When travelling by air and the pilot announces severe turbulence ahead and that all passengers and crew must be seated immediately and buckle their seat belts even the most experienced air travelers are likely to experience some fear. While we know that planes are designed to withstand just about everything that nature can hurl at them, providing the pilot is skilled in dealing with turbulent conditions, there is always the odd niggling concern based on the extremely rare cases where planes have come to grief in storms.

The emotions many investors are experiencing in the recent and continuing severe turbulence in global financial markets are similar to those unfortunate airline travelers about to hit a pocket of severe air turbulence. Most investors know that financial markets will settle eventually and will recover, but there is that niggling concern that it may be different this time.

Each period of severe turbulence in financial markets is not quite the same as the last. The Asian crisis in the late 1990s was mostly about balance of payments problems, currencies under severe selling pressure and issues with various Asian banks. The dot com boom and bust early this century was a classic “Dutch Tulip” bubble story, extraordinarily inflated values of the shares of so called “new economy” companies on little or no underlying earnings. The 2008 global financial crisis was a story of excessive leverage or borrowing. Far too much US home mortgage debt inflating a massive US home price bubble was part of the story, but the engineering of complex financial securities containing highly leveraged layers with inappropriately high credit ratings and spread liberally in to the assets of financial institutions around the world was another part.

Although all of these periods of severe financial market turbulence over the past two decades have been different, eventually there has been a period of recovery from each of them.

However, It is fair to say that the recovery in economic terms from the 2008 global financial crisis has been the softest, at least as far as most of the world’s developed economies are concerned. Many have struggled all of this decade so far to dig their way out of the recession that followed the global financial crisis and then achieve anything close to long term trend growth. Of the big developed economies and regions the US has managed best, but only after several rounds of unconventional monetary policy easing with the Federal Reserve at times regularly buying government and mortgage debt and pushing its Funds Rate (cash rate) down to near-zero.

While the period of extraordinary monetary policy easing probably helped to ensure that US economic conditions were not a lot worse than they were there is also an uncomfortable legacy from that period. There is a sense that the effectiveness of monetary policy may be much diminished if another economic problem arises. What leeway is there to ease policy further in such circumstances other than have another period of security buying by the Fed and push the Fed Funds rate below zero?
In economies where the struggle to recover after the global financial crisis has been even greater, such as Europe and Japan, central banks have pushed their policy interest rates below zero. The sense of ongoing economic problems engendered by policy rates below zero, however, means that businesses and households far from spending more as the authorities would like are more likely to try and save more. Also banks struggle to lend profitably in a negative interest rate environment. Yield curves tend to flatten almost completely in a negative interest rate environment. Banks typically have a maturity mis-match between their funding and lending and tend to fund short-term at comparatively low interest rate and lend longer-term at rather higher interest rate. This interest margin from lending is the main source of a bank’s profitability.

Part of the concern that has been swirling through financial markets of late relates to this continuing struggle for some of the world’s biggest banks to lend profitably leaving them in a weakened position where they periodically need to keep coming back to shareholders for more capital. Interestingly tighter capital adequacy requirements by regulators are placing these banks under even greater pressure – almost a case of well-intentioned moves aimed at making banks safer, because of the unfortunate timing of their implementation inadvertently making banks less safe.

It is fair to say that unprofitable lending issue is not universal. There is still a positive shape to the US yield curve and also in Australia. Banks in both countries are profitable and should not be tarnished by issues affecting European banks and some banks in Asia.

But when markets are bumping around in severe turbulence it is hard to distinguish the good from the bad. At present, another key factor is adding to investor unease about banks, the lumps and bumps in the oil price. Oil is in oversupply by as much as 1.75 million barrels a day according to the International Energy Agency monthly report. Moreover much of the over-supply in oil is coming from countries who have non-economic reasons to continue lifting supply such as Iran (lifted its oil output 80,000 barrels to 2.99 million barrels a day in January alone); Iraq up 50,000 barrels to 4.35 million barrels a day; and Saudi Arabia, up 70,000 barrels to 10.21 million barrels a day.

As long as oil is in chronic over-supply and the price is very weak, the risk is high of a number of company failures in the energy sector and with it a rash of big bad debts for banks. When there is a glimmer of hope in the oil over-supply story, as there was on a rumour last Friday that OPEC might work to contain supply, the selling in global energy companies and banks subsides briefly. Given OPEC’s recent history of fracturing ability to make any supply-containment deal work, best advice is that it is way too early to unfasten the seat belt buckle just yet. Severe turbulence always passes, but this current bout looks like it has a way to run.