- Equity investors are paying progressively more for downside protection.
- Private credit sector stress has been rising.
- Iran crisis could push up headline inflation considerably.
- Each of these shocks have some potential mitigating dynamic at play.
- But their simultaneous occurrence is going to test the global economy and markets considerably.
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Commentary: Implication of three simultaneous shocks
From a sharp rotation of investor sentiment within the US equity space to rumbles in the private credit universe to the ongoing oil price spike, global markets are dealing with a lot at this point. Taken in isolation, each shock looks manageable, but the simultaneous unfolding of them puts the global economic and markets outlook in jeopardy, we’re afraid.
First, the rotation in US equities. In recent months, investors have become cautious about the high valuation of the top US AI names. The rotation away from tech to blue-chip companies, small-cap, and international markets has changed the momentum of the market. The last two weeks’ Iran war has complicated the picture more, with inflation worries creeping in, hurting the blue-chips. Additional concerns include weak job numbers, and the outlook for a wide range of companies made cloudy by AI disruption.
Some adjustment in the equity markets is healthy, and the degree of risk aversion is modest. The tech-heavy Nasdaq is down barely 5% so far this year, and still up 17% from a year ago. VIX, a key volatility marker is high, but by no means at stress levels. One area to look at is vol skew, which has jumped in recent days, suggesting that investors are paying greater premium for downside protection.
Second, private credit. All it took was a few companies to struggle with their performance, and the private credit ecosystem that has flourished in the past decade came under a great deal of nervous scrutiny. Fears that some funds have lent at the top of the cycle, while expanding exposure to retail investors, and could be incurring substantial losses have mounted lately. From the necessity of gating funds to prevent disorderly investor outflow to questions about how major private credit funds value their portfolio, there has been a sudden chilling in the sector. Banks that have been engaged in funding private credit companies are also being watched closely for potential losses. US banks, in particular, underscore the link between private and public markets.
Private credit is not large enough to cause systemic risk, in our view. While the sector has grown sharply in the past decade, it is not even 5% of the US equity market’s capitalisation. Wobbles in this sector is concerning, but unlikely to be a source of financial instability.
Third, the ongoing oil shock. Even before the events in Iran, the year began with US core PCE inflation exceeding 3%. Headline inflation, meanwhile, had been on a more favourable trajectory, tracking sub-3% since October, and falling below 2.5% in February. Now, with pump prices spiking, up 25% in the last four weeks with more likely to come, inflation markers will point uniformly upward. Beyond energy products, the near-halting of shipments through the Straits of Hormuz threatens the supply of a wide range of chemicals and fertilizer. Of course, an expeditious resolution to the going crisis could cap this risk.
One can come up with a fairly convincing set of mitigating factors to each of these risks. But all three developments taking place simultaneously makes us rather concerned about the shock absorption capacity of the global economy and markets.
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