Market update report from Investment Director, Steven Lloyd

I signed off my last update warning investors that 2023 might be a roller-coaster of volatility in financial markets. My goodness, the past 2 weeks has certainly been that!

This is not 2008

As you will know, global financial markets have been rocked by troubles in the US, and latterly, the European banking sector. What started off as an isolated incident in a medium sized, provincial US bank, managed to spread to the European behemoth, Credit Suisse. It is important to highlight that there is currently no reason whatsoever to believe that we are on the cusp of another 2008 style banking crisis. Silicon Valley Bank (SVB) was an outlier in both the make-up of its depositors, which were heavily skewed to technology start-up businesses, and its investment book, which was heavily exposed to US Government Bonds.

The point here is that back in 2008, the securities causing the crisis were very complicated in structure and difficult to value. When the underlying mortgages in these securities started going bad, no-one really knew how to value the securities, or, more importantly, which banks had exposure to the bad loans. This resulted in a huge flight of capital from banks and a general seizing of the global financial system.

Today, the issues we have seen are a result of poor management, not toxic investment securities. SVB was without a Chief Risk Officer for a long period of time and Credit Suisse has been under a great deal of pressure for several years now. Therefore, we see the risk of a widespread contagion from the events of a couple of weeks ago as being very limited.

Nonetheless, markets being markets, investors have thrown the baby out with the bathwater and banking stocks have suffered a very challenging two weeks. Almost indiscriminate selling of banks, and fears of wider contagion, has led to steep falls in global equity markets. The UK has been particularly affected as a large proportion of the UK index is made up of big banks and insurers.

Bonds are back

However, it is not all bad. Regular readers will be very aware of our steadfast belief in the benefits of portfolio diversification over the long-term. Many might have thought us blinkered last year when diversification simply did not work. However, bonds have protected portfolios very nicely through the latest bout of volatility as can be seen in the chart below, where the blue line is UK Gilts and the red line is the UK stock market:

As I have said before, investors over the past two decades have come to think of bonds as drivers of return as values were continually pushed higher due to the compression in interest rates and inflation. Those days are now gone, and bonds should now, perhaps, be seen as an insurance policy against market ructions, such as these.

How does SVB affect the outlook?

The questions on the mind of investors now are, is the SVB/Credit Suisse episode just a storm in a tea cup and will the markets movements influence central bank policy? 

Last time, I wrote about how market expectations for the path of interest rates in the US had moved significantly already this year and how we think that has impacted financial assets. Well, the past two weeks has resulted in another aggressive repricing of US interest rates, as can be seen in the chart below:

The green line shows the market expectations for interest rates on March the 8th and the beige line shows the same on the 16th March. We can see that the market now expects far less interest rate rises and for the Fed to start cutting rates much sooner.

But is this realistic? Well, the Fed passed the anticipated 0.25% rate rise on Wednesday 22nd March and markets rose on the news. Whilst some market participants had been calling for a pause or even a cut to interest rates, my view is that anything other than an increase would have raised serious concerns and questions over the Fed’s credibility.

Shortly after the Fed announcement, we heard from the US Secretary for the Treasury, Janet Yellen, who confirmed that the US Treasury was not considering guarantees for all US bank deposits. Given the issues we’ve witnessed, this caused a sharp sell-off into the market close on Wednesday.

Obviously trying to predict what might happen over the rest of the year is little more than educated guess work but, for now, my best guess is that the Fed will stay resolute in its fight against inflation. My sense is that the Fed will be happy to break a few (more) eggs if it means getting inflation back under control on the US.

We should also bear in mind that the recent pressure on banks may impact the economy in other ways. One obvious way this may cause a slowdown in economic growth, perhaps pushing the US into a widely predicted recession, is through tighter lending standards. Banks may wish to appear to be the least dirty shirt, to avoid flight of deposits or investor capital. This could lead to tighter lending standards and less credit growth. Less credit means less spending and so slower economic growth.

And closer to home?

Here in the UK, core inflation came in higher than expected with prices increasing 6.2% year-on-year. The market was looking for an increase of 5.7% and much of the price pressure continues to come from food. Some analysts pin the blame on fruit and vegetable shortages, but other studies indicate that supermarkets are raising prices much faster than the rate of inflation, particularly on their own-brand goods.

In any case, continued uncomfortably high inflation maintains pressure on the BOE and Thursday’s further 0.25% increase in interest rates was widely expected by the markets.

The Office for Budget Responsibility (OBR) predicts inflation in the UK to fall rapidly later this year, but the latest numbers may cause them to pause for thought. The weaker economic outlook in the UK means we are likely closer to peak interest rates than the US, but this entirely depends on the path of inflation from here.

Bargain banks?

Out of every “crisis”, winners and losers emerge. In the US banking sector, some winners are already beginning to emerge. For example, Bank of America received some $25 billion of new deposits from smaller, regional banks in just a few days.

Brave investors might be tempted to go hunting for bargains amongst the larger banks. It is fair to say that some companies, both banks and insurers, have been unduly punished by the market. However, shares of financial companies tend to do well when economic growth is expected to pick up. As I alluded to above and have been warning for a while now, my view is rather less positive on economic growth from here. Whilst there might be some bargains to be had, investors will need to have both a strong constitution and a good deal of patience.

Until next time, stay well.