NEWS headlines are full of bank runs and bailouts, emergency weekend policy-maker meetings and record declines in short-end yields.
These are signs of the system stress that often accompanies periods of financial tightening.
Last week this was reflected in dramatically lower bond yields as US two-year government bond yields fell 75bps. Brent crude oil was off 11.9% and gold gained 5.8%.
The S&P 500 gained 1.4%, while Australia (S&P/ASX 300 -2.8%) and European equities (EuroSTOXX 50 -3.8%) lost ground.
The common thread was a market view that financial shocks would trigger a recession, requiring central banks to reverse course quickly.
Concerns over economic growth and an expectation of lower rates saw a rotation away from resources and cyclicals to growth and bond sensitives.
The consequences for financial markets are too early to call.
Policy makers face a complex challenge of balancing the apparently conflicting objectives of preserving financial stability and fighting inflation.
The impact on equities will be determined by the ability of policy makers to contain risk and the flow-on effects on rates and economic growth.
Potential outcomes range between two poles:
It is natural to compare this situation with the Global Financial Crisis, but there are significant points of difference, which suggest far less risk for markets.
Bank capital ratios and liquidity buffers are far greater than they were in the GFC.
Banks generally are profitable and have scaled back their more volatile business streams.
Policy makers have the available tools and playbooks to respond and there is far better transparency over the interconnected exposures of financial institutions.
There will be companies with weak or more vulnerable franchises. We are likely to see more of these flushed out in coming weeks.
But that does not equate to a systemic crisis.
The key for markets is whether the policy response can restore confidence beyond just patching up funding in the short term, as has so far been the case.
There are two separate financial issues, occurring simultaneously: 1) Credit Suisse and Europe and 2) US banking issues
1. Credit Suisse and Europe
In Europe, pressure on Credit Suisse culminated in a takeover by rival UBS in a government—brokered deal at the weekend.
Credit Suisse had pre—existing issues. It was undergoing a turnaround plan established late last year alongside a capital raising.
There were continuing outflows from the private bank and asset management business. Clients were losing confidence and shifting assets to other groups or into government bonds.
This reduced profitability, crimping Credit Suisse’s ability to wear losses likely to come from running down the troubled investment bank (which was the source of its issues).
The question is now whether the takeover deal restores confidence or whether we begin to see concerns over UBS.
It’s worth noting that UBS is far more profitable and has a much smaller investment bank.
It is important to note that this is not currently being viewed as a broader European banking crisis.
Capital and liquidity requirements are far stronger than they were in the GFC.
After years of restructuring, banks are less exposed to financial market volatility and are more profitable.
There is an estimated EUR400 billion equity buffer in the system compared to requirements.
As a result, credit default swap (CDS) spreads for big global banks have not surged in tandem with Credit Suisse’s.
At this point we don’t expect the Credit Suisse issue to trigger a systemic problem in Europe, leading to a recession.
This could change, but it would require a significant policy failing.
2. US banking issues
The second issue is in the US and has potentially more structural implications.
The issue is a fundamental weakness in the US banking system relating to a high reliance on uninsured deposits for funding and a lower level of regulation on sub-$250 billion balance sheet banks.
The US banking system is highly fragmented.
The biggest banks — those with more than $100 billion in assets — account for about half the asset base.
Then there are about 100 regional banks with $10 billion to $100 billion in assets and some 3500 community banks with less than $10 billion.
The issue is that smaller banks are not heavily regulated. Just over half of all US deposits are insured under a Federal Deposits Insurance Corporation (FDIC) scheme that promises to cover up to $250,000 of a depositor’s funds.
The fundamental problem is that corporate treasurers and high net worth individuals who are “uninsured” are now being far more careful with who they leave their money.
As a result, we have seen substantial deposit runs, with withdrawals continuing even after the FDIC announced that all deposits would be protected.
This is evident in money market funds which saw US$116 billion in inflows this week. It was the fifth-biggest week on record (dating back to 1992).
It can also be seen in use of the Fed discount window, which is the way the Fed provides a liquidity backstop to the financial system.
Last week banks borrowed $153 billion — an all—time record. The week before it was $4.6 billion.
This reflects depositors withdrawing funds and banks needing to seek alternative funding.
The Fed has announced emergency funding to backstop depositors at Silicon Valley Bank and Signature Bank and the creation of a Bank Term Funding Program (BTFP).
This shouldn’t be seen as quantitative easing. It isn’t creating new money and technically it’s lending — not buying.
It should help stabilise markets, but illustrates that the Fed balance sheet is proving hard to shrink.
Treasury secretary Janet Yellen has tried to calm concerns by drawing on provisions that enable the Fed to act in the face of a systemic financial crisis and by insuring SVB and Signature depositors.
This requires a super majority of the FDIC, Federal Reserve, the Treasury Secretary and the President to agree.
