Credit Cycle Dysfunction Has An Endpoint

June 24, 2022

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Credit Cycle Instability Is The Source Of Higher Market Volatility And Extreme Policy Intervention

Eventually Is Now
David Einhorn

Never seen a constellation where there is no historical analoguemore humility than I have had maybe ever
Stan Druckenmiller

The chart below shows the record wealth destruction, across stocks and bonds in the current drawdown, over the last 40 years, and there is no guarantee that its over yet!

Hopefully, readers of this blog were well prepared. I warned about the Investment Return crisis as far back as January 2020, highlighting “The investment prospective return crisis,” and in October 2021 the “95% probability of Quad 4 in Q2 2022.”

The deeper issues really need to be well understood because the source of this volatility is far from resolved, and the instability and scale of both the credit cycle and policy reactions keeps on rising. How does anyone have any confidence that this is sustainable? While we are asking questions, why do we need a credit cycle that dwarfs the business cycle?

No wonder even Stan Druckenmiller is talking about humility.

The chart below shows that the amplitude of the credit/financial cycle has continually increased since the dollar delinked from gold.

This time around, the scale of the credit boom in U.S. Non-financial Corporate Debt/GDP is truly impressive.

Regulators always like to believe they have this under control even when the expansion of credit is substantial. In recent years credit has been fuelled by record low interest rates, supported directly by the Federal Reserve, and boosted by record money supply growth.

What could go wrong?

William Anderson explains:

“…banking regulators have made a prodigious error in their oversight of the commercial banking system by focusing almost solely on bank balance sheet liquidity as the principal determinant of risk exposure. And on the few occasions in the past when they have demanded banks increase their own capital, it has always been through the creation of preference shares and pseudo-equities to avoid diluting the true shareholders. The consequence is that the level of leverage for common equity shareholders in the global systemically important banks has risen to stratospheric levels.

The regulators may be comfortable with their liquidity approach, but they have ignored the periodic certainty of a contraction in bank credit and the consequences for banks’ equity interests. Meanwhile, G-SIBs have asset to common equity ratios often more than fifty times, with some in the eurozone over seventy. It is hardly surprising that most G-SIBs are valued in the equity markets at substantial discounts to book value.”

G-SIBs are Global Systemically Important Banks. (view the full 2021 list here)

If the market was confident about all this leverage why would these banks trade at substantial discounts to book value?

We have increasing evidence that bank credit is either contracting or on the verge of doing so. This was the message loud and clear from Jamie Dimon’s recent description of economic conditions being raised from storm to hurricane force, and his follow up comments about what JPMorgan Chase was doing about it.

Inflation and higher interest rates have a way of materially changing financial conditions. The Fed’s policy has now fully switched to needing a reversal in the credit cycle in order to get back control of inflation. Does the Fed have any idea how big the amplitude of the credit cycle can get before it becomes unmanageable?

Here is a great video that puts together many of the themes discussed in these insights. It describes the mechanics and risks behind an ever expanding credit cycle.

Stan Druckenmiller’s Perspective:

Much of this perspective is shared by some of the Best Investors of all time. At such a crucial moment it is invaluable to get the latest perspectives of Stan Druckenmiller. During this interview, you can get an investment masterclass into the bargain, with his current views thrown in.

Analysis by David Einhorn:

David Einhorn’s analysis (video below) is always highly informative. And few hedge fund managers understand in depth how the regulators operate after his many interactions over his long career.

“Hedge Fund Billionaire Who Shorted Lehman Brothers Says the Fed and SEC Aren’t Doing Their Jobs” (Read full article)

Summary

It is important for investors to fully understand that current conditions are unprecedented in their own lifetime investment experience.

The scale of the credit cycle has continually expanded over the last 50 years, and policy makers are now confronting the biggest credit cycle peak just as they take on the largest inflation breakout in 40 years.

The Best Investors have been through decades of successful investing and came out far ahead. They have common principles and processes almost no other investors have.

Make sure your investing is aligned with Best Investor Standards and Strategies, at a time when humility and risk management have become essential.

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