Further concerns, or crisis contagion?
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Over the past week, investors have had to digest U.S. banking failures and the threatened collapse of a major European bank. This stress has finally underscored the tensions between global central banks’ efforts to tame inflation and growing concerns that further policy tightening will spark a crisis. As we all follow the latest developments, it’s important to consider each of them in context. Ultimately, investors need to decide if these individual/idiosyncratic crises add up to growing concerns, or mark the start of crisis contagion.
How did markets and global economies get here?
While the specific nature of the various bank crises has come as a surprise to much of the market, it should not be surprising that the banking system and broader economy are under pressure from central banks’ rapid withdrawal of liquidity.
Indeed, the origins of the latest crisis are borne from the sharp rise in policy rates over the past year as central banks scrambled to contain inflation. Recall that, rather than react swiftly when pandemic-induced supply chain issues started driving the Consumer Price Index (CPI) higher, eventually accelerating to multi-decade highs, the U.S. Federal Reserve watched from the sidelines, only starting to hike rates in March of 2022. Since then, in the space of just one year, the Fed has raised policy rates by 450 basis points. Similarly, the European Central Bank (ECB) belatedly started tightening policy and has raised rates by 300 basis points since its lift-off in July last year.
Every central bank tightening cycle in history has induced some sort of financial strains. Notably, not only is the current Fed hiking cycle the most aggressive in 40 years, but it's one of the most aggressive in history. The situation in Europe is equally stark—this is the ECB’s most aggressive hiking cycle since its inception in 1999. Until this week, markets had broadly ignored the threats that tightening policy was starting to uncover. The latest turmoil, however, has quickly reminded investors that risk assets simply cannot escape the wrath of monetary tightening.
Quick perspectives on each of the global market tensions.
As of Wednesday, March 15, 2023 at 5:00pm ET.
U.S. banking sector: SVB, SBNY and Silvergate collapse
U.S. commercial banks’ profits have been under pressure from deteriorating asset quality, slowing loan growth and rising deposit rates. Silicon Valley Bank (SVB), Signature Bank (SBNY) and Silvergate, the three banks that have collapsed in the last week, were, however, somewhat unique to the broader banking sector in that their deposit bases were predominantly from the now-struggling technology and crypto sectors. The banks also held an unusually large proportion of customer deposits in fixed income securities which had significantly fallen in value as the U.S. Fed started to push up rates. As market conditions for the banks' clients grew more challenging, they withdrew their deposits en-masse, forcing the banks to realize their fixed income losses.
With these bank failures threatening a loss of confidence in the financial system, on Sunday, March 12, U.S. policymakers announced that all depositors (not just those insured by the FDIC) at SVB and SBNY will have access to all their money. Hopefully, this will prop up confidence among depositors across other U.S. banks, preventing additional bank runs. The Fed also announced a new Bank Term Funding Program which will provide additional funding to banks that run into future liquidity problems, limiting the need for banks to sell underwater securities if deposit declines materialize. If this works successfully, it too should ward off potential future deposit flights.
FOR MORE INFORMATION READ:
Silicon Valley Bank collapse: The big picture
Credit Suisse again in the crosshairs
Financial stresses rapidly shifted over to Europe this week, with concerns about Credit Suisse (CS) accelerating sharply and spilling over into the broader market. While the bank’s issues differ significantly from those of SVB and SNBY, CS’s problems are not new to markets or investors. The bank is in the throes of a significant restructuring plan, meant to stem major losses and revive operations, both of which have been hampered by a string of scandals over the past decade.
With broad concern about the health of the global banking system and the potential for unrealized losses growing, the weakest links in the sector have come under significant pressure—with Credit Suisse sitting at the epicenter. The pressure on CS, which again, has long been facing market scrutiny, quickly spiraled after CS’ top shareholder, the Saudi National Bank, ruled out providing additional funding, responding “The answer is absolutely not, for many reasons outside the simplest reason, which is regulatory and statutory.”
Investors are now waiting to see if the Swiss National Bank’s pledge to provide a liquidity backstop to CS if needed will calm market nerves, as well as how the ECB responds to the crisis at its monetary policy meeting tomorrow, March 16.
From a broad European banking perspective, direct contagion risk from the SVB and Signature bank fallout should have been limited. Not only do European banks have far less presence in areas such as cryptocurrency, fintech and venture capital, the subsectors at the heart of the U.S. banking worries, the European banking sector also holds stronger liquidity positions and lower duration risk than their U.S. peers, with valuation multiples meaningfully less stretched than those of U.S. banks.