This is clearly meant to represent an implicit guarantee on all depositors in banks with more than $120 billion on their balance sheet.
The challenge is they do not have the authority to make that an explicit guarantee. This can only come from Congress.
That is unlikely to happen any time soon. It would probably come with new rules on regulation and be a complex process to legislate.
The problem is no one knows how far potential support from policy makers would extend.
Yellen got tied up in knots in congressional testimony while explaining why depositors in community banks should not move their money to big banks.
The pressure on these smaller banks is likely to prevail, which leads them to draw on the discount window and the new Fed facility which uses par value (not market value) in assessing collateral.
This is not a sustainable solution.
The next bank in the firing line is First Republic which received a $30 billion deposit influx from the largest US banks, which were effectively recycling the deposits they were receiving as First Republic’s customers were leaving.
This is an effort to demonstrate that they believe the deposit guarantee is there.
At this point we are waiting to see which form the solution takes.
The key issue here is not so much contagion risk, as the other banks are receiving extra liquidity and there are not large direct credit exposures to these banks.
Instead, it is the transmission mechanism to the broader economy, since smaller banks are major providers of credit.
Banks with less than $250 billion in assets provide around half of total commercial and industrial loans and 80% of commercial real estate lending. Smaller banks also dominate residential lending.
The concern is these funding pressures could trigger a credit crunch on top of existing tighter financial conditions — driving the economy into recession.
A more benign outlook may be that this credit tightening equates to 25-50bps of a slowdown in GDP growth, helping deal with an economy that has been running too hot. In this scenario the flow-on effects might be limited given tight labour markets.
This could mean that one of the expected 25bp rate hikes from the Fed is removed.
A more bearish view seems to be dominating at the moment given the sharp drop in two-year US government bond yields.
This move was greater than that seen in the GFC and around 9/11. It’s seen by many as a warning bell for recession.
The consensus for US rates now implies no more rate hikes and 100bps of cuts by year’s end.
A number of other signals support a more bearish view:
The exception to a number of recessionary signals is the most recent one — where there would not have been a recession if it were not for Covid.
A lot of people are wary of betting against history.
It is worth stepping back and thinking about why these historical relationships apply.
Essentially, it is a function of the Fed raising rates too hard for too long, effectively over-tightening and creating a recession and large earnings drop.
Initial rate cuts are therefore a reflection of the weakness rather than a positive for the market.
This cycle is somewhat unusual as we have an overlay of the pandemic, excess savings, extremely tight labour market and a recovering China.
While a recession is probably more likely than not, it is still a more complex issue than some traditional indicators would suggest.
The other — more bearish — complexity in this cycle is that the Fed still has not dealt with inflation.
Historically, Fed pivots have usually come when inflation was running between 1 and 2% — not above 4% as it is today.
The latest US CPI data — lost in the noise last week — did not provide relief.
Headline CPI is better at 6% year-on-year as energy declines and three-month annualised is 4%.
But monthly core CPI was firm at +0.45%, underpinned by +0.6% monthly growth — the highest since September 2022.
If you overlay lead indicators on rents, it’s possible to see inflation falling to 4% — but remaining sticky there. That is just not low enough for the Fed to declare victory.
So, this week’s meeting is lineball on a 25bp move. There is a view that deferring a potential hike to May costs very little on the inflation side but could make a big difference on the financial stability side.
For the equity market, the banking issues are bad for financials, but the prospect of fewer rate hikes is good for growth stocks, helping prop up the market last week.
The ECB’s expected 50bp rate hike also got lost in the noise.
It was notable that the forward guidance moved from saying rates need to rise significantly higher for an extended period, to now being data dependent.
In China, the PBOC sneaked in an unexpected cut to the bank reserve ratio requirement on Friday as well. This is seen as an important signal towards supporting growth
Finally, in Australia rate expectations have stepped down materially from 4.15% to 3.40% at the end of 2023, implying no more hikes.
Credit spreads have been widening out, but not yet signalling something more concerning.
There are pockets of stress emerging in some areas, notably commercial mortgage-backed securities (CMBS).
In terms of equities the US, the S&P 500 has held the 3800 support, but still does not look too healthy.
Commodity Trading Advisers — which are used as an indicator of marginal players in equities — have moved quite underweight in US equities, with potentially more to go into quarter end.
The other feature of the market worth noting is the rotation back to growth as expectations have shifted on the risk of recession and the path of rate hikes.
The S&P/ASX 300 underperformed the US due to the fall in resource and energy stocks on global growth concerns.
Crispin Murray is Pendal’s Head of Equities. He has more than 27 years of investment experience and leads one of the largest equities teams in Australia. Crispin’s Pendal Focus Australian Share Fund has beaten the benchmark in 12 years of its 16-year history (after fees), across a range of market conditions.
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