Is the Banking Crisis Over? How Should we Navigate Short and Long Term?
Prashant BHAYANI CIO Asia, Grace TAM Chief Investment Advisor, Hong Kong & Dannel LOW Investment Specialist at BNP Paribas Wealth Management
Summary
- Largest bank failure since 2008 kick-started what eventually became a merger between UBS & Credit Suisse (CS) in order to prevent a systemic financial turmoil.
- Credit conditions will tighten, and we may be quickly approaching the peak of the interest rate hike cycle globally.
- Navigate the current volatility using our quarterly themes, focused on actions for the short and long term.
Largest US Bank Failure Since 2008
The global financial system went through a turbulent period in March 2023, and it began with the collapse of Silicon Valley Bank (SVB) and Signature Bank, which were the largest bank failures since 2008 global financial crisis, while other regional banks quickly came under scrutiny. The issue revolved largely around the mismanagement of asset and liabilities, with the aggressive Federal Reserve’s aggressive rate hikes severely impacting long term treasuries. When met with large withdrawal of money, SVB was forced to realise losses, which eventually resulted in a bank run. The US regional banking system was shaken as this raises questions about the liquidity of the banking system in general and the potential for contagion risks.
US regulators were quick to stamp out any potential contagion effect. They swiftly devised a plan to backstop depositors, a critical step in stemming a feared systemic panic brought on by the collapse of SVB. Depositors were promised full access to their money, while the Fed also announced a new liquidity plan, Bank Term Funding Program (BTFP). Importantly, assets pledged as collateral will be valued at par, and this eventually helped inject much confidence back into the US financial system.
Confidence Crisis in Europe: CS folds
The SVB collapse resulted in fear seeping into the European banking system. Credit default swaps of European banks were initially relatively calm, but comments from Credit Suisse’s largest shareholder, on not injecting more cash into the Swiss bank due to regulatory restrictions, triggered a new wave of market panic. This shortly transformed into a full-blown confidence crisis for the Swiss bank, having been embroiled in numerous regulatory issues and scandals in recent years. With growing concerns on how a potential collapse of CS (a Globally Systemically Important Bank) may cause the global financial system to sink into mayhem, the Swiss authorities stepped in and brokered an unprecedented deal to bail out Credit Suisse.
Swiss central bank and Financial Market Supervisory Authority (FINMA) announced the merger of the two largest bank in Switzerland CS and UBS, in an attempt to prevent the financial system from spiraling into a systemic collapse. UBS agreed to buy Credit Suisse for CHF 3bn (USD 3.3bn) in an all-share deal (wiping out CHF16bn of AT1* Bonds) that includes extensive government guarantees and liquidity provisions.
Read Investment Navigator March 2023: Hard Landing? No Landing? How Should I Land?
Authorities have acted quickly
After the UBS-CS merger was announced, central banks globally (Fed, Bank of Canada, Bank of England, Bank of Japan, ECB** and Swiss National Bank) announced coordinated action to shore up liquidity in USD swap arrangements. These central banks globally seem to have learned the Lehman lessons well. Actions taken were swift, strong and coordinated, in order to contain the current banking crisis and avoid a domino effect. Financial stress, which is still far from 2008 and 2020 levels, is contained for now. However, it remains too early to declare that the US regional banking stress is over.
AT1 bonds in focus
FINMA’s decision to completely wipe out Credit Suisse AT1 bond before shareholders disrespected the hierarchy of claims, which in turn raised questions and triggered a selloff in AT1 bonds. However, rules differ across jurisdictions and issuers. We continue to remain comfortable with selected European AT1 as the ECB reaffirmed the hierarchy of claims i.e. “common equity instruments are the first ones to absorb losses, and only after their full use would AT1 be required to be written down” 1. In that regard, overall we had been recommending Tier 2 bonds relative to AT1s before recent the crisis. Plus, overall the European banking sector is well capitalized, and credit analysis is key.
