Multi-Manager People’s Perspectives

It’s a pretty good title for describing the sense of crisis enveloping financial markets after the collapse of Silicon Valley Bank (SVB) brought about significant volatility across equities and bonds. This was a week we expected the headlines would be dominated by the US employment and inflation data, but the macroeconomic events were overtaken by financial stability concerns after SVB and Signature Bank were taken over by US authorities.  

Last week I wrote about the issues at SVB with the bank struggling to meet client redemptions given their balance sheet was loaded with long dated bonds which they were having to sell at a loss. The bank saw $42 billion of withdrawal requests on Friday last week – a huge number for any bank, not least one with ‘only’ $212 billion of assets. With SVB unable to raise equity, the US Federal Deposit Insurance Corporation (FDIC) took control of the bank on Friday, and this led to weekend of intense discussions, including a potential sale of SVB which went nowhere given other banks were not willing to shoulder the potential losses SVB was facing on its book of bond assets. In the absence of a buyer, the FDIC chose the path of guaranteeing bank deposits, beyond the standard $250,000 to protect depositors and avoid bank runs elsewhere.

The New York based Signature Bank was also put into resolution. With combined assets of $300 billion, these are some of the biggest bank failures on record and the biggest since the Global Financial Crisis, so it was no surprise to see significant market fallout. While the US authorities appeared to have quelled systemic risks, there was huge volatility in the share prices of other banks globally but particularly among the US regional banks seen as having the closest business models to SVB.

The equity market volatility was mirrored in bond markets – there was a flight to safety in longer dated bonds while at the short end of the yield curve bonds rallied hard on shifting expectations for the path of interest rates. History shows the Federal Reserve ‘hikes rates until something breaks’ and the collapse of the two banks was very much a consequence of their aggressive rate hiking as well as the banks own liquidity imbalances. Financial markets, having been expecting continued rate hikes from the Fed suddenly shifted from pricing a 25 or even a 50 basis point hike from the Fed on March 22 and further hikes over the year to expecting no hike at all next week and then at least three rate cuts before year end.

The more benign expected path for rates suddenly made shorter dated bonds far more attractive – on Monday the US 2-year bond saw its yield, which moves inversely to price, fall by 61 basis points – the biggest single day move since 1982. To give some context on the shifting expectations on rates, when Fed Chair Jay Powell finished his testimony to Congress last week, Fed Funds futures were pricing 48 basis points of hikes and a terminal (peak) rate of 5.6%. By Monday evening, markets were pricing no hikes at the Fed March meeting, a peak rate of 4.72% and rates ending the year back at 4%.

For now, it appears the measures taken by the Fed and FDIC have stabilised the system and the guarantee on deposits should mean no rush for the exit for clients of the smaller banks. All the same, the phrase “there is never only one cockroach” has been heard a few times this week and it is clear that the rapid hikes in rates have exposed some fundamental issues at some banks, not just in the US but in Europe too. By Wednesday the volatility was focussed around long-troubled Credit Suisse, whose share price fell by 24%, to a level 98% below the peak share price back in 2007. The Swiss National Bank stated that they had no concerns over solvency or liquidity but still offered a $54 billion liquidity line to the bank.

Credit Suisse is very much in the ‘too big to fail’ camp, unlike US regional banks, and is in the midst of a restructuring program that needs time to yield results. But suddenly markets are not in a patient mood. The Fed’s new lending facility for banks, known as the Bank Term Funding Program allows US banks to borrow using long dated bonds valued at par should also give the regional banks some breathing space. Bank stocks have been volatile all week and despite some rallies in the aftermath of central bank interventions, bank stocks have not recovered their losses, including Credit Suisse and the US regional banks seen as peers of SVB.

Our portfolios had no exposure to SVB equity or bonds but the collateral damage across the wider banks has still had some impact. We do, of course, have exposure to the US banking sector via funds such as Pzena US Value, who are overweight financials but in the mega cap banks. The balance sheet of SVB was very different to the major banks. SVB was caught up in wider issues around tech companies drawing down capital held at the bank rather than raising new capital which would have required a new (and likely much lower) company valuation.

