When policy tightens: Signals from a non-systemic banking crisis

“All will depend on just how bad the financial market strains become. Only a seer or a charlatan would say they knew.”

Société Générale March 2023

Over the past month, we have witnessed intensifying strains within the global banking system. This is, without doubt, the most intense pressure of its kind since the 2008 GFC. Yet, there are only weak echoes to that time, reflecting strong evidence that most of the recent bank closures are idiosyncratic and not systemic in nature, and that the regulators are more adept than they were 15 years ago at swiftly mitigating contagion risks.

There are, however, still signals to be read and investment implications to be garnered. We are now witnessing the implications of very rapid monetary tightening. Something was always going to ‘break’. In this month’s letter, we explain why central banks would do well to recognise that there is now something to balance inflation risks, namely financial instability risks. We also discuss why the economic outlook has weakened, and why the peak in rates will likely be lower than where many had previously forecast, but that the need to grind out inflation pressures could still see monetary policy stay restrictive into 2024.

“We understand the US regional banks are lightly regulated compared to the US international banks and almost all other developed market banking systems.” 

Hasan Tevfik, MST Marquee March 2023

Idiosyncrasies dominate the recent demise of SVB, Credit Suisse and others

In most respects, the closures of Silicon Valley Bank (SVB), Signature Bank (SBNY) and Credit Suisse (CS) all reflect idiosyncrasies that are not indicative of broad-based global systemic issues. As BCA Research notes, “the three US failures so far all had anomalous elements and are therefore not a perfect read-through for their peers who are still among the living.” Balance sheets, both corporate and banking, remain strong across Europe and the US, and deposits are largely a zero-sum game. Of course, banks will likely now need to compete more aggressively to secure their share of a smaller deposit pool, as deposits increasingly seek out the higher returns now on offer outside the deposit system.

Recent developments almost exclusively reflect issues of liquidity (and confidence in the case of CS), not issues of solvency. The actions of the Swiss National Bank, the European Central bank (ECB), as well as the US regulator’s Bank Term Funding Program have, to date, mitigated near-term liquidity issues. The return of some calm to global financial markets suggests there is confidence that recent measures will be effective.

• SVB was essentially a boutique financial group servicing start-ups in the venture capital (VC) eco-system. A surge in capital raisings through 2020 and 2021 from their largely VC clients—appearing as deposits at SVB—were invested in secure, often longer-dated assets. However, interest rate risk went largely unhedged (in contrast to larger banks). As the combination of cash burn through 2022 and rising rates impacted their VC customers, they drew down their deposit balances. This ultimately required SVB to sell its ‘safe’ assets at losses, which was too great for the institution to absorb.
• SBNY was also a boutique financial group, servicing real estate developers and legal and other professional firms. According to BCA Research, the concentrated deposit base was largely uninsured and 20% was in crypto-related assets, thus “poised to bolt for the exits at the first sign of trouble…[and] given that nearly all the rest of the banking system has kept its distance from crypto, other banks’ ability to function as going concerns is immune to its vicissitudes.”
• CS had suffered a culmination of difficulties over recent years that led Swiss regulators to force a sale to UBS as public confidence waned and deposit outflow accelerated. Exposure to multi-billion dollar hedge fund losses in 2020 was followed by alleged mis-selling of higher-risk investments as low risk. Recent revelations in its annual report that there were "material weaknesses" in its internal financial controls and liquidity restrictions by other major banks ultimately led to its demise.

It’s hard to shake off that niggle in the back of one’s mind that the full impact of recent events will take months, and possibly years, to show their full form.

History argues for staying cautious near-term…the risk of financial flare-ups remains

The idiosyncratic nature of these events provides some comfort that a deepening of the recent global banking turmoil should not be our central case looking ahead. This is not only the collective wisdom of the ‘nervous consensus’ being evidenced across stabilising markets, but also from those analysts who were deeply embedded in financial markets through the Asian financial crisis, the GFC and then the European sovereign bond crisis.

Of course, it’s still hard to shake off that niggle in the back of one’s mind that the full impact of recent developments will take months, and possibly years, to show their full form. The risk of financial flare-ups is likely to remain with investors for some time to come.

Monetary policy acts with a lag. We may only now—a year after key central banks started hiking—be starting to see the financial implications of central banks starting late, and moving policy rates rapidly higher, in one of the fastest rate-hiking cycles in 40 years. It was the inverted yield curve in mid-2006, the collapse of New Century REIT in April 2007, and then the woes of BNP Paribas in August 2007, Countrywide in January 2008, Bear Stearns in March 2008 that presaged the full force of the 2008 GFC that culminated in the collapse, or near collapse of Lehman Brothers, AIG, Freddie Mae, and Fannie Mac.

Central banks would do well to recognise that there is now something to balance inflation risks, namely financial stability risk. Inflation risk now has a counterbalance.

