Log inWhen TINA went missing and the banks were exposed – 27th March 2023 from Jilly Mann
With banks in trouble again and grabbing the headlines, it’s understandable that many will be feeling a sense of déjà vu. However, lurid though the headlines are, we do not believe we are about to see a repeat of the Global Financial Crisis (GFC) of 2008. The huge improvements in global regulatory requirements, balance sheet stress-testing and modified capital adequacy targets that were put in place post GFC, mean that the vast majority of the global big banking beasts should not be dragged into the mire.
That said, we do think there are causes for concern with some banks in the US. Under President Trump, regulatory oversight of smaller and regional banks was loosened in May 2018. This threshold loosening meant that banks who weren’t considered systemically important, no longer had to perform annual stress tests. The threshold was raised from $50 billion in assets to banks with up to $250 billion in assets. That was a huge increase, which the Democrats at the time warned against. One of the key outcomes from the 2008 Global Financial Crisis was increased regulatory oversight of the US banking system by way of the Dodd-Frank regulation. At the behest of lobbying by these “smaller” banks, including Silicon Valley Bank (SVB), Trump reversed some of this oversight.
What happens in the US and why it is different requires some context. In the US, it was only in 1994 that President Clinton passed legislation allowing banks to open branches in other states and provided a set of rules that would apply to banking in each state collectively. Prior to that, state rules meant people had to bank with an entity in their state on individual state rules. For example, they couldn’t live in Nebraska and readily bank in New York. The legacy of this legislation means that the US still has a large tail of regional banks compared to the UK. In the UK, we are used to the banking and building society model which tended to differentiate national from local, but the US is very different.
The US then topped up that regional banking model with start-ups, who would back new business, or technology firms which have been the focus of the problem banks in this latest flare up. The problem with start-ups and technology firms is that they are asset-light, but debt heavy. The issue these banks face is summed up by the table below:
Paper losses are only realised when investors seek to withdraw their funds. Ultimately, it doesn’t really matter how high interest rates go, if savers don’t ask for their money back. Banks then invest the accrued savings capital to generate a return that helps support lending. Those investments aren’t always liquid and without annual stress-testing, banks can end up with too many illiquid investments that can’t be accessed when required.
If savers think their money is at risk, they ask for it back and when they ask for it back en masse, the paper loss turns into a real loss, because the bank hasn’t invested in enough readily realisable assets to fulfil the withdrawals. On the chart above, readily realisable assets are shown in dark blue. The light blue are all of the assets which the bank has invested in that aren’t readily accessible. It is at this point, that the bank fails, because it cannot return investor’s capital.
The US banking system offers investor protection up to $250,000 assets per investor, per account. The continued upheaval last week in the banking sector, which coincided with the latest Federal Reserve interest rate announcement, was because Janet Yellen (US Treasury Secretary and former Chair of the Federal Reserve) had indicated that the Government would secure all deposits above $250,000. Stock markets took this as a sign that all would be well and started to rally. However, on Thursday, Yellen backtracked on this and then on Friday started to make noises that something may be possible again after all.
This is causing the markets to flip flop. Ultimately though, the Government has to be careful. If they start offering 100% security on savings in these failing banks, they don’t want savers to think that failing banks offer more security than the big players and transfer all of their assets to those smaller entities which would then cause a problem with the big banks. Plus, if those smaller entities remain poorly run and often borne out of niche markets such as vehicle finance, nobody really wins long term in that situation.
Ironically, whilst Yellen was confusing markets, Jerome Powell, current Chair of the Federal Reserve (US equivalent of the Bank of England), was confirming a further rise in US interest rates by 0.25%. Just a fortnight ago, a 0.50% rise had seemed certain, but with the banking sector nosediving, Powell settled on a compromise rise of 0.25%.
This halfway house approach could have led to continued confusion as to whether or not he was simply delaying the inevitable and rates would rise again next time. However, Powell was using rhetoric seen historically as a symbol that perhaps this was the last rate rise for the time being, unless of course some other economic shock occurs.
What seems to be reassuring the Federal Reserve is that the impact of interest rate rises is now being seen in the wider economy.
We have spoken before about the time lag between interest rate hikes and the subsequent impact on the real economy and this time lag can be 6 to 12 months, or more, and this is a subject we will revisit later in this article. Whilst nobody wants the current banking crisis in the US to become more widespread, the fact that there are now pressures on lending, industry and households, will have the effect of cooling the economy and thus help to bring inflation down.
Shortly before the US announcement, Christine Lagarde of the European Central Bank had raised interest rates by a further 0.5% and the Bank of England hiked by an additional 0.25% shortly after. Whilst Europe is facing an inflation problem which may be more protracted than the US or the UK, the UK is reaching the point, which a number of other developed countries are also reaching, whereby the peak of interest rises are likely to be in. With Powell indicating that the US may pause interest rate rises, other Central Banks may take comfort in that message and feel less inclined to keep raising themselves.
