Markets have a love/hate relationship with debt. If there is not enough of it available, shares tend to fall. More borrowing helps the world go round. If there is too much debt, markets can also fall. There is a fear that individuals and companies will not be able to pay the interest or meet the repayments.
In the recent sell-off, markets worried about both things at the same time. Many investors were concerned that the central banks were being too tough, throttling availability of credit for new purchases and business expansion. They also worried that maybe there is too much leverage in parts of the corporate sector, as companies heaped up new borrowings to buy back shares to meet high dividend payouts, and as China continued with her relatively high growth rate courtesy of substantial extra debt.
If banks make money available to individuals to buy a home on a mortgage, or to provide a loan for a new car, they are assisting economic growth. If that individual has a decent job, with prospects for pay rises or promotion, the loan will be well-based and the economy benefits. Towards the end of last year, monetary tightening in the US and the UK saw a drop off in new car buying and in some types of property purchase, with knock on effects for jobs in car makers and the housing sector. If banks extend too much consumer credit to individuals in danger of losing their jobs or without prospects of a pay rise, they can be fuelling uncertainty and setting up a future downturn. If they extend extra credit to businesses with good growth prospects which invest it in ways which generate more cash, that is good news. If banks are trapped lending more to businesses that are struggling to keep customers and generate revenue they can be hastening more bankruptcies.
There is a happy balance to be struck between lending too much and not lending enough, and between lending to companies and individuals that will be able to repay, and to those who might fall on hard times. The idea of a cycle is, in part, based on changes in the approach to credit. In the upswings of the late 1990s and between 2005 and 2007 banks lent too much to people and companies that would find it difficult to repay. When they sharply adjusted their approach under the influence of Central Banks that wanted to rein credit in markets crashed as bankruptcies rose and new credit dried up. Investors were reminded that the authorities can lurch too rapidly from too much to too little borrowing, with bad results for lenders and borrowers alike. In 2000, the technology bubble burst. In 2008, the general banking bubble burst.
So far it looks as if the authorities are concerned they have overdone the tightening and are not ready yet for a recession.
So where are we today? Some think we are at the end of another long cycle of building up too much debt, and fret that the authorities will have to contract it all again. Others think the authorities are concerned about stopping growth and will have to take action to prevent the current slowdown turning into something worse. The Fed’s decision, confirmed this week, not to overdo the tightening bolsters the view that this is not the end of cycle. Action taken recently in China to inject more money into the economy implies they too have realised the dangers of throttling credit too much.
Banks and markets are there to shift money from companies and individuals who have a surplus, to companies and individuals who want to build up their assets and have some income to pledge. The retirement generation usually have savings, and the young generation normally needs to borrow to buy their first cars and homes. It can be a good business sending the money from the one to the other. Central banks need to make sure the rates they set and the rules they impose on the banks do not get in the way of a decent volume of such transactions. At a time of rapid corporate change, it is particularly important to shift money into new technology and growth areas.
The markets are right to ask questions about the build-up of leveraged debt obligations by some companies. They are right to want reassurance that China will tackle bad debts at a sensible pace. So far it looks as if the authorities are concerned they have overdone the tightening and are not ready yet for a recession. The Fed’s statement – and the efforts of the Chinese authorities – offer a more-positive backdrop for shares than their actions last year, which is helping the rally.
The above article was previously published by Charles Stanley on 1st February 2019