Investment in a Minute - Beware the Ides of March

The recent stress in the banking sector has put financial markets on edge and resulted in flashbacks of the 2008 Global Financial Crisis. 

In the United States, two banks with ties to the crypto industry, Silvergate and Signature, had to be wound down after suffering significant amounts of customer deposit withdrawals. A larger institution, Silicon Valley Bank, became the second largest bank failure after Lehman Brothers following losses on its bond portfolio and a subsequent bank run.

A few days later, it was European bank Credit Suisse that had to be rescued by its biggest rival UBS, following a decade of underperformance and financial scandals. 

While these events are still unfolding and will have consequences for many years, in our view it is worth making 3 key observations. 

1. Public authorities intervened early and decisively to contain the banking crisis

The collapses of Silicon Valley Bank and Signature Bank within a few days of each other sent shockwaves across the US banking system. In our view, the rapid announcements by the US treasury to insure all customer deposits of both banks (including those above the $250,000 FDIC threshold), was likely instrumental in avoiding further disruptions and erosion of confidence, especially for the smaller US Banks.

The US government has also signalled that it could potentially do more, with US Treasury Secretary Janet Yellen stating that “similar actions could be warranted if smaller institutions suffer deposit runs that pose the risk of contagion”. On the other hand, at present the US government has refused to provide a blanket insurance for all US bank deposits. As a result, markets remain somewhat nervous in the near term.

As for Credit Suisse, even though the decision to bail-in the additional tier 1 debt of Credit Suisse remains quite contentious, the Swiss government’s intervention and forced merger with UBS likely helped to avert further damage to the European banking sector. 

Past performance is not a guide to future performance.

As for credit markets, while European AT1 debt and Contingent Convertible bonds (CoCos) have underperformed in March, the average performance of senior European financial bonds has been much more resilient. This price action shows that investors have been discerning so far between the stronger and more vulnerable areas of the European banking sector and that the current crisis remains relatively contained.

2. Central banks are confronted with their own contradictions

The tensions in the banking sector have also triggered somewhat of an unexpected pivot for some central banks. For example, at its latest Press conference, ECB President Christine Lagarde stated that “our policy tool kit is fully equipped to provide liquidity support to the euro area financial system if needed….”. As for the US Federal Reserve, it has used its various tools (such as the Discount Window and the newly created Bank Term Funding Program) to inject large amounts of liquidity to the US banking system. As a result, its balance sheet has increased by over $300 billion recently, essentially unwinding the five previous months of quantitative tightening.

It is also noteworthy that these liquidity injections have occurred over a period of time where the Fed and the ECB have been HIKING interest rates (the ECB by 0.5% and the Fed by 0.25% in March). This combination of liquidity injections to support financial stability while simultaneously raising rates to fight inflation have been an important cause of bond market volatility. These conflicting forces also highlight in our view the difficulties central banks face today in reigning in inflation after decades of very loose monetary policies and a delayed interest rate hiking cycle.

3. Safe haven governments bonds have fulfilled their role so far

Performance for most equity and bond markets was disappointing in 2022, as higher than expected inflation and interest rates caused many markets to sell-off. As higher government bond yields were often the root cause for the negative performance, many investors started to put into question the diversification benefits of safe haven government bonds versus other risky assets such as equities and corporate bonds. However, during this most recent crisis, government bonds such as US Treasuries and German Bunds have lived up to their safe haven status, providing a performance cushion for many corporate and emerging market bonds. While at the onset of the COVID-19 crisis we felt that low government bond yields offered limited protection in the case of an economic downturn, given the higher yields today government bonds could offer some additional protection in the case of prolonged economic downturn. 

Overall, while it is important to remain cautious and selective, we believe the issues currently facing the banking sector are primarily about confidence. The banks we favour are strongly-capitalised, well-regulated and have robust risk procedures and systems in place since the global financial crisis. While we are of course mindful of the risks of contagion, we also remain comfortable with our exposures at this stage.