Soon after the crisis in UK financial markets in October, current US Treasury Secretary Janet Yellen expressed concerns about the loss of liquidity in the US bond market and one of her predecessors, Lawrence Summers, worried about the lack of access to capital in developing and emerging economies. In late November, Raimondo Amabile, the global chief investment officer at PGIM Real Estate, told the Financial Times that “We are sitting in a market that is close to a credit crunch”.
Just last week, the yield curve’s inversion – which often presages a recession – steepened by the largest margin in more than 40 years. Then, as now, the US Federal Reserve embarked on a campaign to combat inflation with successive increases in interest rates. Fed tightening in the late 1970s and early 1980s led to a brutal recession, and today an unusually large number of economists are predicting one will occur next year.
Deutsche Bank has been making that call since April – the first bank, it says, to do so. Unlike others who see a mild contraction, the bank expects a tough recession. But even if the US sustains only a normal recession next year, it seems “inconceivable that something won’t crack badly in the financial system”, the bank said in its 2023 Credit Outlook released last week.
One area that is vulnerable is private capital, with Deutsche Bank citing the liability-driven mini-crisis in the UK as “an example of the risks in the shadow banking system”.
Indeed, Deutsche Bank said its proxy for highly leveraged corporate non-bank lending standards is “near all-time lows”, giving rise to its expectation that a recession will increase US leveraged loan default rates to 5.6 percent by the end of next year, with a peak of 11.3 percent in 2024. Europe is seen as faring a bit better, with leveraged loan defaults expected to rise to 3.7 percent in 2023 and hit a high of 7.1 percent the following year. Private Debt Investor warns of a similar possibility in our December/January cover story on collateralised loan obligations, which are the main buyers of leveraged loans.
According to Deutsche Bank: “If we see both higher structural spreads and yields and a recession it seems infeasible to us that something won’t fall off the wheel of the shadow banking juggernaut of the last decade.”
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