Contagion is ‘spreading’ from banking to real economy

In the week to 20 March, several FTSE 100 companies reported significant drops, according to data from Morningstar.

While it was expected financial companies would suffer from the collapse of SVB and Credit Suisse’s near miss, some of the most affected were non-financials. Shell was down 13%, closely followed by BP, which lost 12.6% over the week. Other non-financials included Burberry and Rolls Royce, which fell 6.9% and 6.5%, respectively.

Industry commentators told Investment Week this “indiscriminate selling” was due to contagion quickly spreading from the banking sector to the real economy.

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But that was something to be somewhat expected, said Richard Hunter, head of markets at interactive investor.

“Banks are often seen as oiling the wheels of the economy, so that any shocks to the established system can result in intense scrutiny on the financial strength of banks in general.”

As a result, almost any other company will feel the pressure as lending is likely to become a lot tighter in the aftermath of SVB and Credit Suisse, which could, in turn, “increase the likelihood of a recession”, Hunter said.

This means all eyes are now on central banks to see how they will react. The ECB increased rates by 50bps last week, but noted the decision did not take into account recent events.

Ben Laidler, global markets strategist at eToro, said while this may be a crisis for only a handful of banks, “the whole financial system will now be more cautious lending and may see tighter regulations” especially in Europe where, unlike the US, the majority of company borrowing is from banks.

Hunter added while the FTSE 100 has “regained some poise”, the events of the last week have erased gains for the year, with the UK’s blue-chip index now down by 1% in 2023, “having only recently hit a record high”.

Oil

Weakness in the banking sector has been felt in other areas of the economy, with several analysts mentioning the case of oil, which is currently down more than 15% year-to-date.

However, banking issues are not the sole culprit. They have added to a perfect storm of geopolitical worries, supply/demand imbalances, oil price volatility and the Russian war in Ukraine, according to interactive investor’s Hunter.

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Susannah Streeter, senior investment and markets analyst at Hargreaves Lansdown, said the weaker oil price reflected on Brent Crude dropping more than 2% to $71 a barrel on Monday (20 March) – its weakest level since December 2021.

She is also worried about ripple effects on the housing market, which has already faced higher interest rates causing prices to “stall or drop”.

“Strong credit lines are vital for companies large and small, to enable them to grow, so worries are growing about what repercussions a potential lending squeeze will have on economies around the world,” Streeter added.

Charles Stanley head of equity research Arthur Castle said investor concerns over a potential banking crisis deepening and spreading to other banks would “definitely impact economic market activity”.

This would, in turn, affect the demand for oil. H continued: “This is why BP and Shell were two of the most sold companies outside of the financial sector last week”.

Castle believes the sell-off from non-financial stocks was largely a reaction to concerns about the impact on the economy, as many non-financials did trade more positively on Monday.

“But, in addition to the concerns around the fundamentals, I would not discount the extent to which the declines reflected broad based selling from investors,” he added. “In times of market stress, correlations tend to increase and so some of the selling likely reflected this.”

Price movements

Russ Mould, investment director at AJ Bell, said the current key elements for market movements are positioning and leverage. Swings in positioning and sentiment will drive near-term movements, “especially if leverage is involved and a positioning is going wrong”.

“Over the long term, fundamentals, such as competitive position, management acumen, balance sheet strength, cash flow and valuation will matter more,” he added. But right now, near-term sentiment is dominating.

“The only question now is whether the damage is limited to the banking sector or whether there is a wider, spill-over effect.”

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Mould added this could develop quickly as when an investment firm with lots of debt has large positions which are becoming stressed, it might be forced to sell assets to “make good on its borrowing”.

This selling would then lead the market to drop further, prompting additional loss of value of the collateral forcing, in turn, even more selling, in somewhat of a vicious circle.

The phenomenon would not be limited to that individual company, he warned. “Asset classes entirely unrelated to the initial problem position(s) can be caught up in the melee – which explains the old market saying about how ‘all correlations go to one’ in a bear market, as distressed sellers just liquidate anything for which they can find a buyer.”

That is why Mould believes during a crisis, nothing else matters other than “who owns what, and who must sell, even if they do not want to wish to do so”.

As a result, regulators and central banks are working towards restoring confidence by providing sufficient liquidity and preventing this vicious circle from developing further.

But  eToro’s Laidler highlights a silver lining.

The “faster-than expected growth slowdown” will mean inflation will fall quicker, bond yields will be lower and interest rates will be cut sooner.

“This is a relief to those sectors with higher valuations, like tech and healthcare. It also brings forward the long-awaited stock market catalyst of lower interest rates,” he added.