Markets Weekly podcast – 20 March 2023

Henk Potts (HP): Hello. It’s Monday, 20^th March and welcome to the Barclays Private Bank Markets Weekly podcast, the recording that will guide you through the turmoil of the global economy and financial markets.

My name is Henk Potts, Market Strategist with Barclays Private Bank, and each week I’ll be joined by guests to discuss both risks and opportunities for investors.

Firstly, I’ll analyse the events that moved the markets and grabbed the headlines over the course of the past week. We’ll then go into more detail on the impact of the financial crisis that’s playing out. Finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.

It was a truly a tumultuous week in global financial markets, as risk sentiment was hammered by bank failures, policy uncertainty and violent moves in bond markets. European equities were hit hard. The STOXX 600 finished the week down 3.9%, its biggest weekly decline since September last year.

Actually, there was a different picture on Wall Street where the S&P 500 rose 1.4% as gains in technology stocks helped to offset the weakness that we saw in the banking sector. In fact, the Nasdaq had its best week since November, rising 5.8%.

There were some vicious swings in bond markets. Two-year Treasury yields fell 74 basis points over the course of the week, the biggest decline since October 1987. Yields on two-year notes swung between 4.53% and 3.71%. To put that in some sort of context, that’s the widest weekly range since September 2008. Ten-year Treasury yields fell 30 basis points over the course of the week to finish on Friday at 3.38%.

Who were the winners of the week? Well, gold jumped above the $2,000 an ounce level, hitting an 11-month high on Friday. The ‘safe-haven’ asset rose 5% last week. Flows into gold ETFs hit their highest levels in a year as bond yields fell and the dollar weakened.

Cryptocurrencies also had a good week. Bitcoin rose above the 27,000-mark. That’s up 67% since the start of the year. The wave of uncertainty was driven by the stress that we’ve been seeing in terms of the banking sector due to the collapse of Silicon Valley Bank, remember, that’s the 16^th largest bank in the United States, concerns around other vulnerable US regional financial institutions and a crisis of confidence at Credit Suisse, all of which brought back distressing memories of that 2008 global financial crisis.

So, what has gone wrong? Well, in the case of SVB, it was exposed to unrealised losses on fixed income assets due to higher interest rates and its narrow and fast-moving deposit base.

At Credit Suisse, well, the bank has been hit by a series of scandals, management missteps, most recently questions over its previous accounts, all of which has led to significant client outflows and share-price pressure. The problem at Credit Suisse was a crisis of confidence and a lack of liquidity as opposed to asset quality.

So, what have we learnt? Well, the history of financial services is littered with runs on banks. In the new digital world, the speed and the intensity of those withdrawals are faster than we’ve seen in the past.

On the positive side, officials and regulators are furnished with extensive policy toolkits. For example, in the United States, President Biden stated that all SVB deposits would be covered by federal deposit insurance, the UK Treasury facilitated the sale of SVB UK, and in an historic day for the Swiss banking system, governments brokered a deal that sees UBS take over its archrival Credit Suisse in a merger that’s accompanied by government guarantees and liquidity provisions.

The good news is liquidity is available. US banks borrowed a record $165 billion from the Federal Reserve’s facility last week. Yesterday, a group of six central banks agreed to provide daily auctions of dollars till the end of April, thereby delivering a funding backstop.

The real question, I suppose, for investors at the moment, is whether this is financial crisis 2.0. Well, we should remember that capital levels are much, much higher today than they were in 2008, liquidity levels are significantly greater, leverage within the system has been dramatically reduced and the stress tests of the largest financial institutions are far more stringent than where we were back in 2008.

Now, that’s not to say that further pressures on the system will not occur in the coming weeks and months, or, indeed, years, but the risk of a systemic failure of the financial system has been dramatically reduced and authorities have proved adept at isolating and containing some of the risk.

Financial stability concerns are making interest-rate decisions even more difficult. The European Central Bank pushed ahead with its preannounced 50-basis point rate increase, but the Governing Council shied away from any future guidance and moved to a data dependent approach.

The European Central Bank staff macro projections came out. They actually raised their growth forecast for this year up to 1%, though growth forecasts for 2024 and 2025 were revised lower to take into account the ongoing monetary tightening.

In terms of inflation, well, the headline core inflation forecast for 2023 was also revised. They expect headline inflation to come in at 5.3% during the course of this year. That’s down 100 basis points compared to their previous projection, but they expect core inflation to average 4.6% during the course of this year. That’s up 40-basis points as a result of the falling energy prices but sticky core prices coming through.

In terms of inflation, it’s expected to return to 2% target level by mid-2025, although we should acknowledge that these forecasts were done in early March before the recent turmoil that we saw in financial markets.