Now it’s broken something…will monetary tightening pause?

While a deepening of the global banking turmoil is not our central case outlook for 2023, there are still signals to be read and investment implications to be garnered from recent developments, particularly around risks of further tightening and weakening risk appetite.

Firstly, despite the idiosyncratic nature of recent failures, history shows rapid monetary tightening eventually causes something to break. If it wasn’t these firms, it would have been something else. Until now, the path of least regret for central banks was to ensure the risk that inflation became entrenched was mitigated, and a mild recession was a worthy price to pay. During February, prior to the banking turmoil, expectations for the peak of policy tightening were rising, with some forecasts for the US policy rate to rise above 6%, and the futures pricing for Australia moving over 4%.

But there is now something to balance inflation risks, namely financial instability risk. That is, the risk that the rapid pace of hikes has tightened financial conditions such that further ‘breakages’ will set in train more than a mild recession. Of course, the risk of hiking too little and inflation becoming entrenched has not gone away. It’s just now balanced to some degree by the financial risks of overtightening, not previously evident.

Secondly, the economic and equity earnings outlook has also likely weakened in the wake of recent financial shocks, as risk appetite seems set to diminish. Firms’ willingness to invest and grow – as well as the cost and availability of finance to fund this – and their capacity to carry workers during times of weaker activity, have inevitably fallen.

Indeed, recent weeks have seen central banks soften their increasingly hawkish tone through February. US Federal Reserve (Fed) Chair Powell noted, following its March meeting, that “financial conditions seem to have tightened, and probably by more than the traditional indexes say”. Similarly, central banks in the UK, Australia and Europe all appear to have moved to be more data dependent in their latest meetings in March.

“Financial conditions seem to have tightened, and probably by more than the traditional indexes say”.

US Federal Reserve Chair Powell, March 2023

Worse macro still likely for 2023, but activity has bounced strongly in Q1

The resilience of consumer services demand is hampering the pace of moderation in core inflation. While it has eased, it has arguably proved stickier than central banks would likely have been hoping for.

The challenge of improving growth and sticky inflation

Interestingly, while financial conditions are likely to have tightened, activity across the global economy proved increasingly resilient in Q1. European industrial activity strengthened, the US jobs market remains tight, and China’s activity rebounded.

As the first chart above reveals, global leading indicators of activity, namely composite purchasing manager indexes (PMIs) across manufacturing and services rebounded strongly in Q1, consistent with relatively strong global growth. This reflects a combination of easing supply-chain pressures (which are disinflationary) but also resilient consumer demand, with consumers working through their excess savings post pandemic (which is inflationary).

The resilience of consumer services demand is hampering the pace of moderation in core inflation. While it has eased, it has arguably proved stickier than central banks would likely have been hoping for. The second chart shows, core inflation rates remain well above central bank targets, and their moderation from peaks has been relatively gradual.

Core inflation remains close to its peak, well above most central bank targets

We are comfortable remaining modestly cautious in our tactical positioning … To be more constructive, we need to see signs of a faster decline in inflation and slower consumer spending that fosters a clearer pause in central bank tightening.

So, how should we incorporate recent developments into our portfolio views?

Overall, for policymakers, inflation risks must be balanced by financial risks, and the macro-outlook is arguably weaker. This should mean the path of least regret for central banks has shifted. The peak in policy is likely now lower than where some had forecast. The Reserve Bank of Australia (RBA) is now signalling a pause at 3.6%, below recent prior expectations of 4.35%. The Fed hiked 0.25% in mid-March against prior expectations of 0.50%, and its ‘dot plot’ now signals it may only have one final move, not multiple moves, to go.

Of course, the ‘give-up’ from recognising financial risks with a lower interest rate peak is that taming inflation may mean that central banks will keep these ‘less high’ policy rates at these levels for longer. Depending on how the data unfolds, policy rates may now only start coming down in early 2024, rather than mid to late 2023.

Reflecting this, we remain in the moderately ‘risk-off’ position we adopted on 22 February (see Trimming risk–Resilient growth delays central bank pause). At that time, strengthening growth was leading central banks to pivot more hawkishly as inflation rates were proving stickier than expected. Fortuitously, at this time, we closed our underweight to cash, moved underweight US equities and high-yield credit.

Although the pause in rate hikes now appears more in view, there is potential uncertainty associated with ongoing banking instability, likely additional tightening of financial conditions and its impact on growth, and still elevated equity earnings expectations. This leaves us comfortable remaining modestly cautious in our tactical positioning. Importantly, with a greater focus on valuation across all asset classes, we expect there to be increased variability in security and asset class performance. This is an environment where active management should add value to portfolios.

To be more constructive, we need to see signs of a faster decline in inflation and slower consumer spending that fosters a clearer pause in central bank tightening. Within equities, we need to see a further adjustment in earnings expectations that are more in line with margin and demand pressures that are expected through Q2.

