Conditions exist for an equity market crash

History shows that an initial rise in bond yields doesn’t undermine equities. It’s the second rise which kills the bull.

The relationship between the credit cycle and equity markets is well established. The credit cycle has its foundation in bank credit, which expands while economic conditions first recover, then improve, and finally are backed by widening confidence. Bankers are caught up in this changing sentiment, starting with lending caution, increasing confidence in the trading outlook, and finally competing for loans, perhaps targeting rival banks’ customers or lending to businesses and business sectors to build future banking relationships.

This ends with banks cutting their margins to attract business, inevitably fuelling malinvestments. And their balance sheets become highly leveraged in the process. Inevitably, the application of bank credit for other than purely productive purposes fuelling price and wage inflation, undermining business plans, and leading borrowers to demand more credit to bolster cash flows.

Banks now find themselves highly leveraged with the prospect of increasing levels of bad debts, which exposes their shareholders to unacceptable risk. So what do banks do?