In terms of the outlook for policy, under the assumption that financial market developments will affect the real economy and inflation only via a tightening of credit conditions, and not morph into a full-blown financial crisis, we expect the European Central Bank to increase policy rates further by 25 basis points in both May and June, bringing the terminal deposit rate up to 3.5%.

So, that was the global economy and financial markets last week. In order to further discuss the ongoing stress that we’ve been seeing in financial markets, I’m pleased to be joined by Julien Lafargue, Chief Market Strategist for Barclays Private Bank.

Julien, great to have you with us today. First of all, how surprised are you by the calamity that’s been playing out across the banking sector, and do you think this is a repeat of the great financial crisis?

Julien Lafargue (JL): Well, thanks for having me, Henk and I think we’re all bit surprised. I think it would have been wrong to assume, going into this year, that we wouldn’t see anything breaking up on the back of what the Fed has done and what global central banks have done when it comes to increasing interest rates at a very, very rapid pace.

Obviously, when you go from zero interest rate to 475 basis points, at least up to today in the US, you’re definitely taking the risk that something is going to break somewhere. People were looking closely at the housing market because it’s one of the most rate-sensitive parts of the market, while looking favourably, actually, on banks because they are one of the rare beneficiaries, or should be one of the rare beneficiaries, of higher interest rates. But what happened is to some degree a surprise.

Now, I think we have to differentiate between banks. The collapse of Silicon Valley Bank was a surprise in the sense that some people had noticed the vulnerability of these banks, but a bank run wasn’t necessarily something that one would have expected. So, this is a bit specific.

When it comes to Credit Suisse in Europe, I think it’s fair to say that we have seen this bank making the headlines for several months, if not years. And, again, it’s not that the collapse of Credit Suisse was expected, but it was clearly a bank that was on people’s radar. So, a surprise to a degree that the banking sector is undergoing such a turmoil at the moment.

That being said, I think we need to recognise the differences between what’s happening today and what happened back in 2008. In 2008, the issue was really that illiquid assets, in the forms of mortgages related to homes, that those mortgages went sour because there was a collapse in the housing market and house prices in the US, and you don’t turn around a house, in terms of selling it, very easily in a market where actually there are no buyers.

That is very different from what we’re looking at today, which seems to be more a confidence/liquidity crisis and the illiquidity here is not on some very illiquid mortgages. It’s on actual Treasury bonds in the sense that SVB went under because it wasn’t able to sell those Treasury bonds without registering a significant loss.

And that, to me, means that the situation we’re facing today is very different, not only because the basis of the crisis is different, but also because we’re coming into 2023 in a much better place than we were in 2008 when it comes to capital ratios, when it comes to the regulatory authorities’ awareness about what bringing down a bank could mean for the global financial system.

And I think that’s why we’ve seen the Fed and the Swiss National Bank being on top of the situation in their respective economies, putting together resolution plans, you know, over just a weekend and that is very encouraging. So, I think the volatility is probably going to stay, but I wouldn’t compare what’s happening today to what happened in 2008 because there are so many different aspects to the situation that we’re looking at.

HP: OK. So, talking about breaking and thinking about the role of regulators and authorities, what are your thoughts around the UBS/Credit Suisse deal, and what are the broader ramifications for the sector?

JL: Well, first, I think it’s a good deal in the sense that, you know, the alternatives weren’t very good. You could have a nationalisation of that bank, but that would have created a massive precedent. The authorities could have let the worst happen to Credit Suisse and, again, that would have potentially disrupted the entire financial market. So, this is potentially the best possible solution at this particular point in time.

There are two key elements to this deal. One is the fact that we’ve seen the Swiss government, as well as the Swiss regulator, stepping in and coming to help this deal close in the form of very specific guarantees, whether it’s loss guarantees or liquidity guarantees. And this is, I think, a very important sign that the regulator is willing to play its part in helping to solve any of those difficult situations and that should be seen as a positive.

The other key element of the deal, and I think one that is probably going to create a more pressing market, or at least raise a lot of questions, is what happened to bond holders in the case of UBS acquiring Credit Suisse, in particular what we called AT1, additional tier 1 capital. These are bonds that basically were created in the aftermath of the 2008 crisis and their purpose is to, especially in the banking sector, help banks raise capital or debt without having to pay too much.

And the idea behind it is that if you own that bond, or at least that was the thought, that you would be senior to shareholders, i.e. shareholders would take the first loss and you would be next in line. But, in reality, you should be rather protected simply because the likelihood of a bank going under was seen as relatively low. And, what happened in the UBS/Credit Suisse deal is that shareholders will receive some money, albeit very, very little, about 75 cents a share, knowing that, you know, last Friday that it was closer to CHF 2 per share.

So, they’re not getting much but they are getting something, whereas the holders of AT1 bonds, and that represents around 16 or 17 billion of them, those holders will basically be wiped out. And that is strange because the order of liquidation, so to speak, shouldn’t be that wide. So, shareholders should get nothing and maybe if you are a bond holder, could get something.

