Bedrock’s Newsletter for Friday 17th March 2023

Friday 17th March 2023

Since the release of our last newsletter, financial markets have been bludgeoned by a confusing mix of still-solid US labour market and inflation data, unexpectedly hawkish comments from Fed Chair Jerome Powell, and the sudden collapse of Silicon Valley Bank (‘SVB’), the largest US bank to fail since 2008. Volatility has plagued all asset classes as a result, but intraday moves have been most extreme in US Treasuries since the tidal wave of outflows from SVB began on Thursday last week. Particularly at the short-end of the curve, there have been some truly massive swings in prices. These moves have taken place as consensus expectations for monetary policy have been hammered on the anvil of US banking instability. Indeed, at one point on Monday, the 2Y treasury yield had fallen a staggering -100bps since the trouble started three (trading) days earlier. The 2Y has remained volatile in recent days, though has recovered some lost ground since the close on Monday, gaining +30bps to reach 4.2% as of this morning. A more stable level for short-term US rates will likely remain elusive until the Federal Open Market Committee (‘FOMC’) meets next week and delivers its policy verdict.
 
The speed of this decline in short-term yields is reminiscent of the Black Monday crash in October 1987. However, we believe that it owes rather more to the painful market scarring from 2008 and to the growth of e-banking, which made a bank run just a few clicks away. The failure of a major, if not ‘systemic’ US bank – SVB was the 16th largest by assets – has inevitably raised the spectre of the Global Financial Crisis (‘GFC’) that took place 15 years ago. The 2008 GFC remains the defining economic catastrophe of our times. Back then, a combination of perverse financial incentives, frenzied innovation, inadequate banking regulations, and individual avarice and incompetence led to a severe credit crunch, a very deep recession, the weakest recovery in history, a ballooning of national debts, a loss of confidence in free markets, and the normalisation of radical monetary policies that we now fall back on whenever investors so much as sneeze. Together with the European Sovereign Debt Crisis in 2011-14, it also importantly led to new banking regulatory frameworks (on both sides of the Atlantic, to different degrees) that have turned the largest commercial banks (HSBC, Barclays, etc.) into little more than boring utilities.
 
But not SVB. SVB was an outlier, targeting growth at all costs. From end-2019 to end-2022, SVB had grown assets and deposits by >200%, hitting respective peaks of $220bn and $198bn (before trouble started). It had achieved this growth by marketing itself as the ‘go-to’ bank for venture capital (‘VC’) and early-stage tech firms and had become heavily exposed to the whole ecosystem there, both in terms of the bank’s assets and its liabilities. By the middle of last year, VC and tech (together with commercial real estate) were among the most distressed sectors globally due to rising rates and tightening lending standards; and SVB’s venture- and tech-heavy balance sheet was coming under pressure. To make matters worse, those who managed the treasury function at SVB had decided to invest the deposits in long-duration bonds (rather than short-duration bonds) and these assets had sold off as rates rose! The only way to stay competitive is for banks to raise deposit rates in line with the wider market, but this put pressure on SVB’s margins because SVB was receiving low coupon returns on the assets that had sold off. The result was that earnings were being squeezed and putting the business at risk. Finally, on Wednesday last week, SVB announced that it would sell some of the long-duration securities, even if this meant reporting a $2bn loss, and began an equity sale to shore up its balance sheet. The reported loss and subsequent equity offer (which were the right thing to do from a solvency perspective) triggered panic, a flood of deposit outflows, and the bank’s failure. In the push for growth, SVB had allowed its deposit base to become highly concentrated in a comparatively small number of large accounts above the FDIC-insured limit ($250K). Most banks have more than two thirds of their deposits in small, fully insured accounts, which are less flighty. But SVB had just 12% of those. Predictably, it was the large depositors who pulled their money out when the bank looked troubled and SVB’s fate was sealed; and, equally predictably, Federal regulators have since agreed to guarantee all of these large deposits anyway. Do people even think about moral hazard anymore?
 
Thus, the failure of SVB was to a large extent an idiosyncratic event that can be blamed on the usual suspects: greed and incompetence. But despite this, the risk of further bank runs and market contagion is real: financial institutions are only ever as strong as the confidence of their deposit holders due to the liquidity mismatches that exist in any fractional reserve banking system; and the collapse of crypto-focused Signature Bank (arguably the most directly comparable ‘at risk’ bank after SVB) on Sunday, and the extreme turbulence in the securities of many US regional banks – e.g., First Republic (down -68.7% this week) – suggest people are indeed worried. Deposits are flowing out from these smaller, less regulated banks and into the more systemically important banks which are more aggressively regulated and thus thought to be safer. However, even these large and well-diversified banks are not free from bouts of investor or depositor panic. The securities of Credit Suisse, for example, sold off sharply this week in sympathy with the US regional banks despite Credit Suisse having next to nothing in common with SVB. The hit was so strong that the Swiss National Bank was forced to step in with the offer of a backstop liquidity facility (effectively saving the institution from any chance of bankruptcy). We expect the debt and equity of Credit Suisse to rebound further and see little chance of the bank defaulting, but more failures among the less-regulated banks cannot be ruled out and the impact of this crisis is likely to be felt in a further tightening of financing conditions going forward.
 
On the subject of financing conditions, it is worth noting that the collapse of the 2Y yield late last week represented a remarkable about turn in a very short space of time. As recently as Tuesday last week, US treasuries were selling off following Powell’s testimony to the Senate Banking Committee, in which he warned that the Fed Funds terminal rate (then c.5.4%) was “likely to be higher than previously anticipated” and that he was “prepared to increase the pace of hikes” to contain inflation. Immediately following this statement, markets had begun to price in a 50bps hike at the March FOMC meeting (on 21-22 March) and futures pointed to a terminal rate of 5.6% (up 20bps from Monday) to be reached in September. Clearly (and as discussed earlier) given the collapse of SVB, this is no longer the case. As of this morning, the terminal rate is expected to reach 4.8% in May and markets are then pricing in large cuts through year-end. What is more, some research houses are even more dovish than markets. For example, Goldman Sachs are forecasting that there will be no more US hikes in the present cycle. However, we beg to differ: with inflation still running at +0.4% MoM, and the US economy having added >500K jobs in January and >300K jobs in February, we do not believe that the Fed is about to pivot. A 25bps hike in March would be our base case with one or two further hikes before summer’s peak. The events of the past 10 days have made monetary policy harder to predict and increase the probability of a hard landing for the economy, but they have not changed the near-term inflation outlook.
 
From a portfolio perspective, we continue to favour a barbell approach in fixed income, incorporating a mix of very short-term and long-term bonds with a modest duration profile overall but a high all-in yield. We also continue to have a negative view of credit risk in general but strongly favour quality financial credit following the indiscriminate sell-off of the past few days. Credit spreads outside financial credit are narrow and offer limited upside and plenty of downside in the event that a hard landing materialising later in 2023. And we think that a hard landing may be the only option available if inflation proves stickier than expected. In such an environment, gold is an obvious place to hide (and so we continue to favour an allocation). Finally, seasonal factors may help to support equities in the near-term and the inflation-hedging properties of equity assets suggest that reducing exposure here could be a mistake. But the equity risk premium has meaningfully shrunk as rates have risen and that is before the impact of higher financing costs have really been felt in the form of revised earnings projections. Crucial in equities in the present environment is to remain diversified across markets and styles and to be opportunistic rather than thematic in selection. ‘Wait and see’ is a respectable strategy when the fog of war is thick.
 


______________________________________