Cloudbreak Market Wrap Q1 2023

03.04.23 Investing By Anthony Hourigan
Cloudbreak Market Wrap Q1 2023

 

 

It was another volatile quarter to start the calendar year. Markets globally rallied for most of January, however, February and March were different stories. Focus globally is still very much on interest rates, however, this quarter saw a new issue emerge – that of a potential banking crisis.

ASX                   +1.98%

S&P500            +7.03%

NASDAQ          +16.77%

For a large part of last year, tech companies around the world had been under the pump. This can be seen in the performance of the NASDAQ for calendar year 2022, returning negative 33%. That is a horror year by anyone’s measure. Over the same time, the broader S&P500 was down 19.5% and the ASX200 was down 5.5%, so a lean year all round. Coming out of 2022, markets rallied through January, and eased over February as the market has another negative to focus on – a potential banking crisis. Do we think it’s a full-blown banking crisis? No. Do we think it’s positive for markets? No. Do we think it’s healthy for the financial system? Yes. More on this later.

 

At present there are two major focal points for markets, and they are closely interrelated: interest rates; and the banking ‘crisis’.

 

Interest Rates

Central banks around the world are in the midst of their rate-rising cycle. This was always coming, and probably came too late after Covid. With so much stimulus pumped into the system during Covid, combined with low interest rates, asset prices as well as cost of living inflated. Supply chain disruptions compounded the problem. Every corner of the economy was feeling the inflation pinch, yet Central Banks seemed to feel differently. Remember RBA Governor Philip Lowe infamously stating that rates wouldn’t rise here until 2024? And Federal Reserve Chair Jerome Powell stating that the high inflation of Covid was transitory? This was not a great signal for markets – the old cliche about the lunatics in charge of the asylum was quoted frequently.

 

Central banks’ most powerful monetary policy tool against inflation is that of interest rates. They tread the delicate balance between high inflation and recession, with the aim of landing on a consistently strong economy. The problem is if inflation runs away from them and they raise too much too quickly, they risk recession. That is exactly the situation now in the US. For some context of where rates are at now and the relationship with inflation, see below.

 

US Official Cash Rate:

US Inflation Rate:

(For more US inflation data, see https://www.bls.gov/cpi/)

As you can see, the increase in rates is having the desired effect on inflation. But many believe it has now gone too far, i.e. will lead to recession.

 

It’s a different story at this point in Australia, where the official cash rate and inflation are both still rising. The year-on-year inflation of 7.8% is the highest it has been since Q1 1990.

 

Australia Official Cash Rate:

(To see this chart going back to 1990 and other official cash rate data, see https://www.rba.gov.au/statistics/cash-rate/)

 

Australia Inflation Rate:

In Australia, monthly data just out shows that inflation slowed to 6.8% which would have given the RBA pause for thought before tomorrow’s meeting.

 

For the equity market to have any sustainable rally, there needs to be a rebase of rate expectation. Currently, the market is unsure whether there are more hikes to come, but more importantly, we haven’t yet seen the impact of the rate rises on corporate earnings. The next reporting period will be an interesting indication.

 

The Banking ‘Crisis’

 

Headlines have been dominated recently by news around the swift collapse of Silicon Valley Bank. On March 10th, regulators in the US closed the bank. This was the largest US bank failure since the GFC, and was the second largest in US history. (Late last year, the bank was worth USD $44 billion) In its simplest form, the collapse was the result of an old-fashioned bank run, i.e. too many clients tried to withdraw their money at once. What caused the bank run was clients believing the bank was in trouble. Why did they think the bank was in trouble? This came down to the management of the bank.

 

SVB was offering higher interest rates on deposit than most of the big banks. In order to fund their higher interest payments, they bought a lot of longer-term higher-yielding bonds. This was fine until the Fed started to raise rates. As rates rose, bond values declined. SVB was then in a position where it needed to sell assets at a loss. In early March the bank announced that it had sold $21bn worth of bonds resulting in a $1.8bn loss. This startled investors – the stock dropped 60% and there was a run on deposits. This led to the seizure of the bank by the regulators.

 

Signature Bank (another US regional bank) found itself the subject of client fears as a result, and client action was the same here – a run on deposits. Signature Bank collapsed a couple of days after SVB.

 

Credit Suisse, the 167-year-old Swiss bank was the next bank to collapse in March, but for entirely different reasons. Credit Suisse had been plagued by a number of scandals, management turnover and investment losses. This was weighing heavily on its assets under management and subsequently its share price. In the final quarter of 2022, around USD $119bn of funds were withdrawn from the bank. The stock had fallen around 75% over the year leading to that point. In early 2023, Credit Suisse announced plans to borrow up to USD $54bn to shore up liquidity. However, its biggest financial backer – Saudi National Bank – stated in mid-March that it would not be providing any more capital to Credit Suisse.

 

This, coinciding with the collapse of SVB and Signature Bank, was the death knell for Credit Suisse. In a deal brokered over a weekend with the Swiss Government, UBS agreed to buy Credit Suisse at a fraction of its value, for 3 billion CHF (around USD $3.3bn).

 

The banking system relies on investor confidence. When that is gone, in the case of individual banks, it can lead to a run on deposits. This is what happened with SVB and Signature Bank. The timing of these collapses couldn’t have been worse for Credit Suisse, in the midst of a strategic review and mass withdrawals of funds under management. Since Credit Suisse was a globally systemically important, regulators needed to act swiftly to ward off a full-blown banking crisis. They did, and I think we should all be glad that they did.

 

The good thing about times like these is that it leads to improvements in functionality of the system. One of the positive outcomes of the GFC was a much stronger financial system globally. Stricter lending standards, compliance and governance were imposed, reducing the chances of a repeat of the mortgage-backed securities disaster we saw back then. In Australia it led to the formation of APRA’s ‘Unquestionably Strong’ framework. As part of this, Australian banks have more than doubled Common Equity Tier 1 Capital (the highest quality of capital) over a decade. As a direct result of the SVB and Signature Bank collapses, the Federal Reserve has already implemented the Bank Term Funding Program. This was created to support depositors and provide assurance that the regional banks can meet the demands of depositors.

 

So, while the recent failure of a few banks – two US regional banks and one globally systemically important bank – injects more fear into the market, it also brings stability into the system on a longer-term view. Given the swift action of the Swiss regulators, I believe we have avoided a full-blown crisis. It has also given the market confidence that regulators are prepared to act quickly and are not afraid to flex their muscle. The bank failures have certainly given central banks pause for thought in their rate rise talks too.

 

As mentioned above, the next round of corporate earnings is probably the first to give a real indication of what impact aggressive rate hikes have had on the economy.

 

Until next quarter, onwards and upwards!

 

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