So, I think the main repercussion from that deal is the fact that there is going to be a huge repricing in this AT1 space, with people recalibrating their expectations in terms of risk they’re taking, potentially being less willing to transact in those securities which ultimately could raise the cost of capital for banks.

HP: Julien, we have mentioned this, but if you were grading the response that we’ve seen from policymakers, what would you give them, and where do they have room for improvement?

JL:        Oh, I think it’s probably a solid B/B+ so far. Again, there’s no perfect solution. You have to find, as a regulator, the solution that’s going to create the least amount of stress. And if you talk to Credit Suisse shareholders, they’re probably not very happy with the solution that was ultimately chosen. The reality is, what were the alternatives? And, as I said before, I think, you know, one would have been to let Credit Suisse go under and in this case the shareholder would not have necessarily been better off. The same would be said about a nationalisation.

So, I think they’ve done a pretty good job in trying to find the best possible solution and to do that in record time. You know, the Credit Suisse situation really flared up less than five days ago and within that time frame, they’ve been able to, first, secure some liquidity to the bank to avoid an immediate collapse, then work on a potential deal with UBS, and finalise that deal over the weekend. That’s a pretty good job.

HP:      At the same time, Julien, markets still remain very nervous, the banking shares still remain under pressure today. What do they need to do beyond what they’ve done already to try and calm down investors’ nerves?

JL:        The problem really is around this lack of confidence in the sector at this point in time. How do you restore confidence when you’ve seen banks going under and when people are worried about the money that they’ve deposited in those institutions? And, unfortunately, I don’t think there is a short-term solution to that.

We’ve seen, or we’ve heard, in the US both about the government, or at least the Senate is trying to consider the possibility of guaranteeing all deposits for smaller banks for two years. That is one way they see in order to prevent further bank runs. But even if you do that, what is the incentive for any depositor to stay in maybe more risky bank as opposed to going to what is perceived at least as a safer institution, i.e. a larger bank?

This, for us, is not going to be restored overnight and I think it's going to be quite a long process. All the regulators can do is what they’ve been doing, being present, being vocal, reassuring people that things are OK and like, most things, this shall pass, but it will take time.

HP: OK. Let’s try and take a broader perspective. What do you think the impact of the turmoil that we’ve been seeing will have in terms of the broader economy? What influence do you think it will have on the future path of policy?

JL: Well, on the economy I think there are two main implications. First, I believe that banks will be more reluctant to lend in the very short term, and lower loan growth typically bodes ill for the rest of the economy in the sense that growth, GDP growth, should be at least fractionally lower if none of that had happened. So, probably a lower GDP growth outlook.

At the same time, the consumer might feel a bit worried and stressed. So, consumer confidence, which was in many places already hovering around recessionary levels, is probably not going to recover in the very short term. So, all that points to maybe lower growth ahead. And I think the discussion that people were having around is this a soft, hard or no landing at all, when it comes to the US economy in particular, I think we’re going to move back to the hard landing discussion more so than the no landing one.

The positive of that, so to speak, is lower growth, all else being equal, would mean lower inflation, which has been a big problem in most developed countries, and would make the role or the task for central banks slightly easier going forward. So, to your point on what does that mean for policy, monetary policy and for rates, look, we’ve seen the ECB stay the course with a 50-basis point hike. I think that was the right thing to do because if they had paused or, even worse, if they had cut that would have sent the wrong message.

First, it would have diminished their credibility. Let’s not forget they’re in a fight to bring back inflation to their target, and a fight that they’re currently losing. And, second, it would have probably told the market that the ECB may have known something that we didn’t and the central bank was actually even more worried than we were. So, I think that was the right call.

The Fed might decide to do the same. I think it’s probably between a pause and 25 basis points this week but, again, a cut would, in my opinion at least, send the wrong message and probably wouldn’t be welcome by the market at this stage. But what we can assume is this whole episode will mean lower rates going forward.

HP: Julien, we know technology start-ups are cash-hungry businesses. What does the funding pipeline look like following the collapse of SVB?

JL: Well, clearly, this is an industry that has been under some pressure for some time as a function of higher rates and a generally slower economy. The collapse of SVB is certainly not going to help. The reality is, you know, if those companies are still looking for funding that only the best ones would probably be able to find it, at least at this point. So, it’s not so much the collapse of SVB that is creating the issue. It’s more the willing or the ability for those companies to raise capital, whether it’s privately or in markets through IPOs. Those doors seem to be closed for the time being.

We will also probably see some negative mark-to-market in the venture capital space which will hurt sentiment further when it comes to that particular asset class and those particular investments. I think where, if I try to see the positive side of things, is those companies maybe the weakest ones will, unfortunately, perish, but there are still very good companies that have a decent business model and that should still be able to raise capital or have access to capital. And, in this case, maybe they will turn to, if banks are maybe afraid to lend, if markets are closed to them, to private credit.

