Tighter credit conditions call for increased selectivity

09 May 2023

Dorothée Deck, Cross Asset Strategist

Please note: This article is more technical in nature than our typical articles, and may require some background knowledge and experience in investing to understand the themes that we explore below.

Key points

  • The recent turmoil in the banking sector will likely lead to a further tightening in bank lending standards, with negative implications for economic growth and asset quality, raising the odds of a hard landing for the economy
  • The current tightness in US lending standards suggests that analysts’ expectations of flat earnings this year remain too optimistic. As such, earnings downgrades by analysts might be on the way, as more companies unveil their trading prospects in the latest quarterly reporting season
  • In the past year, individual stock returns have been highly correlated with each other, driven by common macroeconomic factors, more than company-specific risks. However, the dispersion of equity returns looks set to increase, as investors become more discriminating and reallocate capital into higher quality businesses
  • With risks tilted to the downside, prudence and selectivity are warranted. The article highlights areas of the market that are most sensitive to the credit cycle globally, and have failed to price in the recent tightening in credit conditions 

Tighter credit conditions raise the odds of a hard landing...

While the impact of March’s bank collapses on the real economy will be difficult to quantify, it is fair to assume that they will lead to a further tightening in bank lending standards and lower loan growth. This will likely contribute to a further decline in economic activity, a deterioration in credit quality and more generally an increase in the probability of a hard landing. 

In that context, smaller, riskier and more highly-leveraged companies would find it more difficult to access capital. Lending facilities coming up for renewal would be refinanced at higher rates and more stringent covenants. This would likely lead to more loan delinquencies and wider credit spreads compared with government bond yields. Corporate earnings would also become less predictable.

At the market level, this should translate into an increase in financial assets’ risk premia, more volatility and a higher dispersion of returns.

As shown in the chart, tighter lending standards are usually associated with wider credit spreads, and more uncertainty in companies’ earnings potential (defined below as the coefficient of variation in corporate earnings expectations over the subsequent 12 months). 


Interestingly, bank lending standards started tightening in the US in September 2021, but were not accompanied by a meaningful widening of credit spreads, or an increase in the uncertainty of earnings projections. The dispersion of analysts’ earnings forecasts seems low considering the increased risk of a recession. In other words, despite the recent deterioration in the growth picture, analysts appear to be in agreement in their expectation of flat earnings globally this year, which seems over-optimistic to us.

...and confirms our view that analysts' earnings expectations remain too optimistic

Historically, the trend in lending standards has led earnings growth by about six months (see chart). At current levels, US lending standards would be consistent with a 10% year-on-year decline in US earnings by September, compared with analysts’ expectations of flat earnings for full-year 2023, according to IBES consensus.

This would be consistent with our expectation of a mild economic slowdown. As we get more information about companies’ views on their trading outlook during the first-quarter reporting season in April and May, analysts are likely to reduce their earnings forecasts.


Stock returns are highly correlated with each other at present, driven by macro factors...

In the past year, as the US Federal Reserve has embarked on one of the most aggressive hiking cycles in history, US and European stocks have been driven by macroeconomic factors more than company-specific risk.  

Individual stock returns have been highly correlated with each other, driven by common factors, which has made it more difficult for stock pickers to generate alpha and beat their benchmarks.  

In the past 25 years, higher levels of ‘pairwise’ correlations, or the correlation of returns for one stock against another, have been observed only on three occasions: during the global financial crisis (2008-09), the European sovereign debt crisis (2011-12) and the COVID-19 pandemic (2020-21). It is typical for stocks and financial assets in general to be highly correlated with each other in times of stress (see chart). 


...but the dispersion of equity returns is likely to rise

A similar observation can be made by looking at the dispersion of equity returns in the 12 months to April across 20 sectors globally. The spread between the best performing sector (consumer products and services, up 10%) and the worst performing one (autos and parts, down 22%), remains low by historical standards, at 32%.  

Over the past 50 years, the spread between the performance of the best and worst sectors has averaged 48%, and in November 2021, it reached 78%, with autos and parts up 82% in the previous 12-month period while food and drug retail was only up 4%.  

As we get more clarity on the growth and inflation outlook, as well as the path of monetary policy, equity investors are likely to become more discriminating and reallocate capital away from companies with weak fundamentals, into those which appear best positioned to weather the current market turmoil and trade at a discount to their fair value. This should translate into a higher dispersion of returns within the equity market.

Sectors most at risk from tighter credit conditions

Credit conditions are likely to play a major role in the performance of equities in the coming months. In that sense, the companies most exposed to higher interest rates and tighter lending standards are likely to underperform the broader market.

The chart highlights the areas of the market, excluding financials, which appear to be most vulnerable in that context, ranked according to their financial leverage and interest gearing ratios on the vertical axis. 


The sectors most at risk globally include utilities, travel and leisure, telecoms, media, food and beverages, and food retail. The horizontal axis shows a high degree of correlation between their share price performance and tighter lending standards since the global financial crisis (-65% correlation coefficient for the broader market including financials). 

If credit conditions deteriorated further and there was a severe economic slowdown, those businesses would find it more difficult to access capital. Their interest expenses would also increase, and those with a high operating leverage would be most negatively impacted by a decline in revenues.

Investment implications

While a further tightening in lending standards is likely to ease inflationary pressures, we struggle to see a scenario where it would lead to a significant decline in inflation without causing a recession.  

The impact of tighter credit conditions on the real economy will be difficult to measure, which complicates the task of central banks, as they judge when to stop lifting rates and contemplate rate cuts. This obviously raises the risk of a policy error and the odds of an imminent global recession.  

Therefore, with risks tilted to the downside, prudence and selectivity are warranted. At this stage of the cycle, it is important for investors to focus on companies with strong balance sheets, low financial leverage and stable operating margins through the business cycle, with a preference for large caps over small caps. 

Of the sectors that are most sensitive to the credit cycle globally, our analysis suggests that financial stocks (banks, insurance and financial services), as well as travel and leisure, industrials, and construction and materials show the most significant downside risk. Their share prices have performed more strongly than expected, given their historical relationship with US lending standards since the global financial crisis.  

In this environment, it is sensible for investors to keep hedges in place, to mitigate downside risk in equity portfolios. While bond volatility remains elevated, equity volatility is still low by historical standards. Therefore, hedging strategies can still be implemented at a relatively cheap cost, despite the recent turmoil. 

Finally, building a diversified portfolio remains key, within the equity market and across asset classes. Given the surge in yields over the past year, for now, government bonds appear more appealing than equities over the coming 12 months.


Market Perspectives May 2023

Welcome to our May edition of “Market Perspectives”, the monthly investment strategy update from Barclays Private Bank.