The bankruptcy of Silicon Valley Bank has changed about everything related to Central Bank policies, i.e., inflation outlook, interest hiking, and economic growth. With the implementation of the Bank Term Funding Program (BTFP), financial institutions are aided in a similar manner to what they were back in 2008/2009. Under the BTFP, the collateral will be accepted at face value (instead of at market prices), allowing banks to meet deposit withdrawals without being forced to immediately sell securities portfolios at a loss.
According to research published by GS, the duration mismatch is particularly big in the US where an estimated USD 620bn of unrealized losses are accounted while in Europe the same is amounting to around EUR 1 billion, equating to around 30pbs of the average European Tier 1 capital ratio. The more regulated European banking market appears to be in a more opportune environment, and European banks generally have a more diversified deposit franchise than some of the more technology-concentrated US banks.
Economic point of view!
Through their deposit-taking and loan accordance, banks are key conduits for transmitting Central Bank interest rate policies into the broader economy. Despite higher interest rates, financial conditions have been easing because risk asset prices have rallied, while Treasury yields were off their highs from last fall. This partly explains why the global economies have been able to perform well despite higher interest rates.
An immediate reaction to the fall of SVB is that counterparty risks have increased in the lending market as organizations will be more reluctant to originate new loans to prevent their liquidity ratios from going out of scale. In turn, since it will be applied across all sectors and globally, it is expected that: a) there will be slower economic growth, so less growth, in the coming quarters, b) consumers will spend less on discretionary items, and c) businesses will reduce capex given that financing opportunities have become less evident.
As of now, the market is expecting much looser CB policies than in the past. Futures are now pricing at a peak in the policy rate at around 4.75 % (down from ~5.7% a week ago), and the FED is to start easing interest rates as soon as September 2023. The expected 12-month path is a 125-bps cut. The failures of SVB and SBNY were triggered in large part by higher rates. Taking off part of that pain is not solving the longer-term mandate of the Central Bank, i.e., they are committed to tackling inflation.
If demand is weakening, then one can expect that the US economy will slip into a short-lived recession and, hence, tackling inflation is less of an issue. However, if growth, against all expectations, should remain strong, it would be very likely that the FED would continue to increase interest rates to tackle inflation while at the same time considering extending the BTFP beyond its present 12 month horizon.
Investment ramifications
Equities: Diversification is the mother of all strategies.
Under normal conditions, it takes about one full quarter for the market to assess a new situation following a major event. Therefore, and for the short-term, we are cautious on US equities as the ramifications will unfold over the next weeks; clearly the oncoming guidance from technology-related companies needs to be looked at carefully. The present valuations in the US are tilted to the high; falling interest rates and chances of a recession may not be the optimum combination to maintain the valuation at this level. In the absence of any consumption statistics, it might be too early to consider the US market an opportunity.
For more international-oriented investors, we see opportunities in the southeast Asian equity market, Chinese equities, and German equities. The southeast economies benefit from China’s reopening which to some extent is also supportive for European exporters. With COVID restrictions belonging to the past, the economic performance of the region is likely to prove more robust than for the last 12 months. On a price-to-book (P/B) basis, the MSCI Emerging Markets index is trading at a 43% discount to developed markets (12-month forward P/B at 1.5x versus 2.4x for MSCI World), a level historically consistent with a relative positive return over the medium term.
At a sector level, we stay focused on energy, consumer staples, and industrials that benefit from the energy transition.
Fixed Income Segment
Many investors have been waiting for quite a long time now for higher interest rates so that their fixed-income requirements can be covered again. But the events of recent days show how quickly future interest rate expectations can change, and it might be too late now to be able to capture some of the best quality opportunities.
As of now, the best opportunities can be found in the high-grade and investment-grade segments, with some selective opportunities arising in the emerging market bond segment.
Credit is another segment of interest. The defensive fixed-income tilted iTraxx Main Series will benefit from the sharp fall in rates while consumption remains relatively strong. While market stress seems to be limited for now, other events can occur at any time. It is therefore opportune to be selective in terms of names, aka series.
PE and VC
Over the past 30 years, Private Equity (PE) and Venture Capital (VC) deals have gained in attractiveness. This occurred on the back of a pre-visible Central Bank policy. As of now, relative to overall private debt fundraising activity, VC and PE debt represents less than 5% of the fund count and about 1% of the total dollar value raised. With the economic path uncertain for a given period of time, investors with the appropriate risk profile might consider this asset class which is particularly sensitive to the well-being of economic flows.
With private companies facing more difficulties in accessing banking facilities, PE funds may take up some of the void created. Most of the PE and VC funds are flush with cash, and they are expected to be in a solid position to capture market share from banks. One of the key benefits for investors is that private credit does not respond as quickly to widening spreads as the public market does, but one of the main disadvantages is that this segment is illiquid by definition. Investors should be aware of liquidity issues and the challenges that come when trying to access money prior to termination of the contract.
Currencies
The flight to quality and the dollar’s status as a safe haven have played out once more. With the high-level alert declining, we believe that the US dollar will weaken against most G10 peers and think that investors can use periods of dollar strength to reduce allocations to the currency. Investors with a very conservative risk profile can consider other traditional safe havens like gold and the Swiss franc. Given that the ECB is lagging behind the FED policy by 9 to 12 months, and on the back of the FED policy being less aggressive than the ECB, investors with a balanced risk profile should favor the EUR. And for investors with a dynamic risk profile and who believe that China’s domestically driven consumption can recover, despite a potential lowering of US consumer participation, we recommend the Australian dollar.