Church House CEO Jeremy Wharton explains how the opening to 2023 was disrupted by the unexpected.
The comparative calm and stability of the first quarter after last year’s turmoil was abruptly shattered by the collapse of Silicon Valley Bank (and a less important crypto bank failure) who repeated the mistakes of previous banking disasters by borrowing short and lending long. HSBC stepped in to hoover up their UK assets, but no one wanted their US interests. The domino effect of close inspection (and social media) spread to the US regional banking sector as a whole and First Republic Bank rapidly lost most of its deposit base too.
The eleven largest US banks, led by JP Morgan, who had received most of these deposits, quickly returned them to First Republic. This was an innovative way of dealing with the problem but highlights that there is a regulatory mismatch between the treatment of large, globally systemic, banks and smaller regionals who rely on uninsured depositors rather than access to capital markets.
In the midst of the turmoil, the spotlight returned to the management basket case that is/was Credit Suisse. Their capital and liquidity ratios remained strong, but in the face of their own deposit flight’ a Swiss National Bank (SNB) capital lifeline made no difference and financially suicidal comments from the head of their largest shareholder, the Saudi National Bank (who has since resigned), ensured that it unravelled with astonishing speed.
This led to a strong arm (weekend) response from the SNB and FINMA, the Swiss regulator, and UBS Group stepped (were pushed) up to the plate to take over Credit Suisse (CS), this was necessary as it was hard to see CS opening for business on the Monday morning. Equity investors salvaged a little, in UBS shares, probably as a nod to their Middle Eastern client base, but CS’s Additional Tier 1 (AT1) bonds were declared worthless, all $17bn worth of them. Thankfully, they didn’t touch the rest of the capital stack, but tremors were felt throughout the wider AT1 market, and the European Central Bank (ECB) and the Bank of England had to move quickly to reassure that in their jurisdictions common equity holders are firmly at the bottom of the heap.
The US Federal Reserve (the Fed) made encouraging noises about the rescue/bail-in of CS, as did other Central Banks. The Fed’s fight against inflation continues and they have certainly inflicted some of the pain they promised. They continued to hike rates as expected, although their statement dropped the reference to “ongoing rate hikes” to be replaced by “some additional policy firming may be appropriate”. These problems in specific parts of the US banking system are likely to lead to a tightening of credit conditions and bank funding will be more expensive as a higher ‘spread’ over Government rates will be sought. US banks have $620bn of unrealised losses on their books (much of it from holdings in US Treasury bonds), which they can handle, but continued deposit flight is worrying.
Allowing Money Market Funds continued access to the Fed’s ‘Overnight Reverse Repo Facility’ has accelerated the bank deposit shift, nearly 100 counterparties are regularly taking more than $2tn at the Facility. Meanwhile, the raising of the US debt ceiling has not been in the headlines recently, but this has not gone away so we look forward to the usual round of shenanigans in due course.
The ECB still has plenty of ground to make up, having waited until after the middle of last year to even take their rates into positive territory. During the CS volatility they felt that they had to stick to the plan and hiked 50bp, which was arguably correct, but their terminal rate is now also anyone’s guess. They are likely to continue to raise the cost of borrowing but probably at a slower pace. It is not certain that the area will escape a mild recession in the face of their hiking cycle but certainly the possibility is now much higher. The good news is that the European banking system is in a much better place than it was, and profits are at their highest levels since 2007, so, if a recession does materialise, there should not be a problem. ECB President, Christine Lagarde, wheeled out her ‘toolkit’ again “fully equipped for liquidity support” and reassured regarding the resilience of the euro area banking sector. Even though their headline inflation has dropped back sharply, core inflation continues to rise and has not yet peaked. Those who hope for a year-end reduction in rates are likely to be disappointed.
The UK remains the laggard in the G7 and our economy remains the only one smaller than pre Covid levels and the most likely to suffer recession, though it has defied the worst forecasts, including the Bank of England’s. Brexit and its associated inefficiencies mean that our imports have ballooned and our exports have collapsed. Inward investment remains way below historical levels.
The Bank has to keep on going though as inflation is still too high and remains deeply uncomfortable, we are still in line for another 25bp increase in May. Sterling, however, had a decent March appreciating against the dollar (see opposite}, and, while not off to the races, recent GDP numbers were much better than expected. The Bank called on pension funds to stress test their Liability Driven Investment strategies to withstand bigger market shocks, no bad thing considering last October.
Sterling credit spreads were volatile over the quarter, rallying into the middle of February and then widening back out to more than 2% as the ‘banking crisis’ unfolded though, overall, they are little changed from where they started the year. The primary market (new bonds / borrowers} saw healthy issuance despite the bouts of volatility and we are seeing some decent yields on offer.
Overall issuance levels remain high in Investment Grade but the High Yield market has a serious funding hump in 2025/2026 and, with credit conditions still tight/difficult in this sector, we are already seeing some companies struggling to refinance and being taken control of by their bondholders.
The full Quarterly Review is available here.
The contents of this article are for information purposes only and do not constitute advice or a personal recommendation. Investors are advised to seek professional advice before entering into any investment arrangements.
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