Bank failures add to a long list of concerns for investors in 2023
Varying expectations about when the Fed will likely reach its rate-hiking cycle’s peak have made for an exceptionally volatile year for stock markets. Developed market equities raced out of the starting blocks at the beginning of the year before coming off sharply in the ensuing months on mounting evidence that the rate hiking cycle may last longer than expected because the economy was proving more robust than anticipated.
US stock market indices have declined some 5% from their February peaks, with the S&P 500 now 3.4% ahead for the year to date (YTD) and the Nasdaq holding onto an increase of 13% after a torrid year for technology stocks last year. The Canadian stock market is marginally in the green for the year so far, with the S&P TSX Composite Index up 0.6% YTD.
Across the Atlantic, European stock markets haven’t been quite as hard hit by the uncertainty regarding the US monetary outlook. The Eurostoxx 50 Index is about 7% higher YTD and 4% off its peak in early March. Meanwhile, the FTSE 100 is down 2%.
This year, the US tech stock market gains have raised concerns that the sector has become overpriced. The S&P 500 Information Tech sector is trading at about 22 times forward earnings, but the sector is likely to be overvalued due to deteriorating quality of earnings. Earnings are being boosted by laying off thousands of workers rather than increasing sales and margins.
A global bank sell-off dominated the headlines in late March when two regional US banks serving niche tech and crypto clients failed, sparking fears of a broader fallout for the banking sector. The two banks seized by Federal Deposit Insurance Corporation were Silicon Valley Bank and Signature Bank, with the former brought down by massive losses on its longer-term Treasury portfolio and the latter shut down because it “failed to provide reliable data and created a lack of confidence in the bank’s leadership,” according to New York State’s superintendent of financial services, Adrienne Harris.
Deteriorating investor confidence also spread to First Republic Bank, a mid-sized lender in San Francisco, which has seen its share price decline by 90% YTD. Urgent attempts to shore up First Republic Bank’s balance sheet haven’t yet been successful. It’s believed US authorities are considering expanding an emergency lending facility for banks to give the bank more time to bolster its balance sheet and survive this crisis of confidence.
A concern stemming from the bankruptcies and emerging vulnerabilities of other regional banks is that venture capital and tech firms will experience a credit squeeze or funding challenges, taking the impetus out of a sector that drives innovation in the global economy.
The US banking crisis then crossed the Atlantic and brought already troubled Swiss Bank Credit Suisse to its knees after depositors pulled an estimated $10 billion from the bank in a week, and its share price tanked to the point of no return.
In a state-backed deal, UBS agreed to buy Credit Suisse for $3.2 billion, and the Swiss government agreed to guarantee 9 billion francs of potential losses. It also allowed UBS to wipe out about $17 billion in Credit Suisse AT1 bonds, assets that don’t need to be paid back if a bank gets in trouble – a move broadly criticized as setting a dangerous precedent in the European banking sector. Ex-CEO of Credit Suisse, Tidjane Thiam, told Forbes that the move would raise the future cost of funding for European banks and US banks were rubbing their hands because of this.
Deutsche Bank has since also appeared at risk of being caught up in the global contagion. But the bank is widely considered to be in a much more sustainable position than Credit Suisse. Nevertheless, its shares declined 9% on Friday after bondholder panic saw the bank’s five-year credit default swaps increase to their highest level since 2019.
The bank quickly moved to bolster investor confidence by redeeming a junior bond at face value. However, it still runs the risk of a deterioration in depositor confidence to the point where there is a run on the bank, which any healthy bank would struggle to survive.The banking crisis has created a conundrum for the US Federal Reserve because they are the first signs that the sharp rise in interest rates over the past year is starting to take its toll at a time when the central bank is firmly committed to maintaining its hawkish stance until inflation comes down materially and it sees signs of an easing in the surprisingly tight labour market.
