According to Ludwig von Mises, credit addiction cannot be cured by more credit.
For the man who believed that “the expansion of credit is built on the sands of bank notes and deposits” and that it “must necessarily collapse”, the discreet credit crunch currently at work in the United States is therefore logical. 30 major US companies have defaulted on their debt in five months (compared with 40 last year). The default rate on US high-yield credit has soared to 3.1%, compared with 1.9% in December 2022… For small businesses, access to bank liquidity continues to be more difficult.
The Austrian-American economist, born 10 years after the Paris Commune, would therefore welcome the end of the truce on interest rates called by the Bank of Canada and the Royal Bank of Australia (which are following in Norges Bank’s footsteps). Since then, 2-year rates have reached their highest levels at 16 and 12 years respectively.
If he were to whisper any advice into the ears of the members of the FED and ECB who will be meeting in mid-June, it would certainly be to follow their Australian or Canadian counterparts. Especially as core inflation remains persistent in Europe, rising at an annualised rate of 5.3% in May. In the United States, tensions on the labour market (unemployment below 4%) do not point to an imminent return of inflation to below 3%.
This is not stopping the equity markets from continuing to rise. It is hard to say what is behind their optimism: the growing assumption of an economic soft landing in the United States and a mild technical recession in Europe? Resilient earnings? Perhaps too complacent expectations of a rate cut at the end of the year? Probably a combination of all three. In any case, one thing is certain: the ability of central banks to contain the volatility of real interest rates has not been without effect on the volatility of risky assets: the VIX is now trading at a two-year low, which is astonishing for a year marked by clear economic and geopolitical uncertainty.
Buoyed by the collapse in volatility, the risk premium is compressing, perhaps a little too much…
On the back of upward earnings revisions, the MSCI Europe offers a 5.3% excess return over 10-year German bond yields. This is well below the 2021-2022 average (6.4%, after peaking at nearly 8% last March)… but four times higher than the S&P500 risk premium… At 1.3%, it is more than two standard deviations below its five-year average, compared with money markets yielding up to 5.2% six months ahead!
The rebound in technology stocks is of course behind this historically low level. In fact, you have to go back to 2007 to see such a compression in the risk premium of the US index. All of which lends credence to those who favour a bear market rally following on from 2022. Ludwig von Mises would certainly be among them… If he was already comparing banking transformation to a sandcastle, what would he think of the valuation of the silicon promises of artificial intelligence stocks? Caution, he would probably advise, until there is evidence of a real start-up of an AI capex cycle in all companies… A cycle which would nevertheless raise other questions, both economic and moral, as to its effect on employment and the current economic model…
Thomas Planell, Portfolio manager – analyst at DNCA. This article was finalised in June 9th, 2023.
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