Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
Credit conditions and real estate are back in focus
Peter Garnry
Chief Investment Strategist
Summary: Leading indicators are still weakening suggesting the US economy could slip into a recession this year and if it does it will most certainly be driven by deteriorating credit conditions which undoubtedly will be a knock-on effect from the current banking crisis. Higher funding costs and more equity issuances in the European banking sector will drive up credit conditions and worsening the slump in European real estate which down 2% again today with Aroundtown down 10%. Sweden will on a country level be the testing ground for how a weakening real estate sector will impact the economy and banks.
A sense of relief, before focus is back on European real estate
Bank, energy, and transportation stocks were leading the gains yesterday in global equities as First Citizens buys Silicon Valley Bank (SVB). The FDIC provided a hefty incentive for First Citizens on top a hefty discount including a $70bn credit line and agreed to cover losses exceeding $5bn on its commercial loans over the next five years and extended a $35bn loan to the bank. It seems that it was a priority for US regulators that it was not one of the big banks that took over SVB, which from a market perspective is a better solution. Higher oil prices yesterday also helped on sentiment in the procyclical segments of the market.
This morning the equity market has attempted to extend its momentum, but it has been faded again with real estate stocks in Europe down 2% with Aroundtown, the third largest publicly traded real estate company, leading the declines down 10% increasing the concerns of a restructuring. We wrote about the weakening European real estate market last week highlighting Aroundtown. The company has real estate properties in the Netherlands, London, and Germany with around 44% asset exposure to office buildings and 31% to residential properties. The dynamics around real estate assets are important because they are big driver of collateral values on banks’ balance sheets and thus a key driver of credit extension in the economy.
The lag factor and why credit is now key to monitor
Real estate and private equity assets are largely what is called level 2 and level 3 assets which means that they do not have an exchange traded price and either have to be inferred from external prices or comparisons to similar assets (that is level 2), and the most illiquid assets are level 3 which are priced used a model. Because many real estate and private equity assets are in those two categories their full impact comes with a significant lag to rising interest rates. But when the valuations finally change it can cause a dramatic impact. The publicly listed real estate companies are now valued at just 0.66 on price-to-book ratio which implies that the market is adjusting lower the outlook for profits but also lower values on real estate assets.
The dynamics that have evolved during the banking crisis are centred around higher funding costs, a fight for deposits leading to higher deposit rates, higher refinancing costs on AT1 capital, and more common equity issuances down the road if AT1 yields remain at present levels. In addition, banks are still part of a intensely regulated industry that is suppressing the structural return on equity. Declining real estate values will amplify all the dynamics above and Sweden will provide a testing ground of what to expect in other countries, because households apply more adjusted mortgages in the financing of real estate than any other country and thus the downside sensitivity to higher interest rates is just higher in Sweden.
Tighter credit conditions will be the natural outcome of the dynamics explained above and will also be the key driver of an economic recession which now looking more and more likely. The US Conference Board Leading Index is down to levels not seen since Q2 2018 and the decline from the peak is close to 7% which is a bit more than the decline from the peak back in 2007 when the US economy entered a recession in December 2007. If take a look at the subcomponent called Leading Credit Index then it shows the tightest credit conditions (the higher the value the more tight credit conditions are) since the Great Financial Crisis, if we look past the conditions during the early months of the pandemic lockdowns.
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