Market Reviews • 20th Apr, 23
A lot of history in one month…
March saw markets dominated by one issue; the banking matters that first arose in the US and have since spread to Europe.
After months of interest rate rises from central banks, a crack eventually appeared in the most interest rate exposed institutions, with Silicon Valley Bank becoming the poster boy for this latest crisis.
- Three US banks have been closed by regulators – Silicon Valley Bank and Signature bank, which were the second and third largest bank failures in US history, along with the smaller Silvergate Capital.
- Beleaguered Swiss lender Credit Suisse was merged by the Swiss authorities into its competitor, UBS, as events in the banking industry spread to Europe.
- Central banks stuck to their inflation fighting focus as both the US Federal Reserve (Fed) and the European Central Bank (ECB) increased interest rates.
- Interest rate expectations have changed significantly as a consequence of these issues, with increased market expectations of rate cuts happening this year. In turn, this has led to gains for bond investors.
- Energy prices had seen further falls following a slowing in expected economic growth, but OPEC surprised markets at the start of April by cutting production by a million barrels which is making the inflation puzzle for central banks even trickier.
Have we not learned our lessons from the financial crisis of 2008? Are we on the verge of another systemic banking collapse?
No, we are not. It’s human nature to look at historical periods to try and make sense of what’s happening today. Therefore, it’s only natural for investors to immediately think of the 2008 financial crisis when they hear news of banks going under.
However, bank failures are not uncommon. In fact, there have been more than 560 bank failures since 2001 in the US alone. Nevertheless, the collapse of Silicon Valley Bank (SVB) stands out, as it’s the biggest bank to fail since 2008.
Firstly, it’s important to highlight that this was no ordinary bank; unlike most banks, the Silicon Valley Bank predominantly took deposits from tech start-up companies in the US. Traditionally, banks make money from lending to their customers. SVB customers did not need loans, as they were getting a wall of money from venture capital investors. The bank decided to try and make some money by buying low-risk government bonds. Unfortunately, bonds decrease in value as interest rates rise.
As the start-up companies were no longer getting floods of cash through the door, they had to start withdrawing their money on deposit to fund day-to-day business operations. The bank then had to sell the bonds at a loss to raise cash to service these customers. Rumours began circulating around Silicon Valley, and clients started to withdraw their money quickly… the rest is history. It’s common practice for banks to take out insurance against potential losses on their bond holdings. SVB had no such insurance. And that’s where they went wrong.
The reality is, it’s a totally different story from banks in the UK and Europe, because they are extremely well capitalised in the aftermath of the 2008 financial crisis. This has led to a big change in behaviour, and these banks now have very high levels of cash in reserve.
In 2010, French bank Société Générale held cash equal to only 5% of its deposit liabilities. But in December 2022, it was 40%. BNP Paribas has gone from 6% to 32%. Deutsche Bank from 3% to 29%. We, like central bankers in the UK and Europe, do not see any systemic issues within the banking sector. The reality is, the banking sector is in a much stronger position today compared to in the past.
We have seen some mixed readings on price rises. Do we still expect them to slow down in 2023?
Yes, we expect inflation to continue to fall throughout 2023. February’s inflation numbers in the UK came in higher than the market expected (surprised to the upside), and no doubt, investors will be concerned that inflation figures have moved back up.
I regularly talk about media noise, which, given the news, will be on full volume about the ravages of inflation. Ultimately, the market believes inflation will trend down, despite the inevitable hiccups along the way.
Here are some examples of why the central bankers, and markets expect inflation to trend down: firstly, supply chains are beginning to normalise after a long period of disruption post-Covid, as companies have hired the required staff to remove backlogs, enabling them to resume normal service.
A variety of different commodities, ranging from oil to cotton, have been falling in price since they reached a peak last year - this is one of the reasons why inflation has begun to fall already. Higher interest rates have led to slower demand for housing, which results in less need for goods to furnish houses, which will help to bring down prices as retailers compete for business by reducing their prices. And lastly, stock or inventory levels at retailers are high due to lower demand, which means we are likely to see increased discounts on goods on sale, which will help bring about lower inflation.
Interest rate rises
Overall, both the banking turbulence and the recent central bank (Federal Reserve or Fed as it is called) meeting in the US (the same applies to the UK and Europe) have sparked a shift in market expectations of interest rate hikes.
Markets currently forecast no further rate hikes, and they expect the Fed to start cutting rates as early as their July meeting. In fact there are three rate cuts priced in for 2023, which would bring interest rates down to around 4.25%, well below the 5.1% indicated by the Fed in their March meeting.
In our view, the Fed is certainly close to the end of its tightening cycle, perhaps with one more rate hike up its sleeve. However, we don’t see scope for rate cuts just yet, particularly as inflation remains high and the labour market is tight. The Fed will most likely cut rates or signal rate cuts when it sees inflation move meaningfully towards its 2% target, or when it sees the economy and labour market sharply weakening.
Energy prices ease
The improvement in sentiment early in Q1 2023 was partly down to the decline that has been seen in energy and, to a lesser extent, food prices. While price levels are still elevated for many energy commodities, they are reaching back towards levels last seen before the Ukraine war which, in turn, is boosting company and household spending power. It is also one of the big drivers behind the trend towards lower inflation. The re-opening of China is having two effects – it is increasing demand for energy but also reducing supply chain pressures.
Oil prices have been declining since they hit a high in August 2022 and by March 2023 they saw levels not seen since before the war in Ukraine (December 2021). OPEC surprised the market at the start of April with a surprise cut in production of a million barrels a day.
Despite the cacophony of overly pessimistic media reporting on market events, we remain optimistic about the outlook for both equities and bonds for the remainder of the year. Inflation is now slowing, and we expect it to continue to moderate for the rest of the year.
As central banks take their eyes off inflation, they will then focus on financial stability. The recent events in the banking sector increase the probability that central banks will reduce interest rates quicker than expected. So we’re expecting rates to begin their downward move towards the end of this year. This will be welcomed by markets, as falling interest rates reduce business costs and increase profits.
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