Interest rates continue to rise, UK inflation has reversed course, and an uninvited guest has crashed the macroeconomic party. Is there any way to know what the future holds?
Well, it's been a bit of a wild ride. The age-old adage that March ‘comes in like a lion’ has proven regrettably true and went a step beyond its quaint meteorological meaning. As snow buried the UK early in the month, equities were pummelled by soaring bond yields, which dampened both demand and stock prices. Then the spectre of another banking crisis arose from the Bay Area mists. Silicon Valley Bank (SVB), a US bank that catered to the tech industry, collapsed following a run on its deposits. Recession risk resurfaced. Bond yields fell. Equities languished.
We’re beginning to gain some clarity on which of the two undesirable scenarios we laid out in last month’s commentary is likely to happen (1. inflation stagnates, so the Federal Reserve can’t cut rates; or 2. interest rates rise, but earnings and valuations stall). At the end of February, markets were expecting the Fed to raise interest rates to 5.5% by late summer. The following weeks brought wild swings in bond markets and the interest-rate expectations embedded in them. Analysts sharply lowered predictions for summer interest rates, which at the time of writing stand at slightly less than 4.5% – a full percentage point lower than what was expected just a few weeks ago. SVB failed, with New York’s Signature Bank close behind. Market participants began to wonder if the possibility of a burgeoning banking crisis was enough to take the Fed’s focus away from inflation.
It wasn’t.
By the fourth week in March, hopes of a quick pivot to looser policy had been dashed. The Federal Reserve and the Bank of England both boosted rates by 25bps, the latter spurred on by the unwanted news that inflation might not have passed its peak; it bounced to 10.4% in February, a far cry from the 9.9% that had been forecast. On the continent, the European Central Bank instituted a 50bps rise.
But it takes economies a while to respond to higher interest rates. See the US: although unemployment ticked up slightly in February, things still aren’t moving in the Fed’s preferred direction. Job openings (a measure of the demand for labour) are much too abundant and far in excess of unemployed people (a measure of the supply), and high wages are allowing households to absorb inflation.
For now, the Fed insists the US economy is strong: it can withstand the shaky tectonics of the banking sector and is not at real risk of recession, committee members asserted at the bank’s March meeting. But businesses are facing sticky costs, and credit for consumers is getting harder to come by. While there’s hope on the horizon for inflation and demand, it’s likely that equity markets are facing a stormy spring. There's just not enough liquidity to let things settle at consistent prices, and, therefore, assets are getting knocked around.
The winds of March continue to blow. Hold on to your hats.
Investment View: Are we doomed to repeat 2008?
The collapse of Silicon Valley Bank initially appeared to be a fairly insular tech-related event. But then came trouble at Credit Suisse, the bailout of First Republic and the failure of Signature Bank. It’s time to ask: will recent events cause another banking crisis?
First things first: our best guess is that they shouldn’t. Silicon Valley Bank was a small US lender, an important player in the start-up world, but ancillary enough to the wider banking industry that its losses could stay relatively contained. A crisis at Credit Suisse sent jitters through the markets, but the bank has since been rescued by Swiss authorities and UBS. Ditto First Republic, a US regional bank that found a coalition of white knights organised by JPMorgan CEO Jamie Dimon, who undoubtedly experienced a bout of déjà vu (legend has it he received the call requesting a bailout for Bear Stearns at his own birthday dinner with his family). Signature Bank was felled, and US regulators stepped in to protect the deposits of those customers who hadn’t participated in the 12 March run on the bank that saw clients withdraw US$10 billion in a matter of hours.
For those of us who’ve seen it before, the facts present as a little bit scary. But therein lies the reason we don’t believe the turmoil will cause widespread problems or crash the economy.
We’ve been here before
Much was made of the 2008 crisis, considered second only to the Great Depression of the 1930s. Markets tumbled, unemployment soared – and bills such as the US’s Dodd–Frank Wall Street Reform and Consumer Protection Act were introduced. Despite the popular cliché, these measures were put in place to prevent history from repeating itself. It is precisely because of the fallout from the ’08 credit crunch that banks find their capital in a better, more protected position today; regulations were created to prevent that pervasive turmoil from happening again. In other words, nowadays banks can withstand harder hits than they were prepared to absorb 15 years ago. These regulations also included new and better protection for consumers: Dodd-Frank in particular introduced the Consumer Financial Protection Bureau – which ensures banks and other financial institutions treat savers fairly.
Who needs to worry?
The Consumer Financial Protection Act in the US and similar legislation elsewhere has rendered depositors less susceptible to losses incurred by bank insolvencies: central bankers and regulators will not allow ordinary depositors to lose money. To paraphrase economist Mohamed El-Erian, depositors are safe: the Fed, the Bank of England and the European Central Bank will do whatever it takes to protect depositors and bank accounts. What this fearful rumbling is really about is the financial markets, and how much these bank insolvencies will hurt investors, both directly (their individual equity and bond holdings) and more widely (could it cause a risk-asset sell-off?). Most investors will have some direct exposure to bank stocks and bonds, as they are a critical part of the financial system (and are generally good at making money in less trying times). These stocks and bonds have taken a hammering recently, as evidenced in the chart below
Systemic symptoms
Ultimately, the Covid-19 pandemic – the shutdown of the global economy, the inability to go out and spend money, euphoria when capitalism came back – made it somewhat inevitable that the world’s financial infrastructure would come under pressure at some point during the journey back to normalcy. Each troubled bank has its own specific problems, but the common denominator is losses on fixed-interest bonds. As central banks have increased interest rates, bond yields around the world have risen, which in turn causes the value of these bonds to fall. Many banks used the influx of deposits made during the pandemic to buy these bonds and have since accrued losses (on paper). The instances in which the banks have failed – SVB and Signature – have been brought on by cases where depositors have panicked and pulled their money, disallowing the time the banks needed to allow bond prices to bounce back up or mature at par.
It's important to keep watching this space. Right now, we think the action of central bankers, regulators and large banks should be enough to avoid a repeat of 2008 and a systemic banking crisis (and a severe sell-off of risky assets). If so, it’s likely the attention of both central bankers and investors will flip back to inflation, which, as this month’s data has shown, remains stubbornly high. However, banking crises are notoriously non-linear and subject to tipping points, so something that feels similar (but not identical to) the experience of 2008 could occur. If the “could” side prevails – if SVB and Credit Suisse have ushered in a wider banking crisis – the battle will be to limit the severity of the recession that would surely result. In such an unknowable and uncertain world, the best defence is to ensure your portfolio is well diversified and that risks undertaken are there with intent and not by accident.
The information and opinion contained in this Monthly Commentary should not be treated as a forecast, research or advice to buy or sell any particular investment or to adopt any investment strategy. Any views expressed are based on information received from a variety of sources which we believe to be reliable, but are not guaranteed as to accuracy or completeness by atomos. Any expressions of opinion are subject to change without notice. Past performance is not a reliable indicator of future results. Investing involves risk and the value of investments, and the income from them, may fall as well as rise and is not guaranteed. Investors may not get back the original amount invested.