Initial Volatility
SVB, CS, CDS, Etc
Before March, few people had heard of Silicon Valley Bank. By the end of the month, many investors were overwhelmed by news items referring to its acronym, SVB. By month-end, SVB had become part of First Citizen Bank, no doubt also known as FCB. HSBC stepped into buy the UK arm of SVB for £1, whilst at the same time, accessing a different channel of clients. Just prior to SVB’s demise, Silvergate, a go-to bank for crypto firms, closed its doors. Two days after SVB, Signature Bank failed and was acquired by Flagstar Bank. The turmoil in regional banking prompted the US Federal Reserve to create a loan support program, the Bank Term Funding Program or BTFP.
US regional banks going bust isn’t a new phenomenon – while in the previous two years of 2021 and 2022, no US bank failed; four banks failed in both 2019 and 2020, none in 2018 and eight went in 2017.
On a larger scale, Credit Suisse (CS) was merged into its Swiss counterpart, UBS after questions about its operational capability prompted its share price to dive and insurance on its debt (CDS or credit default swaps) to sky-rocket. Credit Suisse, like many global systemically important banks (G-SIBs) post 2008/9 was well capitalised. However, Credit Suisse had been poorly run for a number of years which left it vulnerable. Shortly afterwards, Deutsche Bank briefly returned to the spotlight as its share price fell and CDS rose. Both Credit Suisse and Deutsche had born the cost of failing in their attempts to become US-style investment banks.
Borrowing short-term and lending long-term has a history of going wrong, most notably when short-term interest rates rise and it becomes apparent who has taken on duration leverage at the wrong time. Invariably, it is financial institutions that succumb to the aforementioned mismatch.
CoCo pops
Part of the ‘merger’ that brought Credit Suisse into the arms of UBS (formerly known as Union Bank of Switzerland which had previously consumed Swiss Bank Corp or SBC twenty five years ago), was the wiping out of the holders of Credit Suisse’s Additional Tier 1 capital (AT1) also known as Contingent Convertibles (CoCos). Many holders of those CoCos believed that they ranked above common equity holders in the capital structure. However, while that is true in other European jurisdictions, that isn’t the case in Switzerland and was clear to those who read the prospectus of Credit Suisse’s CoCos.*
*Note that TBAM has always viewed CoCos as convertible bonds that are not appropriate as investments in its funds as holders get converted for the benefit of the issuer not the investor. Also, TBAM’s preference is to avoid investing in banks as their use of leverage is counter to TBAM’s philosophy of investing in cash generative businesses with low leverage and strong balance sheets.
Problem Unresolved
While SVB’s depositors were guaranteed beyond the Federal Deposit Insurance Corporation’s (FDIC) US$250,000 limit, other banks will be treated on a case-by-case basis, according to US Treasury Secretary and former Federal Reserve Chair, Janet Yellen. That remains a problem as billions of dollars have left smaller regional banks to be deposited at too big-to fail US banks, aka significantly important banks (SIBs) for greater protection. That is only part of the problem for both regional banks and SIBs as depositors have worked out that they can access money market funds which pay considerably more than banks, thereby hurting banks’ profit margins. The performance of bank stocks reflected the change in profit outlook.
Mistaken Identity
A case of mistaken identity and an example of market hysteria sparked a selloff in Republic First Bancorp, which fell almost 40% in March mainly because investors confused it with embattled First Republic Bank. Perhaps, like the volatility of CDS, illustrative of market liquidity in current market conditions.
Rate Expectations
Rate expectations were met in March as the Bank of England, European Central Bank and US Federal Reserve raised interest rates while they could although the US increase was probably halved due to US banking woes which threatened to blunt the US economy. While each central bank referenced the still too-high inflation rates in each area, they are still making up for keeping rates too low for too long in 2021/22.
Twin Peaks?
The US Federal Reserve’s favoured measure of inflation, Personal Consumption Expenditures (PCE), moved in a downward direction in February as the graph below illustrates. These numbers provided some relief when released in the final week of March but the gauge is still running way ahead of the Federal Reserve’s 2% target.
Source: Bloomberg
Because of banking issues and the expectation of slower economic activity, the rate expectations for short-term US interest rates declined over the month as the following graph illustrates:
Source: BCA Research
Markets
Currency
The perception of lower rates and US economic activity caused the US dollar to drift lower against most major currencies in March. Towards the end of March, a number of countries, led by China, stated that they would challenge the role of the US dollar by trading commodities such as oil, in their own or their counterpart’s currency. Sterling was aided by a relatively better or stable (to previous assumptions) economic and political backdrop.
Equities
Global equities continued to be a mixed bag. Tech stocks continued their rebound to have their best quarter (as measured by the Nasdaq) since 2001, aided partly by lower interest rate projections and probably from being oversold. The rebound in those large cap tech stocks gave a robust look to broader US index returns but in reality, masking the poor performance of banks and smaller companies. Other themes performed less well than tech with healthcare posting a negative return.
Regionally, the UK stock market (as measured by the FTSE All Share) was something of a laggard whereas Europe, Japan and Asia were modestly positive; the latter led by China.
Debt (Bonds)
The recent volatility of bond yields was exacerbated by events in the banking world. Although yields rebounded from their lows, government debt performed well in March as official interest rate expectations moderated along with inflation projections. Corporate debt performed less well understandably. Investment grade debt was flat on the month as a whole but high yield suffered from the expectation that defaults would rise.
Commodities
Gold had a strong month given the geopolitical and banking world backdrop. Oil suffered the reverse on demand concerns which also troubled industrial metals.