The net effect of the US banking crisis is that nobody is lending. Deposits continue to flood out of US banks and into Money Market Accounts at a rate that means offering new lending to anyone cannot be funded. The big problem will come with refinancing. At the moment, this looks to be a huge challenge for individuals and businesses in the US over the coming months. This is likely to have an impact on unemployment numbers and sectors such as construction are already seeing significant falls in productivity and pipelines. The latest banking crisis has perhaps forced the recession to happen sooner rather than later and as things stand today, looks to have removed the possibility of the inflation bubble bursting without some collateral damage.
UK banks continue to lend, but the environment is becoming more challenging and, whilst we don’t envisage a situation such as is happening in the US with a complete refusal to lend, inevitably the challenges of refinancing or new finance for new homeowners at higher rates of interest will present difficulties that are yet to become fully apparent in the UK economy.
This may all sound hugely concerning, but there are very specific reasons why this feels like a systemic problem for the US rather than the rest of the world, where regulation hasn’t been loosened to this extent. The question is then inevitably about Europe, Credit Suisse and Deutsche Bank.
If the US has problems, then the rest of the world is not immune, but we would proffer that the issues with both Credit Suisse (now taken over by UBS) and Deutsche Bank are specific rather than systemic.
Credit Suisse was rarely out of the news whenever there was global weakness in the banking system. It wasn’t a typical bank and managed to land itself in hot water with decision making many times in the past. The latest problem wasn’t actually a new issue, but with sentiment on the turn and investors worried about their capital, safety first took hold and institutions refused to do business with them. The demise of Credit Suisse is not a shock to the financial market in the sense of it being unexpected, but clearly the timing of it happening implies that this could be the first of many. It was perhaps “the canary in the coal mine”.
Deutsche Bank is a similar story. Since the Global Financial Crisis of 2008, Deutsche Bank has been in trouble with the regulator, has struggled for profitability and periodically faces yet more embarrassing headlines about poor practice. German Chancellor Olaf Scholz has come out in support of Deutsche Bank in an effort to settle markets, but the theme in Europe is that any financial institution with a chequered past is likely to come under increased scrutiny for any signs of current weakness. Even if none exist, sentiment can fuel these bank runs.
Any form of bad news for the banking sector is causing global banking shares to fall in value, but it is important to differentiate between the issues in the US and the way they are transpiring in specific stocks globally.
Coming onto inflation, there is some likely good news for inflation through the latter part of 2023. It is widely expected that inflation rates in the UK and the US will fall to around 3% by the end of the year. This may feel unrealistic given that inflation numbers seem to keep going up, but the fallout of dramatic energy price drops over the last few months is yet to be factored into inflation numbers in the UK (albeit energy prices are not such an issue in the US) and this will take the sting out of the data. Where the issue will remain is with core inflation, which is the change in costs and goods excluding food and energy. Core inflation will be much harder to bring down and keep down, but overall the inflation message feels more manageable.
Future interest rate expectations are likely to be a return to “lower for longer”. Again, that may feel unrealistic given where interest rates currently are, but Central Banks aren’t convinced that higher rates are sustainable. The impact on borrowing, employment numbers and productivity will simply be hit too hard if interest rates remain significantly higher than they were before the hiking cycle started. We can’t be sure when Central Banks will start to cut interest rates, but we don’t think it unreasonable to expect some cuts towards the latter part of 2023.
Economic cycles are moving at such a pace that as fast as interest rates and inflation went up, a typical economic cycle sees them come down at the same rate. This economic cycle has been on fast forward, with the latest banking woes expediting it further and so Central Banks will be loathe to cut rates too soon, but once the impact of the rises is really showing in the economic data, they will be looking to cut them back. Ultimately, we think it is feasible that interest rates will largely settle around the 2.5% mark. Again, we just don’t know when that will be achieved. Any form of unexpected shock to the system could take the plan off course, but eventually, we think that 2.5% as a rate of interest is one which economically could be viable.
I spoke earlier about the lag that takes place between interest rates rising and the impact of those rises on economic activity, but how do higher interest rates help to bring down inflation? Higher interest rates make it more expensive for people to borrow money and encourage people to save. Overall, that means people will tend to spend less. If people spend less on goods and services overall, the prices of those things tend to rise more slowly. Over time, such a strategy will bring down inflation. However, this can be a dangerous path for Central Banks to follow. If they raise interest rates too high and too quickly, then there is a real danger that they end up constricting economic activity and causing a deep and painful recession. If that were to happen, equity markets would be hit hard as company profits fall and weaker businesses fail. Given that we have seen interest rates rise from virtually zero one year ago to 4.25% in the UK (4.75% in the US) today, we worry that this has been too steep a change and could mean that a damaging recession is ahead. The coming weeks and months will tell if our worry is real or unfounded, but we would rather prepare for the worst and hope for the best.
