Bedrock’s Newsletter for Friday 12th May 2023

Friday 12th May 2023

Despite the uncertainty that gripped markets in March following the collapse of SVB and the emergency acquisition of Credit Suisse, volatility in bonds and equity fell back in April and asset prices were largely range-bound through month-end. Indeed, by the start of May, the VIX (which provides one measure of S&P 500 Index volatility) had reached its lowest level since November 2021. Rising US rates, which drifted higher in anticipation of another Fed hike in May (since delivered at 25bps, lifting the upper band of the Fed Funds to the highest level since 2007, at 5.25%), helped to keep a lid on asset prices even as support came from an easing of financial conditions and reduced worries about wider contagion.

However, on 1 May, First Republic was seized by regulators and sold to JP Morgan – at a huge discount to book causing JP’s stock to pop. This re-ignited fears about risks in US banking and rather spoilt the mood. The decision was made after First Republic reported that it had lost c.40% of deposits in Q1, and came amid widespread speculation about possible asset sales and bids from rival banks that had by then pushed First Republic’s stock down >95% since the start of 2023. Like SVB, uninsured deposits were a large share of the bank’s total deposits (c.70% versus 55% on average for medium-size US banks), and First Republic had also invested in a lot of long duration hold-to-maturity (‘HTM’) bonds on which there were now large unrealised losses due to the increase in US rates this year and last. As a result, it too had suffered disproportionately from the ‘flight to safety’ trend among large deposit holders. This trend had unceremoniously pulled the rug out from under SVB in March – forcing it to sell large chunks of these HTM bonds at the worst possible time (resulting in large balance sheet losses) – and something similar was about to happen to First Republic… But, unlike SVB, First Republic was well-diversified in terms of its borrowers’ characteristics and, seemingly, had been rather better-managed. What is more a consortium of 11 US banks had infused some $30bn into First Republic in mid-March to stem the bleeding. But all of this came to no avail in the end, and on Monday last week First Republic became the largest US bank to fail since 2009.

Unsurprisingly, in the wake of First Republic’s dramatic stage exit there has been considerable volatility on the KBW Nasdaq Bank Index which is made up of mid-size US banks: by the close of trading last Thursday, the Index had sunk -11.5% since trading for the week began. These large index moves are being driven by a handful of companies that are seen as likely contenders to be next in line for failure after First Republic. Most notably, the weak hands include LA-based PacWest Bancorp and Arizona’s Western Alliance, for which trading had to be temporarily suspended last week after their shares fell -50.6% and -38.5%, respectively, on a single day (4th May) amid reports (strongly denied by Western Alliance) that the banks are exploring partial or full sales. Their stocks have subsequently rallied off the former lows (+81.7% and +49.2% respectively last Friday alone), but PacWest Bancorp is now heading back down (-22.7% over yesterday’s session).

Our biggest concern at this juncture is that tight monetary policy is driving financial instability and that financial instability will grow over time given the lagged effects of high rates on balance sheets and the economy. Low liquidity and tight lending standards amid regional bank retrenchment would then result in severely constrained credit conditions for certain already-vulnerable sectors, such as commercial real estate, where mid-size banks have disproportionate exposure. And this could easily spiral out of control with further bank runs and failures, a severe credit crunch, and a wave of corporate defaults. Of course, this is not inevitable; but with core inflation still running hot – and proving ‘sticky’ so far this year – it is hard to see how the Fed can change policy tack soon to get ahead of the risk (while it is also clearly too late to do a meaningful prudential review to address the now-obvious cracks in the system).

As previously mentioned, the Federal Open Market Committee (‘FOMC’) – which is the committee that is responsible for setting US policy rates – met last week and hiked the Fed Funds another 25bps, as expected. On the dovish side, they also chose to remove certain language from their published remarks that had suggested that future hikes should be expected (a change described as “meaningful” by Fed Chair Powell, in case anyone had missed it). But they also sought to dispel the notion (currently priced in to markets with considerable ‘certainty’ through futures) that meaningful cuts are likely before the end of the year. We agree that cuts may be some way off given the strength of the US labour market (another 296K private sector jobs were added in April, the most since July ’22, vs. just 150K expected, according to the ADP’s report of private payrolls) and the resilience of activity levels (ISM’s April Services PMI came it at 51.9 with new orders hitting a healthy 56.1) even if this makes a hard landing more likely down-the-line. Meanwhile, the Q1 results season was hardly awash with negative earnings surprises… indeed, many Big Tech firms beat downbeat predictions. Therefore, while the monetary tightening cycle may now have peaked, that does not mean that monetary easing is just a few weeks away. Moreover, while the Fed acknowledged that the negative trends in lending are already present – according to the Federal Reserve’s Senior Loan Officer Opinion Survey (SLOOS) survey, lending standards in Q1 reached tights not seen outside recession – this does not yet provide sufficient basis for a major policy reversal.

Still, the one piece of data that could yet transform the outlook for the better (from a rates and financial stability perspective, at least) is US CPI. The most recent CPI print for April came in at +4.9% YoY for headline inflation (modestly down from +5.0% YoY in March, <5% for the first time in 2 years) and at +5.5% YoY for core inflation (which excludes energy and food price inflation). On the face of it this does not look good (indeed, it probably isn’t): core inflation has barely budged since the start of the year despite the best efforts of central banks. But there was a glimmer of hope for the doves to chew on when one digs into the monthly data. While core inflation was up +0.41% MoM (or +5.0% annualised), if you strip out used cars and trucks (which had their strongest rise since June 2021) and shelter (which is a lagging indicator and does not tell you much about the direction of travel) you get +0.16%, which is fairly healthy. This explains why in the wake of the data release on Wednesday, treasuries rallied and the tech-heavy NASDAQ hit an 8-month high. It is clearly too soon to get excited about one data point (and one that you have to dig into quite deeply in order to draw positive conclusions from). But it can’t all be doom and gloom…

Or can it? One emerging risk with no upside if it materialises is a possible US (technical) default in the summer (perhaps as early as June). This will occur if the Republican-dominated Congress refuse to approve an increase to the so-called ‘debt ceiling’ above which the Treasury cannot borrow more money. For now, as ever in Washington, it is all about political showmanship: Republicans need to look tough on the Democrats and on high public spending; Democrats need to look tough on the Republicans and invulnerable to their threats. The problem is that with the current depth of the partisan divide, the radicals from both parties will try to hold the centre hostage to their demands and could scupper the efforts of moderate Congressman to build a bipartisan consensus to allow the US government (and the dollar-based global financial system) to continue to function. In 2011, the US suffered a similar fate and it caused chaos in markets (and surprisingly, perhaps, a rally in the USD and treasuries in the end). We fully expect a deal to be done; but there is also a not-insignificant chance that it can only be reached after the ‘default’ has happened for political reasons. We may be in for a choppy few months ahead – even among supposedly ‘risk-free’ assets!

Finally, then, it will come as no surprise given the contents of this letter that we are worried about the outlook from here and we have increased cash holdings and cut credit across developed and emerging markets in response. In addition, we took advantage of the low volatility (and thus cheap option premium) at the end of April to add equity hedges to portfolios. This more defensive set up – which further includes a large allocation to gold and a mix of ultra-long-end US treasuries and short-dated investment grade bonds – should help us to weather the coming storm without giving up on the possibility of strong returns if inflation falls away and the sunny uplands appear rather sooner than we expect.


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