Global turmoil and the middle market

Financial conditions in the United States deteriorated again in May after a pause in late April. The recent selloff across equity markets is indicative of the policy shift at the Federal Reserve, which intends to tighten financial conditions to achieve price stability.

While we continue to make the case that a recession is not imminent—it is more likely a 2023 narrative—falling equity prices in the near term will dampen consumption among higher-income consumers. These consumers are the 40% of households that account for more than 60% of overall spending, which is critical to the sustainability of the current economic expansion.

And that spending is at the core of rising concerns about the durability of the expansion as the Fed hikes its policy rate and draws down its balance sheet while the American public contends with higher inflation.

The RSM US Financial Conditions Index is now more than 1.20 standard deviations below normal as losses in the equity markets pile up, volatility increases and credit spreads widen in the bond market.

All this signals a tightening of financial conditions and the slowing of the propensity to borrow and lend resulting in a drag on economic growth.

Central bankers now accept that monetary policy is transmitted to the economy through the financial markets. To reduce inflation, the Fed pressures interest rates higher, which dampens demand and increases the cost of investment.

Over the past two years, the level of financial accommodation has reached as low as six standard deviations below normal at the depth of the pandemic. It then rebounded to 1.7 standard deviations above normal as money was pumped into the economy, and vaccinations allowed for normal economic interaction.

Since the end of last year, however, the withdrawal of income support by the government and new waves of coronavirus cases have reduced that perceived normalcy, as has Russia’s invasion of Ukraine.

These events—and the acceptance of the eventual slowing of economic activity—are leading to renewed risk aversion among originators of debt and retail investors.

Risk aversion returns

Corporate issuance of investment-grade debt took a hit during the trade war and the global manufacturing recession that preceded the pandemic. Remarkably, issuance bounced back in 2020 as companies took advantage of near-zero interest rates.

Investment-grade issuance has been within $100 billion to $150 billion per month starting last year.

Issuance of riskier high-yield debt, or junk bonds, has been falling since last year. That is perhaps a sign that investors are unwilling to take on risk at a time when returns on more reliable assets were sure to be higher.

It’s a different story for retail investors. The recent plunge in equity markets and nontraditional investments should be a reminder that all investing involves risk and that it was necessary for the Fed to normalize interest rates.

With fixed-income returns so low for such a long time, it was inevitable that asset bubbles would form as investors searched for higher returns. Investors became inured to the potential loss, whether in GameStop, crypto or index funds.

Bitcoin—which has twice lost more than 50% of its value in the past 12 months—was purported to be a hedge against inflation and a store of value. It has turned out to be neither.

Dealing with uncertainty

There are nascent signs that China, after recent economic shutdowns because of the pandemic, is getting back to normal production levels. But the impact on global supply chains will endure long after the reopening as ports deal with a surge in activity. It is almost certain that the logjams of last summer will return as epic congestion in the South China Sea is cleared, and those ships head toward the United States.

When those supply chain bottlenecks are added to rising inflation and the war in Ukraine, uncertainty permeates global financial markets, affecting their pricing and stability.

Equity markets

The S&P 500 index lost roughly 18% of its value between the end of last year and May 19, with technology stocks leading the way.

Volatility has increased above its long-run average, implying reluctance among increasingly risk-averse investors.

Our composite indicator of equity-market performance is now more than two standard deviations below normal, a level reached only during economic or financial crises.

Bond markets

The bond market’s selloff has 10-year Treasury yields now flirting with 3%. Analysis by the Fed suggests that expectations of higher short-term rates have been the predominant factor in the selloff, which seems a logical response to the Fed’s intentions to crush inflation.

The selloff has resulted in higher volatility in the Treasury market and an increase in the cost of funding private debt in absolute terms and relative to risk-free Treasury bonds.

Money markets

The money markets appear to be reacting to changes in monetary policy, with Libor and the floating rate agreements anticipating additional Fed rate hikes. At the same time, an insufficient supply has moderated Treasury bill rates, sending the commercial paper and the TED spread higher.

The result is that risk in money markets is at normal levels while we wait out the disruptions to the supply and demand for short-term financing.