The crisis in banking
On the morning of Wednesday the 8th of March, Silicon Valley Bank (“SVB”) was a relatively unknown regional US bank. Later that day the bank would announce that it had sold over USD21 billion worth of securities, borrowed USD15 billion, and would hold an emergency sale of some of its common shares to raise USD2.25 billion in cash to pay withdrawals by some of its depositors. The announcement, coupled with warnings from prominent investors, created widespread fear among account holders. By the time Thursday evening rolled around the ensuing bank run saw customers withdraw USD42 billion in funds. By Friday, the bank was a household name and officially considered insolvent. The event marked the second-largest bank failure in United States history.
In the days following, another regional US bank, Signature Bank, would close. The heightened fear among global investors led to panic over other possibly troubled banks. Just 5 days later, Credit Suisse’s share price plunged 31% as investors panicked after the leading shareholder, the Saudi National Bank, ruled out further investment into Credit Suisse due to regulatory issues. As Credit Suisse is a globally systemically important bank, the Swiss authorities brokered a USD3.2 billion deal in which UBS Group agreed to buy Credit Suisse. The deal was rapidly agreed upon and announced before the Asian financial markets opened on Monday to prevent “market shaking” turmoil in the global financial markets. Despite the best efforts of the Swiss authorities, Credit Suisse’s share price ended the month down by 71%.
Many would agree that March 2023 was a horrible period for banks and by extension a bad month for broader equity markets. However, perversely, the turmoil in the banking sector may turn out to be a positive for equity markets going forward.
Why this could be a positive
Over the past year, market commentators have frequently stated that good economic news is often bad news for equity markets. Good news typically indicates that the economy is still too hot and that the Fed needs to respond by hiking rates to slow growth and ultimately lower inflation to their target rate. However, the recent banking crisis will likely result in banks tightening their lending standards as they prioritize shoring up sufficient capital to fortify their liquidity ratios. Tighter lending standards lead to a reduction in lending and thus a slowdown in economic growth, lowering inflation.
If banks begin to slow the economy, the Fed will not have to raise rates as aggressively to tame inflation. If this does occur, it would be a positive for equity markets as a lower discount rate increases the present value of a company’s future cash flows. This leads us to question; how much will tighter lending standards slow economic growth, and will it be enough to reduce inflation?
The drag of tighter lending standards on growth
In 2008, banks were not as well capitalized as they are today, and their loan books were of lower quality. In the months following the Global Financial Crisis (“GFC”), banks dramatically tightened their lending standards. Creating a vicious cycle where repossessed houses flooding the market were met with little demand as buyers struggled to obtain a mortgage. This led to prices of mortgage- backed securities (“MBS”) to fall which made banks less willing to extend credit, perpetuating the cycle by creating a weaker economy and even lower MBS prices.
Now, 15 years later, better quality loan books mean that investors are pouring into safe-haven assets such as Treasury bonds and MBS when faced with the prospect of a weaker economy. This is supporting the banks that hold these assets and, unlike 2008, is creating a self-limiting cycle rather than a self-perpetuating one. Consequently, we believe that the drag on US growth will likely be less than what followed the GFC.
However, we do still expect a credit squeeze as almost half of deposits reside with smaller US banks with less than USD250 billion in assets. The majority of which do not have to meet the more stringent capital and liquidity requirements that the bigger banks are subject to. Ironically, this uneven regulatory playing field has become a source of systemic risk in itself as customers move their deposits from smaller banks to larger, better capitalised banks. This migration of funds shrinks the deposit base of smaller banks, putting their liquidity at risk and forcing them to rectify their balance sheet by tightening their lending criteria.
Smaller US banks make up half of commercial and industrial lending and more than half of commercial real estate and residential real estate lending in the US, as seen in Figure 1 below. Therefore, as these banks are forced to tighten, the US economy will experience the effect of tightening credit conditions, weighing on growth despite being less severe than what was experienced in 2008.
Figure 1 – Small banks have significant market share
Can the US economy endure a banking crisis?
We mentioned that a banking crisis, may benefit equity markets as the tighter credit conditions lower inflation without requiring the Fed to raise rates. Of course, there is a limit to this thinking. If the crisis grows too big, the economy could be severely impacted, which would be bad for equity markets.
However, the US economy still appears reasonably robust, with the latest Atlanta Fed GDPNow tracking GDP growth of 3.2% in Q1. Private domestic demand is expected to increase by 4.1%. While households continue to maintain their buffer of USD1.4 trillion in pandemic savings. Real disposable incomes are rising again, which should increase spending.
Considering the above economic indicators, the US economy does appear relatively healthy, and will probably stave off a recession until 2024, at which point the lagged effects of tighter monetary policy will have taken hold.
Inflation could fall despite the absence of a recession
We do not believe a recession must take hold for inflation to fall. In past editions of the Market Synopsis, we used the kinked Phillips curve to explain that it is possible for inflation to fall materially, while output declines marginally – see Figure 2.
Figure 2 – Material disinflation with little decline in output is possible
Looking closer at inflation, we can split it into three components: goods, shelter, and services. Leading indicators in all three categories indicate that inflation is either declining or will in the near term. For example, goods prices have fallen over the last few months but remain 8% higher than service prices. We expect that goods inflation will continue to decline as prices fall back in line with service prices based on their pre-pandemic relationship – see Figure 3.
Figure 3 – Goods prices should decline further
A useful leading indicator for shelter inflation is rents on newly leased properties. According to Zillow, rents have barely risen in recent months, as seen in Figure 4. Moreover, the Bureau of Labor Statistics expects shelter inflation to sharply decline based on new rental prices.
Finally, service inflation, which is typically driven by the trend in wages, appears to be slowing. Average hourly earnings growth has slackened from 7% to 5%. While the quits rate (which measures how confident people are about finding new work) has fallen about two-thirds of the way back down to pre-pandemic levels. Indicating that the bargaining power of employees, and the ease at which they can find work is deteriorating.
Figure 4 – Rents on newly listed properties are rising slower
At the beginning of March, the market was predicting that the Fed would hike rates a further 90bps by year-end. However, given the recent banking crisis and its implications on credit markets, the Overnight Index Swap (“OIS”) curve has made an about-turn and is now pricing in 73bps of rate cuts by the end of the year. While we believe this level of rate cuts is possible, it will likely take longer than what the market expects. Assuming the Fed does begin decreasing interest rates, it is possible that they could offset the impact of credit tightening on the economy. If this is the case, equity markets should benefit in the medium term before the mild recession expected in 2024 sets in.