The failures of Signature Bank, Silicon Valley Bank and First Republic Bank in the US and the speed at which Credit Suisse Group fell into distress and needed rescuing have shocked market participants.
In all these cases, deposit flight was the over-riding reason authorities had to step in. Each bank had a separate reason which led to depositors losing faith in that bank’s solidity. Credit Suisse’s rescue, in particular, highlights that confidence (or more accurately, a lack of confidence) trumps all measures of capital adequacy and liquidity in a sector whose business model is to ‘lend long and borrow short’. This means extending long dated loans such as mortgages to customers (‘lend long’) and financing this activity by taking in deposits from savers who can remove those deposits at short notice (‘borrow short’) if they lose confidence in the bank or can get a better deal elsewhere.
The difference between what a bank receives as interest on its loans versus what is paid out to depositors is, in simplistic terms, the profit a bank generates. Given the inherent maturity mismatch between assets (loans) and liabilities (deposits), the model requires confidence to work, hence the role of regulators.
These bank failures, however, should not be seen as the cause of the banking crisis but, rather, as a symptom of rapid monetary tightening in the west in response to the inflationary pressures being witnessed. Authorities are trying to engineer an economic slowdown, through monetary policy, in order to weaken labour markets, reduce upward pressure on wages and take inflation back down to target. The speed and scale of the interest rates rises during the current upcycle are greater than anything observed during the past 40 years.
Banks have been slow at raising the rate they pay savers and this has enabled banks to benefit from the widening spread between the rising interest rates they charge on loans and the relatively static deposit rates they offer their savers. Savers, however, aren’t stupid. They can see that if they move their savings out of the bank sector and into short-dated government (and investment grade) investments via money market funds they can achieve a significant increase in yield without taking on appreciably higher risk and, in fact, in the case of weaker banks, less risk. This deposit flight from banks to money market funds has been one of the unintended consequences of western central banks’ aggressive interest rate upcycle.
The truism that central banks increase interest rates until ‘something breaks’ seems to have been proven once again.
Whilst western central banks have been doing the early running, in terms of trying to slow economic growth (and thus reduce inflationary pressures) via interest rate rises, it is likely that this baton has now been passed to the bank sector which is likely to continue to tighten lending standards to consumers and companies as a reaction to the stresses now observed. This means that what had started as a deposit flight issue at a very small number of banks, due to company specific reasons, could now morph into a wider issue as banks manage their loan books more conservatively by reducing credit availability, which ultimately impacts end demand.
As end demand falls and pricing power dissipates, corporate profit margins are likely to come under further pressure as productivity falls and companies find that there is an appreciable step up in their interest charges as they refinance the ultra-cheap loans obtained over the past few years. As company management teams battle to preserve profits, layoffs are usually the next shoe to drop.
This all paints a rather bleak picture, however, the issues being faced are nothing like the issues of the 2007-2009 financial crisis. Banks are far better capitalised, and the authorities now have a play book which they can swiftly utilise to stem issues in the finance sector before they become systemic.
As a result of the above, sentiment towards investment assets is low and investors are holding relatively high levels of cash, the economic headwind of higher energy costs has been dissipating, and we now believe headline inflation is likely to fall fairly significantly into year end, thus giving central banks’ the cover they need to cut interest rates.
As a result, we can see light at the end of the tunnel and, in some respects, are getting slightly more positive concerning the investment outlook.
However, with a greater than twenty percent rise in the technology heavy NASDAQ 100 index since the beginning of the year and a below average differential between the yield on riskier corporate debt (‘high yield) and that of safer corporate debt (‘investment grade’), we believe investors have been quick to embrace some of the positives that derive from the likelihood of interest rate cuts to come. Importantly, though, we are not convinced that investors have yet to put enough weight on the negative impacts that will stem from the coming economic slowdown as described above.