which could feed back into social tensions.

Chart 3: Healthcare Capacity and CDS

Log, As of 4/8/2020

Source: Verisk Maplecroft, Bloomberg, Brandywine Global. [1]

Deep Coronavirus recession and political instability

The global economy is expected to decline—and sharply. That economic deterioration will worsen unemployment rates and negatively affect incomes, which disproportionately falls on citizens that are the least able to manage it: the poor and the low-income worker. Food could become scarcer and more expensive. The coronavirus will only worsen the existing income inequality in the world, but especially in EMs. Widening inequality raises the risks of civil unrest, populist uprisings, and political instability, particularly in those countries facing scarce food supplies. Regime change is certainly a possible outcome from this environment.

Chart 4: Food Security & Civil Unrest

Score (0-10), Q2 2020

Source: Verisk Maplecroft, Brandywine Global. ^[1]

Chart 4 examines the relationship between food security and civil unrest. There is a probability that food scarcity could catalyse civil unrest. The civil unrest variable in our research measures the perceived business impact from protests over a public concern, whether it be economic, political, or social. Food security measures the risk of having an adequate supply. The relationship between food security and civil unrest is a positive one, meaning the risk of not having an adequate food supply could foment an uprising. Chart 4 above plots a country’s food security score from 0-4 on the x-axis. The cluster of countries—India, Indonesia, and the Philippines—would seem to be at a higher risk for civil unrest, as are many countries in Africa.

What could reduce the risk of civil unrest? An effective government could reduce the tendency for social, economic, and political upheaval. Based upon our research efforts, an effective government would be perceived as seeking policies that benefit its citizens. The relationship in Chart 5 suggests ineffective governments are at increased risk for civil unrest. In the COVID-19 era, citizens would trust the government to act in their best interests. Governments deemed as ineffective in the era of coronavirus would be unable to meet the demands and needs of its citizens, who would then resort to an uprising.

Chart 5: Government Effectiveness & Civil Unrest