We expect there to be increased variability in security and asset class performance. This is an environment where active management should add value to portfolios.

Our latest views on positioning portfolios (and implementation)

Equities–Modestly underweight, favouring emerging markets and Australia

We moved underweight US equities in February and continue to see better value in some non-US markets, particularly Australia and emerging markets. The US position reflected the strong rally from December-February, which lifted valuations to relatively ‘full-ish’ levels (contrasting relatively attractive valuations in domestic and emerging market equities).

Recent developments have seen us retain these positions, reflecting a range of tailwinds that argue for a more positive tilt and headwinds that argue for ongoing caution.

Tailwinds–We are now 17 months into an equity bear market (against an average of about a year), which means we are closer to finding a baseline from which markets can move sustainably higher. An approaching end to the central bank rate-hiking cycle is widely considered to be supportive as well. Other positive drivers remain in play, including peaking bond yields, China’s re-opening, policy stimulus, and lower European gas prices that have improved the European growth outlook and somewhat eased global inflation risks.

Headwinds–Headwinds include falling economy-wide liquidity, tighter financial conditions, and the exhaustion of post-pandemic excess consumer savings, as jobs markets weaken, and interest costs rise. Equity valuations also appear elevated relative to the consensus macro outlook, while ‘hoped-for’ rate cuts look somewhat optimistic, given the current strength in underlying economies and sticky inflation. Either rates will be higher or earnings growth lower, with particular pressure on profit margins as labour costs move higher.

Fixed income–Maintain overweight, favouring government bonds and quality credit

In February, we added to short maturity (reducing duration) and moved underweight high-yield credit (where the risk of tighter financial conditions could weigh on certain segments of the market). While government bonds have already rallied significantly, they remain an attractive hedge against either a sharper-than-expected macro slowing or re-emergence of financial instability. Should disinflation accelerate and central banks confirm a peak in policy tightening, the option to move more neutral fixed income may present itself.

A recent area of interest for investors has been the domestic bank hybrid market. This follows decisions by regulators in Europe to fully write down CS Additional Tier 1 (AT1) capital hybrid securities to zero (while returning some capital to equity holders). While we have witnessed significant price volatility in European AT1 hybrids, the domestic major bank hybrid market has held up very well with limited price movement.

Importantly, domestic AT1 hybrids also differ in structure and receive a higher rating compared to offshore peers, with an investment-grade BBB- rating by S&P, which is much stronger than the CS hybrids' junk rating. If a bank failure requires a government bail-out, domestic bank hybrids convert into ordinary equity, diluting equity shareholders, rather than being written-off. Moreover, the Australian regulator may not need to fully convert all hybrids into bank equity (noting CS hybrids did not allow for any partial write-down).

Domestic AT1 hybrids also differ in structure and receive a higher rating compared to offshore peers … If a bank failure requires a bail-out, domestic bank hybrids convert into ordinary equity, diluting equity shareholders, rather than being written-off.

Alternatives–Favouring hedge funds and real assets

While we don’t tactically asset allocate alternatives, for those deploying capital, we continue to favour increasing allocations to hedge funds and real assets. For hedge funds, market volatility continues to provide a ripe hunting ground, where mis-pricing has created opportunities across asset classes. For real assets, we believe higher-grade commercial assets (where up-leasing and repositioning is viable) will outperform lower-grade assets. We also like infrastructure for its inflation protection characteristics and ability to capture strong thematics across the energy transition. Private equity is our least preferred alternatives class, albeit 2023 will be an attractive year to deploy new capital.

For equities, a range of 40-60% would be an appropriate deployment that reflects the tension between the age of the equity bear market (and being unexposed to a rally) and caution around current valuations that remain, at best, ‘fair’.

Cash–Scope for deployment in current market

In February, we closed our underweight to cash, signalling a more cautious tactical position. Still, for those deploying capital, we view the current environment as embodying less valuation risk across both equities and fixed income as was the case through much of the past few years. Equity multiples are no longer at historic highs, while the broad-based rise in interest rates has eased duration risk significantly.

Within fixed income, a very high portion of any portfolio could be deployed, in order to capture current relatively high yields, particularly across government bonds, investment grade credit and fixed rate short maturity (while a more cautious view on high-yield credit should be considered). For alternatives, a high portion of allocation into hedge funds and real assets (with a focus on infrastructure, and only moderate allocation to property) could be made, with an even more moderate deployment into undeployed private equity.

For equities, a range of 40-60% would be an appropriate deployment that reflects the tension between the age of the equity bear market (and being unexposed to a rally) and caution around current valuations that remain, at best, ‘fair’. Allocations should favour non-US markets, with a tilt toward defensive versus cyclical exposures.

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