Market participants seem to believe that the first step toward relief would be a slashing of interest rates. Unfortunately, with the region facing significant inflation pressures which are even worse than in the U.S, both the ECB and Federal Reserve find themselves in a similar conundrum—cut rates to alleviate current market angst and risk spurring inflation higher, or, alternatively, persist with aggressive rate hikes in order to avoid reinvigorating inflation, but risk accelerating contagion to the broader financial system.
Inflation and jobs data
With central banks’ policy efforts to loosen the labor market and tame inflation at the heart of recent market turmoil, investors need to maintain a watchful eye over those economic data points. Last week, the February U.S. employment report delivered another strong gain in payrolls, while the unemployment rate remained historically low, suggesting that wage pressures—and therefore price pressures—remain strong. The CPI inflation report, released March 14, showed a similarly concerning story, with monthly core inflation rising to its fastest pace in five months. The longer it takes for the labor market to loosen and inflation to fade, the greater the dilemma for central banks will be: Price stability vs. financial stability.
FOR MORE INFORMATION READ:
February CPI: Inflation stays hot
February jobs report: Big picture is one of strength
Where do markets and investors go from here
A week ago, a materially more hawkish narrative from Fed Chair Jerome Powell at his Congressional Testimony had convinced financial markets that the U.S. Federal Reserve could revert to a 50 basis point hike in March. In Europe, with core inflation hitting a new record high in February, expectations for European Central Bank policy had also shifted, with markets pricing in a peak ECB deposit rate of 4%. In light of the bank collapses in the U.S. and the renewed turmoil with Credit Suisse, the policy arithmetic for these two central banks has likely changed. What policy actions they each take at their next meetings (the ECB is meeting on March 16, while the FOMC meets on March 22) will be instructive for the crisis outlook.
Both central banks will need to take into consideration the additional pressures a rate hike could put on the financial system. Of the two, the ECB likely has the tougher dilemma given the immediacy of the CS crisis, coupled with the timing of their meeting.
Expectations for the ECB
With inflation hitting a record high in February, the ECB had essentially pre-committed to a 50 basis points hike in March. Moving forward with that plan while a major European bank is in the middle of a very disruptive crisis could rapidly escalate the situation. Yet, if the ECB does not hike, it could be interpreted as a sign of panic and could also raise further significant concerns about the inflation outlook. As such, the ECB may opt for raising rates by 25 basis points and accompanying the decision with reassuring language about the strength of the European banking sector and the availability of various liquidity facilities. Additionally, they may even offer additional measures such as looser collateral requirements or additional funding. Whether any of those would be sufficient to calm market nerves is an almost impossible read at this stage.
Expectations for the Federal Reserve
While recent market events show that the Fed’s rate hikes have hit segments of the banking system hard, those hikes still haven’t had the desired effect on inflation. Yet, the Fed will likely need to put extra focus on the financial stability side of its mandate. While a rate hike pause could result in a loosening of financial conditions, it would likely be offset by the inevitable tightening in bank lending standards, greater risk aversion, and (now that there is a greater appreciation of the financial stability risks of higher rates) higher rate sensitivity of risk assets. As a result, pausing in March may actually not set the Fed back in its inflation fight. Certainly, with markets already pricing in a pause next week, it would at least settle investors' nerves.
Ultimately, financial conditions will tighten further—either via additional central bank tightening as they try to tame inflation, or via a deterioration in the current banking crisis.
Asset allocation views
Given the sudden realization of risks, investors should ensure their exposures minimize vulnerability to the macro-driven threats. High-quality, defensive assets should be sought out, while diversification will be increasingly important.
Broad U.S. equity markets will likely remain challenged as the twin concerns of risk aversion and economic weakness come to the fore.
- Maintaining exposure to segments which have lower exposure to cyclical sectors and have less stretched valuations will be important, as will focusing on corporates that are able to preserve margins and top line growth via pricing-power.
Within fixed income, U.S. Treasuries and high-quality credit merit portfolio allocation.
- As is already unfolding, bonds are positioned to provide risk mitigation during periods of volatility and risk.
- The negative correlation between stocks and bonds has reasserted itself, and the diversification benefit of fixed income has been restored.
- By contrast, riskier credit segments will likely see fairly significant spread widening over the coming months.
Ultimately, as investors experienced during the COVID crisis, policymaker intervention can be powerful and can completely change the market landscape. Staying invested and waiting for the situation to stabilize, rather than attempting to time an extremely volatile market, remains the best option for reaching portfolio goals.
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