In the US, the bigger banks will likely be beneficiaries of the events this week as cash deposits seek the ‘safest’ home while smaller banks will now likely face tighter regulation as some of the rules that were eased under the Trump administration. The Fed will now review the capital and liquidity requirements for banks with fewer than $250 billion in assets while President Biden said he would propose new regulation that would “strengthen the rules for banks to make sure that it is less likely thank this kind of bank failure would happen again”.

So, the big question is whether the events the week will be enough to change the path of interest rates. We are currently in a ‘blackout’ period ahead of the Federal Reserve meeting next week, so financial markets have not had any signals from the Fed as to how their thinking has changed but what is clear is that the Fed’s two areas of focus – the labour market and inflation – are still sending signals that more interest rate hikes are needed. The US inflation data for February, published on Tuesday, showed the pace of prices easing to 6% year on year, in line with expectations.

The driver of inflation has moved from goods to services, which tends to be ‘stickier’. Core inflation, which excludes food and energy actually increased in pace month on month to 0.5% – the fastest in 5 months. The US labour market remains in solid health after non-farm payrolls for February reported at +311,000, ahead of the 225,000 expected. Unemployment rose slightly to 3.7% as a result of labour force participation picking up – i.e. more people are coming back to the workforce as a result of higher wages.

Given the market gyrations during the week the UK Budget was something of a sideshow. Chancellor Jeremy Hunt made use of the ‘windfall’ from lower costs associated with the energy price guarantee than expected to announce some tax and benefit changes designed to promote growth and labour force participation though it appears some fiscal powder is being kept dry to be deployed closer to the next election. The Office for Budget Responsibility forecast the UK would escape recession in 2023 by avoiding two consecutive quarters of economic contraction but still sees the economy shrinking by 0.2% over the course of the year.

The European Central Bank met yesterday and despite the volatility in financial markets stuck to their pre-announced intention to raise interest rates by 50 basis points. Despite trimming their 2023 inflation forecast from 6.3% to 5.3%, the bank said inflation was projected to stay “too high for too long” with core inflation forecasts moving higher. ECB President Christine Lagarde said that it is “not possible at this point to comment on the rate path” but commented underlying price pressures remained strong and upside risks to inflation remain. Lagarde noted that lasting market tensions would be a downside inflation risk, but the European banking sector was in a “much, much stronger position than 2008”.

Where does this leave us? We’re still cautious overall and remain comfortable being underweight equities. We are in more volatile times – as we’ve been saying for some time, aggressive hiking by the Fed, as we have seen over the past 12 months, will inevitably cause ‘accidents’ and unintended consequences. The market is now believing the Fed is virtually done with hikes – but with inflation still well above target and the US labour market still in decent shape they still need to hike rates further – we will know a lot more about this next week. However, their job has become a lot harder now – they don’t want to cause a credit crisis or systemic risks so maybe the pace of hikes will have to ease but inflation is not yet defeated.

We are now 12 months from the initial rate hike in the US – this is the time where history shows the lagged effect of rate hike begins to be felt. Hence the tightening in credit conditions and volatility of the past week should not be a huge surprise and reinforces expectations of weaker economic growth ahead. We were already cautious in our positioning and remain so for the moment, but we do feel that this selloff will create some opportunities once the dust settles.

While systemic risks may well have been brought under control, the consequences in terms of lower provision of credit will have an economic impact. The authorities cannot and will not allow contagion to spread in the banking system but that does not mean there will not be pain for other bank share and bondholders, and we are likely to see elevated volatility in the coming days until (1) there is more confidence that these are isolated incidents and (2) we have greater insight into where interest rates are headed. The economic consequences will take longer to determine, but the barometer has certainly swung back towards a more difficult outlook overall, even if interest rates reach a lower terminal rate as central banks’ balance the fight against inflation with the economic and systemic consequences of their actions.

Scott and I will be hosting a webinar on 13 April to discuss our thoughts the on market moves in the first quarter of 2023, portfolio positioning and our outlook. Please register via this link to join us: Scott and I will be hosting a webinar on 13 April to discuss our thoughts the on market moves in the first quarter of 2023, portfolio positioning and our outlook. Please register via this link to join us.