The next consideration is what are we doing with this information to protect portfolios, given that we think markets are at a turning point. We think the equity market rallies that we have seen in recent weeks have represented the last throes of a bull market. Assuming Central Banks and Governments don’t step in to shore up all deposits everywhere and they allow some pain to happen in the banking sector, we think TINA has gone away. TINA, There Is No Alternative, was an acronym used in recent years to explain that the only return from investment could viably be achieved was from equities rather than any other sector.
Cash was earning nothing with interest rates at zero, Fixed Interest (Bonds) weren’t generating a return above the equity dividend yield, Property was similarly challenged and so with equity markets trending upwards alongside a healthy dividend yield, there was really no alternative asset class to invest into for a return.
We think those days are over for now. We believe that Bonds offer the strongest opportunity for returns in the months ahead. We have rotated the portfolios in recent weeks to reduce our equity content further, to 25% equity in our Moderate strategies, diverting allocation into Bonds and Money Market funds. We are looking at continuing with this strategy and flipping some more equity along the same lines. We cannot say exactly when the Bond market will win out, but we have seen glimpses of this of late. The Bond market is warning of a recession and is warning that there is some economic pain to come. The Bond market could be wrong, but we saw something similar back in 2008/2009 and at that time we were heavily overweight Bonds and did very well from the call at that time.
The chart above shows UK Gilts in red, the S&P 500 in green and the FTSE 100 in blue since the start of 2023. As the FTSE 100 and the S&P 500 fell 6-8% from their high, UK Gilts rallied by over 5% from their low. The S&P 500 clearly shows the uncertainty of Janet Yellen’s announcements last week as it couldn’t decide if it was going up or down with the will they/won’t they provide banking support scenario. Our expectation is that the S&P 500 will head down from here and so we are looking to further reduce our US allocation accordingly.
We have been defensive for some time, but our concern has been that the markets cannot keep willing up the stock market, nor can they keep running from the inevitable consequences of rising interest rates. This time something has to break in order to reset and go again more sustainably. Too many businesses and individuals have been reliant on cheap credit for too long and the desperation in financial markets to keep launching the latest new product time and again to try to attempt to beat the system is simply something we want to steer well clear of. When those things start happening, the fallout isn’t too far down the road.
Our positioning leaves us exposed if equity markets do rally and something fundamental changes in Central Bank or Government strategy. Were that to happen then we can rotate back into equities very swiftly, but our view is that there is more risk in not being positioned for a bond market rally, thus avoiding the worst of an equity market slump, than the risk of remaining invested in the hope that the good days in the equity market outweigh the down days.
This strategy may seem frustrating whilst we wait for the bond market to fully turn, bonds can fall and thus impact portfolios, but we think any falls from here are going to be recouped swiftly when the tide turns and investors will be rewarded for their bond exposure whilst equity markets struggle. One needs to be invested to take advantage of this strategy though and so for long term investors to wait in cash for the moment to buy back into bonds, is likely to see them miss out on some significant returns.
The chart above demonstrates why being invested in bonds when the time comes matters. It is a very short time horizon, just one week in March 2023, but over that week as the banking woes started to hit, our Gilt holding was up 3.64%, our Strategic Bond holding was up 3.11%, whilst the S&P 500 was down 1.64% and the FTSE 100 was down 6.80%. Over one week, that equates to over a 9.5% difference in return between Gilts and the FTSE 100.
Not all bonds are worth buying at the moment. We are focused on Government lending (i.e. UK Gilts and US Treasuries), alongside high grade (i.e. highest security) corporate bonds. We are mindful of the banking sector in our bond allocation and so we are only investing with fund managers whom we know are equally aware of this within their own strategies. Default risk is likely to become a bigger issue in high yield and lower grade (i.e. lower security) corporate bonds and so we are avoiding these in our strategies. The yield they pay may look attractive, but the risk return profile is not what we are looking for.
The moment the bond market fully turns isn’t the moment that the recession is over. We expect that when bonds start rewarding investors fully, it will continue to feel difficult economically and from a consumer perspective. Markets lead the economy and in this case, we expect it to be bonds leading equities. At some point equities will recover and we are equally positioned to take advantage of that when the time comes. It won’t be all equities at the same time, just as it isn’t all bonds at the same time now, but opportunities will be there and so if we can limit the downside in the meantime, investors should be in a stronger position when the uptick happens.
We are in an economic cycle, such as we haven’t been in for quite some time. It feels unusual and at times unnerving, but barring anything unexpected happening from here, we are positive that this defensive strategy will prove to be the one which protects investor portfolios and also, crucially, exposes investors to those assets whereby they will be fruitfully rewarded. Now remains the time to be invested, but invested in a way that is quite different from the TINA years.