That’s the big question. Will the Fed keep tightening to fix inflation now that banks are failing? My thought is that they should continue to fix the inflation problem or face a much worse challenge down the road. The payment for years of loose monetary policy has come due.
The Fed’s decision to raise the interest rate by 25 basis points shortly after their demise highlighted that it is still committed to fighting inflation. However, chair Jerome Powell did make reference to the “isolated” problems of a few banks but acknowledged this could undermine depositor confidence in healthy banks. He also assured depositors that the banking system was still “sound and resilient”. Market participants did view the omission of the reference to “ongoing increases” as slightly dovish.
One crucial component of the Fed’s monetary policy tightening program is its quantitative tightening after the central bank’s balance sheet had grown to an immense $9 trillion. The Fed has committed to withdrawing $95 billion monthly from the financial markets until it has sufficiently wound down its balance sheet.
As the biggest buyer of Treasuries, the Fed effectively reduced the money supply by not buying as many securities to replace those that are maturing, amplifying rising rates’ impact on the economy. Société Générale’s head of North American Quantitative Equity Strategies, Solomon Tadesse, has tried to quantify the probable effect of quantitative tightening and estimates that a $2 trillion reduction would be roughly equivalent to 2.4 percentage points of additional increases in the Fed funds rate. “It would have a serious impact,” he said in an interview with the New York Times. However, the Fed remains committed to continuing on its current trajectory and is only likely to change its stance in the event of a full-blown financial crisis.
While other developed market central banks have maintained their hyper-hawkish stances, the Bank of Canada became the first developed market central bank to keep rates on hold in early March despite the monetary policy committee’s concerns that inflation may “get stuck” above 2%. They indicated the bank would raise rates again if necessary but wanted to measure the effects on the economy of previous rate cuts, something some economists would like to see the Fed do because of the lag between rate hikes and their impact on the economy.
Meanwhile, China looks set to maintain its economic turnaround, with the government setting a target of about 5% and some private sector economists expecting as much as 6% growth this year. However, investors remain ambivalent about upping their exposure to China. Thus it’s unlikely that foreigners will up their exposure to levels that prevailed before the Communist Party unexpectedly clamped down on the regulations governing the tech sector. Some mainstream investors still view China’s stock markets, including the Shenzhen, Shanghai, and Hong Kong exchanges with a combined market capitalization of some $20 trillion, as uninvestable.
After getting off to a positive start, with stock markets rallying, both headline and core inflation looking set to continue falling, and the economy possibly experiencing the economic soft landing the developed market central banks have hoped to engineer, the mood has soured as investors have grown more jittery about the outlook for the economy and financial markets. All as the geopolitical risks mount with respect to the US’s relations with China and the protracted war in Ukraine, with Russia committed to claiming territory there, and the prospect of a broader war not out of the question.
This year has been a year of surprises, and it has been a challenge to grasp all the risks that are materializing in a rapidly changing environment where sentiment can shift on a dime. Even in a more stable situation, there are always risks lurking in the markets. Hence, the importance of constructing portfolios that can withstand various scenarios.
Predictions about where the market or economy are going will always be problematic – and now it is even more so. None of us can be 100% sure. However, it’s crucial to remain aware of the environment in which we operate. At this juncture, many causes for concern will likely result in slower hiring, tighter credit, and a generally worse environment for businesses. Going through this slower period of growth or contraction is necessary to rebalance the economy and asset valuations that have been inflated.
Whatever happens, we will continue to invest in high-quality companies to safeguard our client’s wealth while carefully and proactively managing risks.
Garnet O. Powell, MBA, CFA is the President & CEO of Allvista Investment Management Inc., a firm with a dedicated team of investment professionals that manage investment portfolios on behalf of individuals, corporations, and trusts to help them reach their investment goals. He has more than 20 years of experience in the financial markets and investing. He is also the Editor-in-Chief of the Canadian Wealth Advisors Network (CWAN) magazine. He can be reached at gpowell@allvista.ca