In the Eye of the Storm

Look at the headline move in global equities last week and you would have no idea that the financial sector is facing its biggest test since the global financial crisis. Markets were down all of 0.2% and are still up 2% or so year-to-date.

Beneath the surface, however, the signs are quite evident. Banking stocks were down 6% worldwide and 10% in the US, while somewhat remarkably and unjustifiably the tech sector managed a gain of 5%.

This marked divergence fed through to the country level. The UK and Europe fared worst due to the high weightings of banks in their indices, falling 4-5%. By contrast, the US (despite the latest crisis originating there) was up 1% and Asia and Emerging markets were broadly flat.

In bond world, the turmoil was all too apparent. Government bond yields fell back further, particularly shorter dated yields in the US, leaving US Treasuries and UK Gilts up 1.5% and 2.9% respectively over the week. It is notable that government bonds are once again providing a buffer against a risk-off move.

All of two weeks ago, the market was expecting the Fed to push rates up close to 6% from 4.5-4.75% currently. Now, it sees minimal further tightening and rates to be back below 4% by year-end.

So how big a worry is the financial sector? The problems at Silicon Valley Bank have certainly spread faster and further than we and most commentators were expecting. This is in part down to the internet and social media which mean deposit runs on banks can occur far faster these days than in the past.

Indeed, it is shortfalls in liquidity created by the reality and/or threat of rapid deposit outflows, that are at the heart of the problem. Back in the global financial crisis, it was much more of a solvency issue, namely that bank balance sheets worldwide were in much worse shape and stuffed full of toxic subprime mortgage-backed securities.

The good news is that the authorities have acted rapidly to try and stem the current contagion. A shotgun take-over by UBS of the ailing Credit Suisse was announced on Sunday and the central banks have increased the amount of liquidity banks can draw on if needed. The big US banks also injected $30bn into First Republic Bank, another mid-sized regional bank, which has come under marked pressure.

These various actions should help shore up investor confidence and reassuringly European markets are up a little this morning. That said, worries could well continue for some time yet. Some of the regional banks in the US could come under further pressure as deposits are currently only insured up to $250k. Meanwhile, the takeover of Credit Suisse has unexpectedly led to total losses for some of its bond holders, which may concern investors in similar instruments at other banks.

This all comes against the background of central banks tightening policy aggressively in a belated attempt to push the inflation genie back into the bottle. This complicates matters as unlike in the GFC, central banks will be very reluctant to cut rates in a bid to restore financial stability. Indeed, the ECB stuck to its guns last week and ploughed ahead with a 0.5% rise in rates to 3.0%.

This week sees meetings of both the Fed and the BOE and a rate rise of 0.25% is hanging in the balance in both cases. In the US, last week’s numbers showed inflation remaining well above the Fed’s comfort level. While headline inflation eased to 6.0%, the more important core rate continued to run at 5.5%. Against that, the latest banking problems will feed through to a tightening in financial conditions and slowdown in bank lending, reducing the need for further rate hikes to slow the economy.

As for the UK, last week’s Budget should have little impact on the BOE’s deliberations. The main initiatives were aimed at boosting the labour force, through the expansion of childcare support and the abolition of the pension life-time allowance, and business investment through new tax allowances.

While these should all help at the margin to improve the supply side of the economy, their impact on growth near term is likely to be small. Even so, the big picture is that activity looks set to hold up considerably better than had been feared and the official forecast is now that the UK economy will shrink only by 0.2% this year.

We believe a further substantial deterioration in the banking situation is unlikely, even if it cannot be ruled out given confidence is fickle and lies at the heart of the issue. The banking sector is fundamentally in much better shape than back in the GFC and the authorities seem to be taking the necessary action to prevent further marked contagion.

We have been emphasising for a while that equities are set to remain volatile for a while yet and could retrace a further part of their rebound, before recovering again further out. The latest events only make this all the more likely and only serve to highlight the merits of a well-diversified portfolio.

Rupert Thompson – Chief Economist