And I think the outlook, ironically, for private credit has probably improved on the back of the recent events because they’re still the lender of last resort when it comes to start-ups and, therefore, they might be able to come on better terms when they lend money to those companies. So, I would look that way, with an optimistic view.

HP: OK. Let’s try and bring that together a little bit and consider the market response that we’ve seen already. Clearly, the violent movements that we’ve seen across financial markets have been unnerving. What other key messages do you have for investors about how they should be positioned?

JL: Well, I think as we discussed at the very beginning, these were very unexpected events and I don’t think, you know, anybody was really planning for SVB to collapse and for Credit Suisse to be acquired the way it has been by UBS. And those events are as unexpected as maybe the invasion of Ukraine was, the pandemic was. My point is you always have those unknown unknowns coming your way. We’re trying to think about what could go right and what could go wrong, but we cannot envisage every single possibility.

And there are not many ways investors can prepare for that. One is, obviously, to stay in cash forever, being afraid of the next black swan. And while that might look very good in the very short term, the reality is, over the medium term, inflation is going to erode your capital.

The other option, which is the one that we prefer, is just to be diversified. That’s the only way you can account for as many risks as possible. It doesn’t mean that by being diversified you won’t be able to avoid losses, but at least your portfolio and your investments should be able to weather any kind of storm in a better fashion than if you concentrate your risk in one very specific asset class.

I’ll just point out that the traditional 60/40 portfolio, which forms the basis of many strategic asset allocation, this 60% equity/40% fixed income portfolio has done fantastically well. And by fantastically well, I mean more than 6.5% annualised return since the peak of 2007. So, even if you had invested in such a portfolio right before the great recession, you would still have averaged 6.5% return already, which is a great outcome and that’s simply the power of diversification and we think this is probably the only thing people can do today to protect against those unknown unknowns.

HP: Well, it’s certainly worth remembering the importance of diversification and long-term market performance, but there is a saying in financial markets, Julien, never waste a crisis. Where should investors be looking to take advantage of some of the mispricing of risk that we’ve seen playing out over the course of the past couple of weeks?

JL: Well, I mean it’s a tough one simply because things are moving so fast that something might look interesting, you know, right now but in a few hours it might be slightly different. What I would say is, as I mentioned earlier, private credit is probably an area where demand is going to be relatively strong in the coming weeks or months, and that’s probably one area that I would look at.

The other area that I think could be interesting is still the fixed income space. We’ve been talking a lot for the past few months that there was a great opportunity to lock in yield. Obviously, yields have come down quite significantly since the beginning of the year, but you’re still getting something from your fixed income exposure. I would prefer the higher quality fixed income simply because of the uncertainty that we’re still facing, but having exposure to fixed income markets still makes sense at this point.

Now, when it comes to equity markets, look, I think we need to maybe look outside of where the stress is for the banking sector. Obviously, you could see some sharp repricing once the dust settles, but these types of trades are not for the fainthearted and are more, I would say, bets rather than investment at this stage. But look in Asia, look in other regions, look in sectors that are benefiting from circular trends. That may not be OK immediately but that should be OK within the next six, 12, 18 months and beyond that.

HP: Well, thank you, Julien, for your insights. It’s a turbulent time for markets and one thing that we have learnt from this is the best way to navigate those troubled markets is, indeed, as you said, for a globally diversified portfolio.

Let’s move on to the week ahead where the Federal Reserve and the Bank of England will take centre stage. For the Federal Reserve, the expectations have been bouncing around over the course of the past couple of weeks with an unprecedented divergence in forecasts, ranging anywhere from a 50-basis point increase to a 25-basis point cut.

We think that on the balance of probability, we expect the US central bank will opt for a second consecutive 25 basis-point increase as the Fed tries to balance the string of robust consumption, inflation and labour market data with the financial stability considerations that we’ve been talking about, which you could certainly argue has probably taken that 50-basis point hike off the table. If we were to see an escalation of financial instability leading into the meeting, we do think there is, of course, a possibility for a pause.

In terms of the Bank of England, well, it’s also expected to be a pretty close call as the MPC considers the backdrop of financial instability, decelerating wage growth and rates, which are already in restrictive territory versus better-than-expected activity data, double digit inflation, and the fiscal easing that was announced in last week’s Budget. We think the Committee will hold off on the anticipated 25-basis point rate hike and opt for a policy pause as they wait for greater transparency over the trauma in financial markets to play out and assess the incoming economic data before considering whether to resume policy tightening at the main meeting.

And with that, we’d like to thank you once again for joining us. I hope that you’ve found this update interesting. We will, of course, be back next week with our next instalment. But, for now, may I wish you every success in the trading week ahead.