Investment Insights: Crisis of Confidence

“The Depression, which started in 1929 was rather mild from 1929 to 1930. And, indeed, in my opinion would have been over in 1931 at the latest had it not been that the Federal Reserve followed a policy which led to bank failures, widespread bank failures, and led to a reduction in the quantity of money.”

“One of the great mistakes is to judge policies by their intentions rather than their results”

Milton Friedman

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The recent collapse of Silicon Valley, Signature and Silvergate Banks, sale of Credit Suisse to UBS and concerns over banking stress contagion has seen an increase in market volatility and renewed questions and uncertainty around the path of interest rate tightening and economic growth.  We provide some context to what has happened and investment implications as we see them.

 

What just happened?

• • 10 March: the US regulators (the Federal Deposit Insurance Corporation (FIDC)) took control of Silicon Valley Bank (SVB), a technology and private equity focused bank, and placed it into receivership. This was the twelfth largest US bank and largest US bank failure since Washington Mutual in 2008.

• • 12 March: regulators seized control of Signature Bank, a New York based lender to largely real estate and law firms, after a run on the bank. The US Treasury department and FDIC jointly announced they would guarantee all depositors of these failed banks after invoking a “system risk exception” allowing the Government to intervene in the interests of financial stability.

• • 16 March: First Republic received $30bn in deposits from nearly a dozen of the largest US banks following a torrent of deposit withdrawals on contagion spreading from the collapse of SVB and other regional banks.

• • 19 March: UBS (Switzerland’s largest bank) agreed to buy Credit Suisse (the second largest Swiss bank) in an emergency rescue deal sanctioned by the Swiss National Bank aimed at stemming a broader financial crisis.

• • 20 March: the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Federal Reserve, and the Swiss National announced co-ordinated action to enhance the provision of US dollar liquidity swap lines to provide a backstop and ensure the global funding of markets.
  • 21 March: US Treasury Secretary, Janet Yellen, said the US Treasury would do what is “necessary to protect the broader US banking system” and guarantee deposits of smaller banks that pose risk of contagion.

 

Why did this happen?

It is not unusual to see banks fail.  In the last 20-years there has been some 560 US bank failures.  This has slowed dramatically in the last decade with ultra-low rates and loan losses at or close to record lows.  The current round of bank failures has been driven not by credit defaults, but a crisis of confidence and bank runs.

In the case of SVB an over concentration on technology companies and deposit base funded largely from venture capital customers saw a withdrawal of deposits as tech start-ups finding it harder to raise capital withdrew cash and began to invest their funds in higher yielding more attractive risk adjusted alternatives (like government bonds). This resulted in a run on deposits.

In the case of Credit Suisse, the issue was not so much a case of sector or deposit concentration risk given the different regulatory capital accounting and systematic importance of the bank.  Rather, it was a crisis of confidence resulting from a re-appraisal of counterparty risk and depositor behaviour across global banks in the wake of SVB’s failure, and following years of financial restructuring, litigation, management changes, balance sheet losses and mismanagement.  News the bank had found “material weakness” in its 2021 and 2022 financial reporting process and its largest shareholder would not inject any more equity further fueled the situation.

In the days following SVB’s collapse Credit Suisse was losing greater than SFr10 billon of deposits a day according to the Financial Times (19 March).  The problem is with outflows of this magnitude any fears become self-fulfilling, regardless of whether the reasons are correct or not.  This ultimately forced the Swiss government to take action to prevent serious damage to the Swiss and international financial markets given Credit Suisse’s standing as a “global systemic bank”.

 

Market Observations

In many respects, we are not surprised we are starting to see some things break given the aggressive and coordinated nature of the central bank rate moves.  The UK pension Liability Driven Investment (LDI) crisis last September and collapse of FTX in November were also casualties of higher rates and mismatching of assets and liabilities, coupled with perverse incentives and in the worst-case, fraud. We expect there will be further events and failures as the full impact of the moves in credit spreads and valuations is felt.

For markets, the important thing has been the swift action taken by Governments and regulatory authorities to moderate the contagion risk from the fallout to date and stop the crisis of confidence spiralling into a solvency crisis.  The decision to provide an unlimited guarantee to all depositors in the case of the failed US regional banks was important in managing contagion risk and a broader run-on US regional banks.  This has helped alleviate some depositor concerns and slow deposit outflows.  However, news reports of deposit flight from smaller to larger banks means confidence remains fragile, as reflected in the share prices of many of the listed US regional banks which remain down 20-50% YTD.

A growing concern is what the turmoil in the banking sector means for the medium-term availability of credit growth.  In the US, the regional and community banks have been an important driver of loan growth.  Banks with less than $250bn in assets account for roughly 50% of US commercial and industrial lending, 60% of residential real estate lending, 80% of commercial real estate lending, and 45% of consumer lending.   In the US about 70% of US jobs also come from the small business sector who tend to bank with small and regional banks.  Whilst the full impact remains difficult to assess, the risk is it presents a new challenge for the US economy which will impact lending and cause credit and economic growth to slow.

