Chart of the Week (COW)
Financial conditions, which are a function of interest rates, bank lending standards, inflation, returns on financial assets and a variety of other metrics, have continued to tighten for much of the past 6-months. We watch this chart very closely (it is released weekly) for signs that things are beginning to stabilize. Generally speaking, while markets can overcome tight financial conditions, it is generally a headwind, which can act as a drag on performance. Anyway, let’s look at this week’s COW and then comment:
The grey bars in the chart indicate U.S. recessions and as you can see, leading into recessions and especially during the recession, financial conditions tend to get very tight for a period of time. Then, as the Central Banks cut interest rates to stimulate the economy and pent up demand for loans (as well as more relaxed lending standards) add more fuel to the recovery, financial conditions begin to loosen, often at a rapid clip. These more favorable financial conditions tend to create a nice feedback loop with stock and bond markets as looser conditions beget strong gains in stocks and bonds, which in turn causes financial conditions to loosen further.
With the Fed and the BoC likely to continue hiking rates into the fall and tighter lending standards (as well as lower demand for loans in a slowing economy with higher rates), the index is unlikely to loosen up anytime soon. While the Financial Conditions Index is essentially an aggregate of a lot of different things we may look at in isolation, it is a good “one-stop shop” for an indicator that can shed some light on when markets may start functioning more normally.
Despite a myriad of headwinds, the equity market generated a strong return for the week with U.S. tech stocks, amongst the hardest hit stocks in 2022, amongst the biggest gainers. We are in the midst of second quarter earnings and for the most part, results have not been as bad as some might have feared given high inflation, rising interest rates and slowing demand.
As far as Canada is concerned, the Canadian banks do not report results until the end of August; although, we have seen some movement by analysts to reduce estimates ahead of these results. Under new accounting rules that the banks adopted a few years back, the banks must reserve for potential loan losses well ahead of time, which will likely lead to a ratcheting up of reserves this quarter as economic conditions have deteriorated.
These reserves do not necessarily equate 1 for 1 with higher loan losses as the banks will generally be cautious and take more reserves than necessary. Thus, while earnings for the banks are likely to decline over the next couple of quarters, it is important to keep in mind that part of this decline is due to a cautious approach to reserves.