Central Banks: nearing end of cycle
The major central banks have fought persistent inflation with rate hikes. That said, the tone of central bankers has softened amid the banking crisis, suggesting that policy rates are approaching their end-of-cycle rates. We expect the Fed to end its tightening cycle in May with a rate of 5.25%, and the ECB in June with a deposit rate of 3.5%.
Credit conditions will likely tighten over the next few months, as banks turn more risk averse after the recent turbulence. The tighter credit conditions will achieve Fed’s aim of slowing growth and combined with the lagged effects of interest rate hikes, should cool demand, and thus inflation.
A temporary recession in the US in the second half of this year is our base-case scenario, albeit there is a probability it gets pushed to 2024. In the eurozone, economic activity is expected to slow further but a recession could be avoided. This, in turn, should allow for lower short- and long-term interest rates in the near future.
How should we navigate short term?
Volatility spiked across most asset classes as the banking crisis developed. Near term, shorter duration investment grade corporate bonds look attractive, based on our macro scenario of a modest recession in the US in 2H 2023. For equities, we retain our preference for Europe (Euro Stoxx 50 YTD* (USD) +16%), UK (FTSE 100 YTD (USD) +6.3%), and Emerging Markets (MSCI EM YTD (USD) +3.4%). We continue to prefer quality, given the fall in long-term interest rates and the greater near-term economic uncertainty.
We stay positive on Chinese equities, as we still see strong fundamental drivers for the Chinese recovery story. Recent momentum in economic data is already starting to suggest that the economy could overshoot the NPC’s target of 5% GDP growth this year figure. China’s monetary policy still has an easing bias. Additionally, the domestic A-share market could be more immune to the banking turmoil in the short term. Once the dust settles, we expect outperformance of broad-based Chinese markets (onshore and offshore). This is also inline with our Quarterly Investment Theme 1: When consistent losers become winners. The theme focuses on tapping onto the “mean reversion” effect.
How should we navigate longer term?
Another means to ride out volatility is by investing longer term, through leveraging on multi-year megatrends. This is very much in line with theme 2 and 3 of our quarterly investment themes.
Theme 2: Ride The Cleantech Investment Wave: This theme talks about longer term beneficiaries of the US Inflation Reduction Act and European equivalents, boosting investment in renewable energy generation, infrastructure and storage, and other sub-themes including circular economy leaders and software and industrial systems aimed at improving productivity and lowering energy consumption in manufacturing, services and transport industries.
Theme 3: Scarcity And Security Are The New Watchwords: investable sub-themes include food security and alternative food sources; reshoring and securing supply chains; efficiency, reuse, and recycling as well as cybersecurity and safety.
Please refer to our quarterly investment themes update on page 4-6 for more details. Download the full report above.
CONCLUSION
The collapse of SVB and Signature Bank kick started a crisis of confidence on the global financial system. Eventually, Credit Suisse (as a Globally Systemically Important Bank) needed rescue from UBS and the Swiss authorities, to prevent further financial carnage. Financial stress seems contained for now.
Actions from central banks have been strong, decisive and coordinated, seemingly having learnt from the Lehman lesson. Inflation fight is not yet over, but given the banking crisis, we may be much closer to the peak of the rate hike cycles than previously thought. We expect the Fed to end its tightening cycle in May with a rate of 5.25%, and the ECB in June with a deposit rate of 3.5%. Our base case now is for temporary recession in the US in the second half of this year.
In the near term, we prefer shorter duration investment grade corporate bonds, while for equities, we retain our preference for Europe, UK and Emerging Market geographies, and continue to like quality. We stay positive on China who is more immune to the banking turmoil in the short term, while looking at multi-year megatrends for longer term investing.
CIO Asset Allocation April 2023
1. Source: BNP Paribas Strategy Update, as of 4 April 2023
*ATI = Additional Tier 1 **ECB = European Central Bank YTD: Year-to-date