Can Cockroaches fly solo?

‘…when you see one cockroach, there’s probably more'.

Jamie Dimon, CEO, JP Morgan

Late last week, equity markets retrenched as some US peripheral banks (Zions and Western Alliance) disclosed suspected loan fraud. This comes on the heels of the collapse of First Brands (a US auto part maker) and Tricolor (an auto financing company), a few weeks ago, as well as a 20% three-month selloff for the Blackstone Secured Lending fund. Markets recovered a day after, mostly on positive sentiment after good earnings from US large caps, but also due to a general equity-bullish sentiment permeating Wall Street in the last few weeks.

Yet, simmering underneath are worries about financial stress.

The signs to anyone having a job previous to 2008 are familiar: Failing lenders and questions as to where the risk lies. Jamie Dimon, JPMorgan’s CEO, implied that credit risks don’t come in isolation. Failed companies usually cause stress to their lenders, and the stress tends to ripple across the market. This has been the experience of every major financial crisis recorded. Risk asset rallies masking fragile financial conditions are a dangerous cocktail.

It becomes even more dangerous considering that Private Assets are involved.  It’s no coincidence that the Bank of England has been reportedly considering stress testing private credit (although we can’t help but wonder what the mechanism might look like). The Private Equity market, which flourished in the decade-and-a-half of ultra-cheap financing, is facing harder conditions after interest rates began to rise. Regulators were happy to let them take on a much bigger role post-2008. If they failed, the thinking went, it would not be as bad as the Great Recession, since they weren’t systemic. The problem with PE is two-fold, of course: a) Their transparency requirements are much lower than banks, which means their losses remain undisclosed. b) They are still not independent from the financial system, as they borrow heavily from banks to finance their purchases.

So banks do have risks. And these risks may be compounded by their own Sword of Damocles, unrealised losses after the bond repricing which took place after 2022. ‘Unrealised’ can become ‘realised’ if a bank is forced to sell assets, in case, for example, depositors increase withdrawals. The liquidity challenge remains for banks, especially peripherals. Unrealised losses are not a ticking time bomb, but they can become a serious issue in times of real stress. Still, it would be good to remember that by March (for when the latest data is available), these were about 40% below peak.

What banks don’t have yet is evidence of a serious credit risk buildup. These come from bankruptcies.

There are several mitigating factors:

First: banks with failed loans are holding up.

The credit losses from First Brands and Tricolor are close to each other, and they do reflect a bad auto loan market, a known risk.

But the fact that the bad debtors belong in the same market suggests that the problem is not yet widespread. Both banks rushed to ease investors' minds, reiterated their outlooks. Zions $50m charge is low compared to its balance sheet of $88bn, 0.06% of total assets. Fifth Third Bank, another entity which had $200m at risk in Tricolor, has a balance sheet of $210bn. Both banks will likely recover something.

And at the time of writing, no deposit flight was observed. In fact, Zions, Fifth Third and Western Alliance recovered most of their losses on Monday.

Still, investors may rightly be worried about stresses appearing in other areas. If banks begin to reduce credit (despite rate cuts), it could become an issue. The latest US Small Business Survey showed a sharp reduction in credit availability perception. Which brings us to our Second point. Systemic balancers and tailwinds. In the 2023 peripheral banking crisis, larger banks stepped in to alleviate the pressure. JP Morgan estimates that the top 13 US banks have $200bn in excess capital. And considering a wide push for deregulation, the number could rise significantly, easing the pressure for both the core and the peripheral banking systems.

According to a study by Alvarez and Marshall, another $140bn of capital could be freed immediately if deregulation proceeds.

The central bank, which is now in easing mode, can also readily step in. In 2023, the Fed expanded its balance sheet by $300bn, even as it was raising interest rates. This time around, markets are pricing in two cuts until the end of the year.

What this means for businesses and investors?

This piece, in many forms, has been written countless times by myself and thousands of other analysts: “don’t fear, the problem isn’t too big”. Enron had a nearly-universal “buy” rating right before its collapse.

So no, we will not utter the most poisoned words in the history of finance, “This Time is Different”. Risks are risks, and they could very well accentuate, which is why we continue to monitor this (and every other risky) situation closely. The lesson from history is that there might very well be more “cockroaches” that we would not discover until it's too late. Parochially focusing on one company or sector misses the probability of systemic events.

Having said that, financial systemic events have a financial systemic cure: the central banks’ promise to act quickly as a stabilising force. Over the last 17 years, we have seen that central banks have learned that it’s better to fire the monetary “bazooka” early rather than late. While the Central Bank Put may, at some point, prove ineffective, for the time being, we are confident that financial markets will find it more difficult to panic, knowing that the monetary safety net will be there for them.

So maybe the better entomological question is not whether cockroaches fly solo, but whether the insecticide is strong enough.

Market update

Global equities advanced by +2.5% during the week, supported by easing inflation and strong corporate earnings. In the US, equities rose by +2.8% in GBP terms, driven by upbeat earnings from tech giants and optimism around US-China trade talks. The UK’s equity market climbed +3.1%, buoyed by a softer-than-expected inflation print and a rebound in consumer sentiment. Across the Eurozone, equities were supported by improving PMI data, though gains were tempered by France’s political uncertainty - reflected in the markets. Emerging markets saw renewed interest, as they rose by +2.8%, particularly in Asia, where Chinese equities rebounded on signs of policy support and improving industrial output.

The US 10-year Treasury yield ended the week -1 basis point lower; throughout the week, yields rose, influenced by improved US-China relationship, but fell on Friday as investors digested dovish Fed commentary and lower-than-expected inflation. In the UK, gilt yields declined by -10 basis points following a drop in CPI and despite expectations that the Bank of England may pause further rate hikes. Eurozone bond yields also eased, with German bunds benefiting from safe-haven flows amid geopolitical tensions. In emerging markets, sovereign debt saw inflows as investors sought higher yields in a stabilising rate environment. The relative calm in bond markets reflected a wait-and-see approach ahead of key central bank meetings in early November.

Oil prices rose by +7.7% during the week, amid renewed geopolitical tensions and expectations of tighter supply following US sanctions on Russian oil exports. However, gains were limited by concerns over slowing global demand and rising inventories. Gold experienced heightened volatility, surging early in the week to an all-time high of £3,369 before retreating sharply - the steepest single-day fall since 2013, falling over 6%, with an overall decrease of -2.4% throughout the week.

Macro news

Consumer prices rose 3.8% year-on-year in September, unchanged from August and below analysts’ expectations of 4%. Transport made the largest upward contribution to the monthly change. Core CPI (excluding energy and food) rose by 3.5%, down from 3.6%; the goods’ CPI rose 2.9% (up from 2.8%), while the CPI services annual rate was unchanged in September, at 4.7%. The CPI print increases the likelihood of a rate cut in December.

Sanae Takaichi has been elected as Japan's prime minister by its parliament, making her the country's first female leader. Takaichi's economic agenda is expected to boost fiscal spending by increasing subsidies for electricity and gas bills and raising the defence budget. Monetary policy is likely to be looser, with the Bank of Japan maintaining its interest rates on hold for longer.

The US federal government has now been shut down for over three weeks, making it the second-longest in history at 22 days, surpassing previous standoffs except for 2018–2019. The shutdown has stalled the release of key economic data (including labour and trade figures).

The US blacklisted the Russian oil giants Rosneft PJSC and Lukoil PJSC, while the European Union adopted a new package of sanctions targeting Russia’s energy infrastructure. This includes a full transaction ban on Rosneft and Gazpromneft, as well as a ban on importing Russian liquefied natural gas from 2027.