The financial sector turmoil that started with the collapse of Silicon Valley Bank in the US and subsequently spread to Europe saw market sentiment turn as the situation evolved. The initial panic eventually gave way to concern over tighter credit conditions, raising the risk of recession and disinflation. That outcome might prompt the principal central banks to slow their tightening of monetary policy. Probably not anytime soon, though. Recent data suggests inflation and tight labour markets still pose more of a challenge to monetary authorities than recession risks.
Investors now face two potential scenarios: Either the recent financial tremors deepen into a global financial crisis or they fade away as conditions stabilise.
Could confidence collapse?
If the woes were to worsen, the outlook could be for a collapse in financial market confidence that pulls the rug out from under the global economy. That could trigger deflation and force central banks to reverse their tightening policies. Such an outcome would likely lead the US dollar to appreciate significantly, while bond yields and equity prices fell.
However, the likelihood of this scenario seems lower now than it did a few weeks ago. Recent data shows that after a USD 196 billion decrease in deposits the week ending 15 March, deposits at small US banks rose by USD 6 billion the following week.
Furthermore, bank borrowing from the US Federal Reserve, through either the discount window or the new Bank Term Funding Program, fell by USD 11 billion in the same period. This suggests the regional bank stress level has passed its maximum fear point, as does the resilience of the S&P500 equity index (excluding banks) in the wake of the initial shock (see Exhibit 1).
To manage the first wobbles, monetary authorities in the US and Europe signalled a separation of their interest rate policy decisions to combat inflation from their roles as macro-prudential supervisors to prevent financial contagion. The inflation battle was aided by the tightening of financial conditions in credit markets, as funding costs rose to reflect greater uncertainty. The degree that this tightening will be a drag on the economy we will only discover later. But against an increasingly disinflationary backdrop, this would boost the odds of recession.
If the turmoil fades…
Should the stress in the financial sector fade, markets will likely return their focus to the pre-SVB situation where stubbornly high inflation was pushing central banks to raise rates to growth-restricting levels. Recent data indeed shows that inflation has remained stubborn and therefore a top policy concern.
In the US, the Fed’s favourite inflation gauge, the personal consumption expenditures index, rose by 5.0% year-on-year in February after peaking at 7.0% last June. Crucially, core PCE services inflation excluding rents rose by 4.9% YoY.
The declining trend in headline PCE is good news as it puts less pressure on the Fed to raise rates aggressively. However, the fundamental problems remain: Core inflation is still persistently high and conditions in the US labour market remain tight. Both factors are limiting the Fed’s room for manoeuvre.
Similarly, Europe’s headline inflation slowed by 1.6 percentage points to 6.9% YoY in March from February due to sharply lower energy inflation, but the core rate rose by 10bp to 5.7% YoY. Core inflation has been stickier in Europe than in the US, forcing the ECB to be more hawkish than the Fed. The latest data show the recent fall in energy prices is not changing the upward trend for core goods and services inflation.
Headline inflation will be boosted by the 4 April decision by the OPEC+ group of oil producing countries to slash oil output by 1.6 million barrels a day, even though the decision appears defensive in that it is probably intended to encounter weaker demand.
Inflation is also hitting Japan, with the March Tokyo consumer price index excluding food and energy prices rising by more than expected to 3.4% YoY. The inflation rate is higher than the Bank of Japan’s 2.0% target, raising market expectations of an early normalisation of the BoJ’s loose monetary policy.
If core inflation pressures do not subside, a decline in the headline inflation rate will not necessarily prompt a shift in central bank policy anytime soon, though the pace and the magnitude of tightening should slow.
China – A countervailing force
The prospect of stagflation hangs like a dark cloud over developed markets. Job openings in the US fell by 6.0% YoY in February, and January’s data was revised lower, although not by enough yet to signal a decisive trend change. However, the Institute of Supply Management manufacturing index fell to a low of 46.3 in March, continuing a five-month downtrend.
Arguably, disinflation and economic recovery in China are partly offsetting any drag from developed markets on global growth. The post-pandemic reopening of the Chinese economy should have a positive spill-over on global growth, especially on Asian growth, through international trade and the support it provides to commodity markets.
Concern over China’s recovery adding to global inflation and putting more pressure on central banks to tighten policy has been misplaced, in our view. For China to export inflation, its inflation rate must be higher than that of the rest of the world. This is clearly not the case: China’s headline and core CPI rates are significantly lower than those in Europe and the US.
Finally, China’s relatively closed capital account and well-capitalised banks have sheltered it from the negative impact of the financial sector turmoil. This can be seen in the outperformance of China’s financials stock index over its US counterpart since 8 March when the SVB bust-up ignited the turmoil (see Exhibit 2).
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