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20th April 2023
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Market update

A little over a month has passed and investors’ attention has moved on from fretting about the stability of the US and European banking systems, and back to the outlook for the global economy.

Whilst fears of a widespread banking crisis have largely eased, investors are now grappling with the longer-term effects of the collapse of two mid-sized American banks and the forced takeover of Credit Suisse by UBS. I mentioned in my last note that banks might impose stricter lending standards, in an effort to stem their loss of deposits to larger institutions and, or money market funds.

Money Market funds seem to be “winning”.

Why would investors pull money off deposit with their bank and place it in a money market fund, and what is a money market fund?

Well, these funds invest in very short-term (i.e. less than 30 days to maturity) bonds and other similar instruments that pose very little risk to capital and so are deemed to be “near cash”. Whilst high street banks in America, and here in the UK have been very slow to pass on higher interest rates to savers, money market funds now offer highly attractive rates of interest. So much so that money market funds can now be treated as a genuine asset class for investment, rather than just a short-term cash park, for the first time since 2007. Furthermore, money market funds offer daily withdrawals as opposed to banks, which only offer the best rates to those willing to lock up their money for a term period.

There is clear evidence that money market funds in the US are enjoying huge inflows of capital of late:

graph 01

Why does this matter?

Well, loans are the lifeblood of the economy. Companies often use debt to help finance growth, consumers rely on credit to make large purchases, and the global housing market is entirely built on debt.

Lending standards were starting to get stricter before the collapse of SVB and less deposits means that banks have less ability to create new loans. If lending standards continue to tighten, credit growth slows and so does business and consumer spending. The chart below shows that the growth in commercial loans (light green line) follows lending standards by about a year:

graph 02

This certainly doesn’t appear to bode well for loan growth, or the economy, over the coming year or so.

If we wind the scenario forward, a slowing economy increases the risk of loan defaults as borrowers struggle to repay their debts, which has a further negative impact on banks who must bear the losses.

Shouldn’t markets have priced this in?

Financial markets appear to have largely ignored these trends, with equity and bond markets remaining reasonably robust. The commonly held belief amongst investors seems to be that the US Federal Reserve (Fed) and other central banks will step in and cut interest rates at the first signs of trouble.

This was commonly known as the “Fed Put”, a term borrowed from the equity derivatives market where a “put” option effectively puts a floor under potential losses. To be fair, that is exactly what central banks around the world did for much of the decade or so following the 2008 Global Financial Crisis. So, a cohort of investors could be forgiven for believing that this behaviour is now the norm.

As I have said many times before, I can’t see central banks stepping in with rate cuts and I firmly believe that the “Fed Put” is dead. Inflation around the world remains sticky and month-on-month core inflation in the US is still running well above the Fed’s 2% target:

graph 03

I struggle to see how the Fed can remain credible and cut rates in the face of high inflation.

Is the Fed Put really dead?

Of course, I could be completely wrong. Goods inflation in the US has fallen sharply from its peak, shelter is expected to come down as well. However, as shown above, core inflation remains sticky. Should inflation fall more rapidly, then that might give central banks room to pause or stop raising interest rates. Further, the communications from the Fed following their last rate rise did strongly hint that Fed members felt that the hiking cycle is nearing an end. This could bode well for markets.

A counter-argument might be made following the latest release of UK inflation data.  The fastest rise in food inflation in almost half a century allows all of us to experience the ‘reality’ of inflation first-hand.  There is also evidence from companies’ profits announcements that a significant proportion of inflation is driven by companies ‘price-gouging’, i.e., taking advantage of the dominant inflation narrative to increase their profit margins.  Monetarist policies such as increasing interest rates do not impact profit-led inflation.  Nevertheless, the UK’s disappointing inflation numbers will make it harder for the ‘doves’ on the Bank of England’s monetary policy committee - two of the nine members believe interest rate rises have already gone too far - to argue for a pause in interest rate increases, let alone cuts.

However, we need to bear in mind that interest rate rises take time to be felt in the real economy. This hiking cycle has been very aggressive, and the impact of more recent interest rate rises is yet to be felt. As they are, the emerging effects on banks, lending standards and their consequences for loan growth might well start to impact company earnings. 

As ever, the ongoing transition from ultra-low interest rates and inflation to higher levels of both is making the outlook rather difficult to navigate. We remain resolute in our message, which is to rely on long-term diversification and well-constructed portfolios.

Until next time, stay well.


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