If the financial market were a living organism, then liquidity – the availability of money to borrow, spend and invest – would be its circulatory system. Gauging liquidity is critical to understanding the financial market’s risk-taking appetite. Credit spreads, the premiums lenders require to extend loans to lower-quality borrowers, is a valuable real-time risk gauge. Lenders tend to tighten their purse strings by requiring a higher premium when they anticipate challenging credit conditions. Tight credit conditions not only tend to lead recessions, they often cause them. They also tend to be useful early-warning indicators of equity market upsets. The S&P 500 has returned 1 per cent on average in the six months subsequent to credit tightening versus 5.6 per cent over a similar timeframe in response to easing credit conditions.
As of yesterday, the spread between 10-year, BBB corporate bonds and 10-year Treasury notes broke more than 10 per cent above its 200-day moving average, a level consistent with tight liquidity conditions. While we don’t see an impending recession, widespread reticence among lenders is certainly a cause for concern as the availability of credit is constrained. Cheap borrowing helped fuel the 300 per cent equity market rally over the last 10 years. Closing the tap is a headwind.
Adding to our concern, the shambolic trade environment has prompted manufacturers to pause their hiring. Monday’s manufacturing data, while expansionary, fell short of economists’ expectations. Employers added a scant 12,000 net new production jobs over February, March and April combined. That’s well below the 17,000 average monthly net new job gains enjoyed over the last 12 months.
The economic outlook has dimmed but, in our view, recession is not currently the most likely scenario. That said, the breakdown in credit conditions certainly warrants attention.