A personal view from Ian Stewart, Deloitte’s Chief Economist in the UK.
* Economic downturns in the post-war period have been generally caused by a tightening of financial conditions. Consistent with this picture, recent months have seen a marked tightening of financial conditions caused by rising inflation and higher central bank interest rates.
* What we are seeing today is far milder but, as in 2009, credit has become more costly and scarcer, risk appetite is falling and asset prices have become more volatile. These are classic harbingers of slower growth to come.
* To get a clearer sense of how conditions are changing, my colleague in the economics team, Eduardo Palombo, has developed a monthly financial stress index (FSI) for the UK. The index is constructed using 15 data series on interest rates and government yield spreads, valuations and volatility across six areas of the financial market. A negative reading on the index implies lower than average financial stress and vice versa.
* Government and central bank action to counter the effects of the pandemic created easy financial conditions and put the FSI into negative territory through 2021 and into the spring of this year. Since then, the index has moved positive, denoting rising financial stress. Not every data component is available for October, but Eduardo’s initial estimate shows a marked rise in the index last month (note that the chart available on our blog above contains data to September). October’s reading seems likely to have exceeded the last peak in financial stress seen in April 2020 when the pandemic triggered acute volatility and sell-offs in parts of the equity, real estate and foreign exchange markets.
* October’s increase in the FSI partly reflects rising market expectations for interest rates. This was a phenomenon seen in other developed economies. In the case of the UK, it was greatly accentuated by the destabilising effects of the government’s mini-budget that pushed interest rate expectations, and the yield on UK government bonds, sharply up, and knocked the value of the pound.
* So won’t levels of financial stress fall back now that the mini-budget has been abandoned? After all, UK government bonds and the £/$ exchange rate have more than made up the losses that occurred in response to the mini-budget. Moreover, in the wake of last Thursday’s 75bp rate hike by the Bank of England, the Bank struck a distinctly dovish tone, indicating that UK rates were unlikely to need to rise as high as financial markets were assuming (a peak of around 4.5%-5.0% in UK base rates).
* Some decline in the index does, indeed, seem likely in the short term. But with further interest rate rises on the way, and the UK probably already in recession, financial stress is likely to mount. Not only does financial stress affect activity – weaker activity feeds back into higher levels of financial stress. Rising corporate insolvencies and unemployment, for instance, are likely to affect the pricing and availability of credit. Sharply higher public borrowing can, as recent events confirm, result in bond markets demanding a premium to lend to the UK government.
* The slowdown unfolding across the West has been caused by inflation and the higher interest rates that have ensued. Until there are clear signs that inflation is beaten, and that growth is coming back, we’re likely to be stuck with high levels of financial stress.
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