A broader emerging question is how central banks will manage the issue of financial stability whilst continuing to fight inflation by raising interest rates.  In the wake of the collapse of SVB, the US 2-year treasury yield fell over 120bps to 3.84%, their biggest fall since the stock market crash in 1987, and currently sit around 70bps below the US cash rate implying the Federal Reserve will reverse and cut rates later this calendar year.

It seems likely the short end of the yield curve has been impacted by bank deposit holders flight to safety and treasuries, not just a recalibration in economic conditions.  Therefore, at face value the recent moves may be overstating the Fed reversing course and cutting rates so quickly.

Inflation is still a serious issue, proving stickier than expected due to strong labour market conditions and the large job-worker gap.  At a minimum the events of the last week have muddied the policy rates path.  The ECB’s decision to go ahead with a 50 bps rate hike after the collapse of SVB suggests while the rapid rise in rates is breaking things the broader economic data is still too hot and there is more work to do in fighting inflation.

In Australia the added challenge for the RBA is that underlying inflation is proving higher than global peers on the back of better economic momentum.  There are signs supply chains and commodity prices have eased and goods inflation is receding, but services and rental inflation is proving very sticky.  The RBA’s own forecast only has inflation back in the band in mid-2025 based on another 25 bps hike in April.

That said, the Australian economy is more economically sensitive to rising rates given the nature of the housing market and direct link between the higher official cash rate and variable mortgage rates. The RBA has been explicitly cautious of global policy tightening and at a minimum we expect the events of the last week mean financial conditions have tightened and confidence weakened, increasing the probability of a pause and/or lower terminal rate (peak in interest rates).

 

Investment implications

The crisis of confidence and US and Credit Suisse bank runs raises the question as to what are the implications for the major Australian banks?  We believe the direct risks are relatively low and Australian banks have little exposure to the causes that triggered the overseas events given their: 1) lack of concentrated single sector exposure 2) material excess liquidity and deposit franchises are robust and reasonably sticky 3) mark to mark risk is low and they hedge out interest rate risk.

It is also important to recognise that post the GFC lessons, Australia’s regulators significantly strengthened their liquidity, funding, and capital requirements to ensure Australian banks were “unquestionably strong”.  This is something that arguably did not happen with Europe’s banks.   The main risk we see for the Australian banking sector is the second order impacts from widening credit spreads impacting wholesale funding and deposit pricing.  This could lead to an earlier and lower peak in margins but is likely to be a much bigger issue for non-bank lenders.

An area which doesn’t seem to have attracted a lot of mainstream commentary from the SVB collapse is the building financial problems in private equity and private lending. The decision to provide an unlimited guarantee to all deposit holders was important in restoring confidence in the banking sector and got a lot of attention, but it also effectively bailed out large private equity deposit holders as well as retail deposit holders.  We see SVB as a red flag for the potential risks to come in private equity and lending, given the boom in credit growth in this part of the market over the last decade.  The lag between the sharp rise in rates and financial impacts are yet to be really felt through the credit problems and reflected in unlisted private market valuations, in our view.

More generally, the failure of SVB and recent run-in banks highlights the dramatic increase in rates over the last 18 months and rising cost of capital.  At the heart of it, this is the root cause of the stress in financial markets as the ramifications of higher rates, lower risk appetite and lower valuations drive shifts in capital allocation and returns.

It is important to remember only 18 months ago roughly a quarter of all government debt globally had a negative yield.  Investors were paying for the privilege of lending money to governments. Now that there is a decent return on cash – with zero risk; the fallout from this adjustment in the cost of capital is likely not yet complete.

Looking through the short-term volatility and gyrations from recent market developments we see several enduring themes form a portfolio management perspective:

• Firstly, the rising cost of capital will have ongoing implications for valuations, sector returns and broader asset allocation. We remain wary of companies vulnerable to structurally higher interest rates, with a strong preference for companies that are well capitalized, have low leverage, are profitable and generating strong free cashflow.
• Secondly, the risk credit growth and the velocity of money slows seems to be increasing. This has implications for economic growth and increases the probability of a harder landing. To date, earnings growth has proven relatively resilient in the face of higher costs as companies have been able to pass on the impost through higher prices. There are signs this is becoming harder requiring an increased focus on which firms have a genuine competitive advantage and pricing power to navigate a more challenging outlook.
• Thirdly, the risk that something more serious breaks in raising rates versus the risk of not getting on top of inflation is an increasing dilemma for central banks which could lead to a rethink about peak interest rate expectations and quantitative tightening. Whilst they mightn’t explicitly say so, to the extent financial stress and failures destroy demand and take the heat out of inflation without causing broader systemic issues central banks are delivering on their objective.

 

Hamish Tadgell
Portfolio Manager
23 March 2023

Hamish Tadgell and Michael Kordick recently discussed how they are positioning the SGH High Conviction Fund in the current environment. If you missed this webinar, click here to access the recording.

 

 

 

 

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