Market Movements - March 2023

“History doesn’t repeat itself, but it often rhymes.”

Mark Twain

It is this quote, alongside investors’ vivid memories of the Global Financial Crisis (GFC), that is currently causing much anxiety in markets with respect to the recent stress in the global banking system.

There have been many articles, podcasts, and much analysis over the last few weeks examining the collapse of US banks, Silicon Valley Bank and Signature Bank, as well as the shotgun marriage of Swiss banks, Credit Suisse and UBS, last weekend.

As banks and the overall banking system itself is relatively complex, understanding the events that have transpired is not easy. As usual, media headlines and reporters have often been lazy in their accuracy, and in some cases seem simply to be scaremongering.

However, the purpose of this article is not to take a deep dive into the events that have occurred but instead provide an overview of the severity of the situation and what the knock-on impact might be. However, if you are interested in taking a more in-depth look at the subject, I would recommend the following link which provides an expert, but balanced, summary: here

Is this 2008 and, if not, what is different this time?

Clearly, what we have seen within the banking system recently is far from normal however, there are compelling reasons to believe that this is not 2008 all over again.

One should always be careful when stating “this time is different” however, the way the banking system operates and is regulated is fundamentally very different to 2008, as is the current economic environment.

The core differences between now and 2008 can be summarised in three words: capital, liquidity, and transparency.

Capital: the level and ratio of banks’ core ‘Tier 1’ capital (the capital held in bank reserves and used to fund business activities) is 50% higher in the US and more than 100% higher in Europe.

Liquidity: bank balance sheets are far more liquid. This means assets are easily converted into cash without incurring losses. Furthermore, the availability of cash through central bank reserves is also far greater compared to 2008.

Transparency: the assets currently held on bank balance sheets are not complex toxic assets (such as packaged subprime mortgage debt) that were a major part of the GFC. Instead, banks are far more transparent and no longer operate as a black box allowing investors and regulators to clearly see what assets they hold and where potential losses might lie.

What has been the response and what might the impacts be?

As a result of the stress in the global banking system, the response from governments and policymakers has been swift, direct, and substantial. Many of the playbooks and market operations to support banks were formed in the aftermath of the financial crisis and during the more recent Covid crisis, and so were ready and waiting to be deployed quickly to stop further contagion.

It would be foolish to think that there will be no further impact, however, we would avoid extrapolating these too far, as many in the media are.

It is likely that any major medium-term impacts felt in the global economy will likely be driven by a tightening of credit conditions. This is a result of a decrease in banks’ willingness to lend due to an increase in the standards that they are willing to accept when providing loans, reducing the risk of their overall balance sheet. By being stricter they will further shore up their capital positions, again providing further comfort to financial markets that they can weather shocks as well as a less favourable economic environment going forward.

This action has an impact on the economy and ultimately acts as a deflationary force as reduced lending means less money is available for spending and investment, both of which are key drivers of growth.

Ironically, this is what central banks have been trying to achieve over the last 12 months. By raising interest rates, they have been aiming to cool demand and lessen inflation. Unfortunately, and as history has shown in the past, inputs at one end of financial markets rarely lead to smooth and consistent outputs.

Though the intended outcome has potentially been achieved, how it has happened has been far more aggressive and rapid than central banks originally planned. This is illustrated by the fact that we have experienced the fastest rate-rising cycle in history.

Ultimately, this leads us to expect that central banks will be forced to pause and even cut rates earlier than they might have expected, given their mandate to maintain financial stability and contain inflation.

Markets have been quick to price this in. In the US the peak interest rate expectation was 5.5% on the 9th of March, by the 20th of March this had already fallen to 4.5% with rates expected to be below 3% by the start of 2024. Despite this, both the US Federal Reserve and the Bank of England raised interest rates by 0.25% following their latest meeting.

Summary

Overall, it looks likely that recent issues in the banking sector will be largely contained. This has been helped by the increased regulation of banks, their capital requirements, and the swift and substantial action of governments and policymakers. Naturally, we are keeping a close eye on how things progress, yet we feel as though we are through the main part of the crisis rather than on the precipice of a new financial disaster.

Higher lending standards will no doubt impact growth going forwards however, the actual effects could be marginal as banks had already started to tighten credit conditions going into this year. Goldman Sachs Research estimates that in the US, the impact of tighter credit conditions will only lead to a 0.3% drop in fourth-quarter GDP growth (year-on-year) bringing the final figure to 1.2%.

On aggregate, we expect the tightening of credit conditions to be a deflationary force and we believe that central banks will now need to factor this in when making future monetary policy decisions. This could ultimately mean interest rates are near their peak and will potentially be cut sooner than originally thought.

Written by Jonty Brooks

General Disclosures: This article is based on current public information that we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied on as such. The information, opinions, estimates and forecasts contained herein are as of the date hereof and are subject to change without prior notification. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. The price and value of investments referred to in this research and the income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur.