Don't Worry (Too Much) About the Decline in Credit

 | Apr 12, 2017 | 9:00 AM EDT
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The decline in commercial and industrial loans in the U.S. has been on investors' minds as a reason to believe the economy is about to take a turn for the worse. However, these worries probably are not justified, according to analysis published by Oxford Economics, a U.K.-based think-tank.

With banks' first-quarter earnings due to be released soon, this indicator, albeit a lagging one, is more significant in this period than in any other.

Federal Reserve data show that commercial and industrial (C&I) loans declined by 0.2% in February from January and by 0.7% in March from February. On a 13-week annualized basis, total loans contracted by 2.3% as of the end of March, compared with high growth of 8.7% in mid-November, Kathy Bostjancic, head of U.S. macro investor services at Oxford Economics, wrote in a report.

"The decline in C&I loans does not presage an economic downturn, but rather a reflection of last year's slowdown in inventory accumulation and tighter lending conditions, both of which have recently reversed," she said.

There is a close but lagging relationship between loans and changes in inventory levels. Companies need to finance their stock of inventories, and the fall in C&I loans this year seems to be related to a previous downshift in inventory accumulation.

That downshift turned around at the end of last year, which suggests that C&I credit is set to rebound in the coming weeks. "However, the rebound could be short-lived, as the change in inventories trended lower in the first quarter," Bostjancic warned.

On the issue of tighter lending conditions, remember the fears about defaults in the energy sector back in 2015, when oil prices collapsed? In the fourth quarter of that year, banks started tightening their lending standards for the first time since 2012, partly because of the worsening conditions in the energy sector.

Changes in banks' lending standards and in demand for credit lead activity in the C&I loan sector by four quarters, according to Bostjancic. Therefore, the year-ago pullback in the supply and demand for the loans explains the current slowdown in C&I credit.

But over the past six months, as oil prices have recovered, credit tightening by banks and demand for the loans both have moderated. This indicates that the contraction in C&I loans will ease in the coming weeks.

C&I loans also have a close but lagging relationship with capital expenditure. Here, the data must be looked at in conjunction with data about issuance of corporate bonds, because large- and mid-cap corporations rely more on the capital markets to finance themselves than on bank loans.

There was a boom in corporate borrowing from the capital markets in the first quarter by corporations that are rated investment grade and non-investment grades, which suggests that "the spigot remains wide open for corporations," Bostjancic said.

The data indicate that investors worrying that capital expenditures will dry out should not: capex is poised to firm, and it is very possible that some of that corporate borrowing will keep financing share buybacks and dividends.

The issue of falling C&I loans has been weighing on investors' mind for a while, with the bears adding it to their list of reasons why a big correction is on its way. It looks like they might need to take it off, at least for the short term.

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