Banking crisis…what banking crisis?

Following bruising performance of most asset classes last year, 2023 so far has been a roller coaster, although, on balance, both equities and bonds have done well. Global equity markets started the year on a strong footing, registering gains in January. Bond yields fell, sending fixed income prices higher. February was a mirror-image amidst rallying bond yields and stocks coming under pressure. The collapse of the $212 billion tech-lender Silicon Valley Bank (SVB) in the US, followed by further fallout in Europe amidst Credit Suisse’s failure, saw equities weaken in March before clawing back losses to end the month and the full quarter higher.

The Fed’s narrative has been volatile; driving this is rates. Just as markets were ready to call nearing the end of rate hikes, investors were being forced to re-price terminal interest rates higher. This was amidst the bank’s comments around its willingness and ability to re-accelerate the pace of the hiking cycle if necessary, and in the event of the ‘totality’ of data pointing towards higher inflationary pressures persisting. However, bond yields slid sharply in March as the markets priced in the likelihood of central banks having to ease policy in response to the banking sector fallout. As markets took fright, flight to quality saw growth stocks outperform value, supported by falling bond yields. At the sector level, banking shares struggled, with energy and healthcare lagging, whilst (notably) technology stocks posted high-teen gains. Investors would be forgiven for thinking we may have entered the world of quantitative easing (again) given a relentless rally in the tech-heavy Nasdaq – the index sky-rocketed to return 16% in January alone, before retreating and staging a 7% rally between mid-March and the end of the quarter, up just under 12% in the year so far (sterling terms). Profitless tech, long duration assets, bitcoin (and all other rate-sensitive stuff) rallied hard.

Looking back at the recent market developments, ‘tail’ events are evidently becoming more frequent, contributing to market volatility. Back in November last year, markets were buffeted by a sudden bank run and the subsequent collapse of FTX, one of the world’s largest crypto exchanges. A collapse that some called crypto's ‘Lehman moment’ unfolded following mass exodus from FTX. This was soon followed by strains emerging in commercial real estate, resulting in Blackstone’s BREIT, KKR’s KREST and Starwood’s SREIT gating redemptions following elevated investor withdrawal requests gathering pace. We also saw Blackstone’s recent default on Nordic CMBS, a bond backed by a portfolio of Finnish offices and stores, showing signs of stress in the European commercial real estate market amidst rising interest rates.

The fallout from the banking sector in March was the largest bank failure since the 2008 global financial crisis (GFC). Silvergate and Signature banks were the two main banks for crypto companies, whilst Silicon Valley Bank had crypto start-ups, crypto-friendly VC and digital asset businesses as its customers. The shutdown of the crypto banking trifecta followed US bank runs.

A combined liquidity backstop by the US Treasury Department, Federal Reserve and FDIC to prevent bank runs across small and medium-sized banks sent a strong message to the market. Taking steps to shore up confidence in the banking system, authorities launched emergency measures guaranteeing all deposits held at SVB and Signature Bank, whilst the launch of the Bank Term Funding Program lending facility was to ensure liquidity and provision against depositor demands at other banks.

Despite the immediate market panic post SVB (and soon after Credit Suisse), rapid central bank actions to calm markets and shore up confidence appear to have done just that. With the current tightening rate cycle being the fastest and sharpest in decades, there has been much talk about the financial system coming under considerable pressure and things starting to break. What of the rate hiking cycle from here? Recent events highlight the need to carefully consider the lagging impact of higher and rising rates on asset prices and the broader economy. Major developed market central banks continue tightening interest rates in unison in their pursuit to curb the inflationary price spiral, albeit increasingly recognising the need to tread carefully.

The recent banking fallout could prove to be a blessing in disguise. Curtailed credit availability may have allowed central banks to back off earlier than otherwise would have been possible amidst tightening financial conditions, without the Fed (and other major developed central banks) having to lift rates much further.

History never repeats itself, but it does often rhyme – the increasing frequency of anomalous events are pointing to a continuation in the bubble-bursting debt cycle, through tighter financial conditions leading to restricted credit growth and liquidity struggles. Whilst the crisis of 2008 saw a bubble in residential real estate, this time we are seeing commercial real estate and negative cash flow in venture and private equity sectors, as well as the crypto market coming under pressure from higher rates and tighter financial conditions. In the main, the problem is manifesting through liquidity and interest rate (duration) risk.

Following the 2008 GFC, the Dodd-Frank legislation was designed to eradicate Too Big to Fail (TBTF) in order to promote financial stability. Jen Hensarling’s Wall Street Journal remarks resonate today: “Too-big-to-fail institutions have not disappeared. Big banks are bigger, small banks are fewer, and the financial system is less stable. Meanwhile, the economy remains in the doldrums”. With the recent unravelling of the SVB, too big to fail may not be simply about size. As well, Dodd-Frank’s Volker banned banks’ proprietary trading activities, curtailing liquidity. This, many believe, may be the cause of the next financial crisis. For now, poor risk management and inadequate business diversification is to blame for the recent banking fallout, which may prove to be an isolated incident. Or, the crypto banking trifecta failure may be a canary in the coal mine that heralds further impact on the venture capital sector and beyond. Watch the space…

Where do we go from here? Whilst the markets have calmed and the financial system has stabilised (for now), the macro backdrop remains volatile and financial conditions tight. This leads us to believe the risks in the system to be finely balanced. Investors need to be alive to the possibility of further signs of stresses emerging. Central banks remain in a tricky spot: as inflation continues to print high (albeit showing signs of abating) and things are starting to break, central banks will increasingly have to appraise the situation more holistically, as they near the turning point in the hiking cycle. Until then, fasten your seatbelts; it's going to be a bumpy ride.

In the interim, investors may look to draw on tried-and-tested principles that stand the test of time. Let’s remind ourselves of some of them, which should help investors endure:

• Seek value (both valuations and costs matter). Following a boom in growth stocks following the GFC, many investors questioned the relevance and validity of valuations since they did not matter much in a world of low and falling interest rates. Following a drastic change in the rates environment, having a valuation anchor is key. On costs, this is one of the key elements that investors can control – seeking to minimise cost whilst ensuring value for money should help compound returns over time.
• Control your emotions. As markets remain volatile, there is often a temptation to fiddle and to ‘do something’. Oftentimes, the best strategy is to do nothing. Plenty of research has been published over the years around investor inability to time markets as well as limited success in trying to get in and out at the right time. Crucially, missing a limited number of best trading days typically leads to materially inferior performance over time.
• Focus on the long run. Whilst shorter-term outcomes are increasingly difficult to predict, long-term investing tends to generate more consistent outcomes.
• Diversify. Do not put all your eggs in one basket.

Staying the course…

Until next time, stay well.