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Do you want the good news or the bad news? Luckily, it is the same either way: one month on, it seems the short, sharp banking crises on both sides of the Atlantic have fizzled out without causing an outright disaster. (Yet).
No sensible investor wants to see a repeat of the 2008 crisis, and the IMF has reminded us that even the thin sliver of that possibility is something that keeps its officials awake at night.
Its regular Global Financial Stability Report noted that financial risks had “increased rapidly” since the previous update in October. Tobias Adrian, director of the fund’s monetary and capital markets department, told the Financial Times that those risks were now “acute” and warned: “The financial system is being tested by the stresses that are being triggered by monetary policy tightening . . . The risk going forward is that the situation could create more stressors for the financial system.”
Sobering stuff. Even without any more blow-ups to add to the list, after Silvergate Bank, Silicon Valley Bank and Signature Bank in the US, as well as Credit Suisse in Europe, asset managers are nervous about what it all means for economic growth. It does not take a genius to figure out that banks are likely to tighten up further on household and commercial lending, potentially with alarming consequences.
The adverse treatment of some Credit Suisse bondholders also points to higher borrowing costs for banks, which is likely — on the margins at least — to constrain the economic recovery on the continent. Bank-reliant commercial real estate is in a tricky spot in both regions.
And, yet, markets have recovered very nicely from the shocks of early March. Regulators assumed control of SVB on March 10. Since then, the S&P 500 has risen about 7 per cent — a nose ahead of global stocks and more than making up for the sell-off just before SVB’s demise. Calm before the storm? Maybe. We all remember that the crisis of 2008 did not happen in one day — it was a tragedy in several acts. But it does seem reasonable to conclude that the string of bank failures has passed without morphing in to something uglier.
David Zervos, chief market strategist at Jefferies, said in a note to clients that he had always been “sanguine” about the risks stemming from that period in early March, albeit with some “nail-biting moments” when bond market volatility exploded. Now, he is feeling vindicated. “Thus far, there seems to be nothing systemic in play,” he said. “I will therefore stick with my initial assessment: The road may be bumpy, but this is not [an] Armageddon moment.”
So how can this be bad news, for equity investors at least? Here to spoil the party is Bhanu Baweja, a strategist at UBS. He points out that a big reason why stocks have rebounded so healthily from the shock of multiple bank failures is precisely because at the time, bond markets responded with such horror.
In part because of investors’ urge to find safety, and in part because some investors were saying that interest rates would stall and possibly even fall quickly to soften the blow of the bank failures, US government bonds rocketed in price, cramming down yields.
“Banking stress proved sufficient to quell the market’s number-one worry: rising rates,” wrote Baweja and colleagues in a note this week. Two-year US government debt yields — the tightest reflection of interest rate expectations — have dropped by more than a full percentage point since early March and other market metrics suggest that investors are anticipating as much as another full percentage point over the coming year.
This increasingly feels like a big overreaction, and one that many investors believe has been exaggerated by unusually high levels of speculation from hedge funds and other quick-firing accounts that had been betting against shorter-dated debt.
As Baweja notes, it “sounds reasonable” that the US Federal Reserve might cut interest rates, until you consider that unemployment is much lower and inflation is much higher than at other points when rate-setters have gone into reverse.
The upshot is that any boost to equities that has come as a mechanical response to lower bond yields in the two asset classes’ tried-and-tested see-saw relationship, is on shaky ground. “Equities are running out of fixed income help here, and we believe it’s once again time to consider buying downside protection,” he said.
This all underlines something that fund managers know, but often struggle to take on board: the game has changed.
“Inflation may fall, but the era of ultra-low inflation is behind us,” said Karen Ward, chief global strategist for Europe at JPMorgan Asset Management. That ties central bankers’ hands and makes it essentially impossible for them to cut rates to get out of spots of trouble, even if they wanted to. (Highly targeted responses to the UK bond market crisis last year, for instance, suggest they do not).
“I don’t think we are going back to the low inflation world we had in the past,” Ward said. “It’s really important for us as investors to recognise that.” If stocks do unravel from here, this whole episode will enter the textbooks as yet another example of the sometimes painful process of accepting this new reality.
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