2023-03-17 04:12:27 ET
Summary
- We are seeing the ripple effects of concerns about the banking industry across markets as of today, with Europe taking a latent hit after Asia and the US.
- This is what the monetary authorities wanted: a credit crunch to cool off the economy. Banks are going to be tightening credit standards now that they're being seen as fragile.
- We are not in prosperous times. Can IXUS really justify being at the same price as at pre-COVID levels, in an era of free money?
- Consider what a real downcycle for credit can mean. Regulators should stand in the way of a major deleveraging, but corporate profits are going to be going down.
- Moreover, household wealth is going to be hit as credit standards tighten in retail banking. Actual signs of a downturn should start kicking in around now.
The iShares Core MSCI Total International Stock ETF ( IXUS ) is a pretty broad ETF that covers a lot of typical exposures you'd find in a relatively diversified portfolio. Its skew is a little excessive towards financials, which is a bit of a concern of course at this moment, but in general we think markets need to be aware that an economy at the high of a credit cycle is turning. Credit is a money multiplier, so what went intensely up will go intensely down as we think the next leg of the economy will be a recession as credit standards tighten and persistent loan growth ends, including to households.
Quick IXUS Breakdown
Here are the sectoral breakdowns.
This ETF is massive, it has more than 4.3k holdings. Financials are the biggest exposure, but it's spread across banking, insurance and brokerages, where mostly banking has been subject to pain in the markets on account of all the recent developments . The reason there is quite a lot of financial exposures is the skew towards Japan and the UK, which has a lot of large cap exposures in those sectors. IT exposure is a little low because non-US stocks are being excluded in the mandate. The ETF's diversity has put it down more or less in line with any general market index, showing a loss of around 4.36%, and also puts the expense ratios are really low levels (0.07%) because of how passive it is.
Macro Considerations
All of the top sectoral exposures are going to be vulnerable to a credit drop. Financials obviously suffer on tightening credit standards and higher deposit costs in that they cannot build up their asset base and pressure on households means their assets become riskier. Industrials are capital intensive and their investment cycles typically move sharply relative to sentiment, especially so when sentiment is linked to cost of capital. Consumer discretionary is also very dependent on the amount of credit in the system as a consumer durable but also an explicitly financed consumer durable.
While we've seen the beginnings of tightened credit standards, it hadn't hit a couple of spheres yet, where M&A at least in the mid-cap space is still strong, and comps against pre-COVID still show strength in the IB world. Households still are seeing loan growth, and growth of asset books facing corporate clients have also continued to grow, despite tightening credit standards on paper, with the economy still warranting a certain amount of investment.
We may see new waves of regulations on financial institutions as a result of the recent bank runs and this would raise the cost of doing business and reduce the investments banks can make. Households make a large part of the debt being extended by major banks, and their wealth which is stored in leveraged assets like housing depend on credit that won't continue to the same degree as before. With a more difficult funding environment the credit cycle will start requiring austerity to deal with reduced money multiplying, and ultimately we should see some degree of unemployment as the profit decline - employment decline spiral kicks off. When this happens, the Fed and other monetary authorities will have achieved their objective, and with the ECB being the first monetary authority to signal that inflation remains the key concern , albeit other monetary authorities like the Fed have other mandates too, we should expect the final push for some employment decreases and real economic decline to start to pick up for the rate hikes in dealing with inflation.
There's also the matter that more private credit will be needed for smaller businesses, especially in America where regional banking has been so badly hit. Private credit is more expensive, so there's a sort of mix effect going on there where credit costs are going to rise.
While the end of rate hikes is a good thing for assets whose yields can resist a downturn, as at least benchmarking against higher risk free rates doesn't have to be a concern, it is not going to be good for the majority of stocks in the IXUS sectors which are demand dependent on leverage. A 12x PE implies an earnings yield around 8%. Relative to RFs around 4% on the current yield curve , it's not great considering prospects of earnings declines due to topline reductions, but also due to refinancings at higher rates or duration gap issues in some of the financial exposures. Overall, IXUS is trading ahead of pre-COVID levels, and the reality is that we need to get to a worse demand situation than before then because geopolitical concerns are still at play, and we have lost economic integrations with its deflationary contribution.
For further details see:
IXUS: No One Hides From A Credit Crunch