The Goldman Sachs Financial Conditions Index (GS FCI) hit an all-time low at 96.92 on November 9, 2021. Since then, financial conditions have been tightening. The FCI sits at 97.84 today. The high on the FCI over 2021 was set early February last year at 97.98 as US 10-year rates pushed higher over Q1 from 0.92% to 1.75%. Back then, the tightening of US financial conditions was driven by rising 10-year rates and a stronger USD. Equity performance was solid and corporate credit spreads flatlined over Q1.
The brief tightening of financial conditions over Q1 2021 was not broad-based. However, this time around it is broad-based. Let’s have a look first at the definition of the Financial Conditions Index.
The GS FCI is defined as a weighted average of riskless interest rates, the exchange rate, equity valuations, and credit spreads, with weights that correspond to the direct impact of each variable on GDP. This index is calculated across regions and countries. When one hears ‘financial conditions’, think of these 4 variables (level of interest rates, the exchange rate, equity market levels and corporate credit spreads) but do not forget to link the direction and impulse thereof with the change in economic growth over the medium term. Financial conditions exert an influence on the output gap or deviations of growth (positive and negative) from potential. Over the past 40 years, the GS FCI in the US averaged 100.60. Since the Great Financial Crisis of 2009, the index has averaged 99.60. Expect mean reversion as central banks dial back accommodative policies.
US monetary and fiscal stimulus administrated over the past two years resulted in a positive output gap. However, inflation surprised to the upside as a nasty side-effect from supply chain disruptions. The FED is not taking any chances here. Inflation and inflation expectations require anchoring. Inflation expectations have been normalising. Target achieved. Since the start of the year, 30-year US inflation expectations have dropped by 30bp towards 2.12%. 30-year real rates jumped into positive territory towards +0.12%. That is a rise of about 70bp since early December. Nominal 30-year US rates only rose 50bp, towards 2.24% since then. Market-based inflation expectations re-anchored. The contrast with the popular belief that headline and core inflation will continue to rise is stark.
As if aggressive policy rate tightening over 2022 and 2023, priced by markets and with little push-back by economists, will not have an impact on inflation…and growth. An economic soft landing is expected by markets. Indeed, the rise in long-term nominal rates has been muted and reflects a return to potential growth (1.8% in the US) and on target inflation without any hiccups.
But what happens if the other three components of financial conditions continue to ‘worsen’ or tighten? The impact on consumption and investment over the next couple of years might turn into something worse than currently expected. The recession narrative might make an appearance sooner rather than later.
Indeed, it‘s worth noting that IG and HY credit spreads across the US and the EU have been widening since the start of the year. In cash IG corporate bond markets, across EU and US, we pencil in a rise of approximately 50bp. Across IG CDS indices we are crossing the 70bp markers whereas end of 2021 we printed below 50bp. The nervousness across HY investors is even more visible. Cash spreads in HY have risen 85bp in the US and EU towards 365bp and 345bp respectively. The impact on corporate funding levels is real.
Equity markets seek proof that the upcoming monetary hiking cycle will not lead to a policy mistake that results in a boom-bust sequence. Equity markets have their eye squarely on real rates. All DCF (discount cash flow) models assess sensitivity of growth rates in corporate revenues and expenses as well as cost of capital when discounting future corporate cash flows to the present. The Shiller Cyclically Adjusted PE (CAPE) ratio on the S&P 500 stock index (price earnings ratio that is based on average inflation-adjusted earnings from the previous 10 years) ended the week at 35.59. Over the past 100 years, the mean CAPE PE stood at a multiple of 17. The high was established end of 1999 at a multiple of 44.
Fair enough, across sectors we witnessed a high degree of technological innovation by companies that turn in solid free cash flows and robust profitability. Also, more than a decade of zero interest rate policy (ZIRP) led to a sticky increase in multiples. The number of quality-growth companies outpaced the number of historically defined value company within US main equity indices. Moreover, often, value companies are required to transition into growth companies as their business models get disrupted and challenged by established global quality-growth incumbents. Fact is that US ZIRP and EU NIRP (Negative Interest Rate Policy) was conducive to capital misallocation. The current equity market correction is a healthy adjustment. Expect markets to consolidate as central banks return to normal.
The last factor that might impact financial conditions is the currency. An appreciating currency might weigh on exports but, at the same time, limit imported inflation. So one should see the currency effects as a residual factor. In a globalised trading environment the negative and positive effects across growth and inflation balance out. If history is our guide, expect a less forceful ECB and a steadfast FED. The path of least resistance is USD supportive, setting-up the EURUSD pair for a test of 1.10 over coming quarters.
DM financial condition tightening is broad-based. Adopting a quality bias in portfolio construction is warranted. The bulk of tightening across EM markets took place over 2021. Allowing for a tilt in favour of EM assets can buttress capital preservation over a challenging 2022.
