The ugly side of interest rate rises has dominated headlines, after Silicon Valley Bank (SVB) – a lender to the US tech industry – went to the wall. Suspicions then switched to other regional US lenders as well as the much more globally connected lending giant Credit Suisse, which has struggled with market confidence issues over a long number of years.
The peculiarities of SVB were its undoing. Having a large proportion of technology focused, venture capital borrowers coupled with a substantial investment exposure to bonds meant it was doubly exposed to the negative side of rising rates. As a result, its credit quality plummeted, a matter that didn’t go unnoticed by the bank’s depositors, many of which had deposits above the government’s US$250,000 insured limit. A run on the bank ensued.
The combined challenges that faced Credit Suisse were rather different. The trigger for a run on the bank’s shares was a statement from the bank’s largest backer to the effect it isn’t prepared to provide further financial support. That the bank also admitted there were “material weaknesses” in its financial reporting processes didn’t help.
The responses from policymakers were swift and effective and markets responded in kind. The US Federal Reserve (Fed) launched a new one-year lending programme – which has already been accessed by some banks.
Perhaps the greatest problem caused by these events is a new alertness to vulnerabilities in pockets of the banking sector. Stock markets have an aspect to their nature akin to a part of quantum mechanics, whereby the mere observation of an event necessarily changes the event. The early signs are, however, that the authorities have done enough to assuage concerns.
Self-fulfilling prophecies aside, this was an example of good news and bad news emerging at the same time. Two of the year’s most important themes – inflation and China’s reopening – recently registered improvements. The latest from Washington was that US consumer prices remain in a downtrend, with the annual rate of inflation falling again to 6.0 per cent in February1.
Critics will quite rightly point out this is precisely three times the rate the Fed wants to see. Also, that the pace of improvement has slowed. However, the direction of travel is just as important, as is the fact we are now a good way down from a peak inflation figure of 9.1 per cent last June.
We are all looking to China to deliver the excess growth the world needs this year and, so far, the signs have been good. In line with a strong rebound in activity in the services sector picked up by business surveys in February the latest data shows consumers have swung into action again. Retail sales grew 3.5 per cent in January and February, which covered China’s Lunar New Year celebrations. Interestingly, given the new post-lockdown environment, online retail sales of physical goods increased at an even faster 5.3 per cent annual rate2. This hints at the growth that could yet come from a widespread return to the high street.
The SVB debacle, however localised a matter it might seem, has sparked new fears about the possible concentration of risks in certain parts of the financial system. That harks back to 2008, where everything that could go wrong seemed to do just that.
However, Washington and the Fed have plenty in their arsenals to make sure those experiences are not repeated. Importantly from a markets point of view, the Fed has scope to rein back the interest rate hikes it had planned for this year and possibly reverse some of its previous tightening.
As usual, the bond markets are ahead of everyone on this. In less than a week, a whole percentage point was shaved off two-year US government bond yields.
The inference is that significant further rate rises this year – once a given – are no longer certain. You could go further and say bond markets are expecting rates to start to fall, perhaps as soon as in the latter stages of this year. Presumably though, that would also require inflation to play ball. There is clearly no appetite at the Fed to relinquish its 2 per cent target.
So, for investors, the outlook remains as it usually is – a combination of opportunity coupled with risks. Taking a longer-term view usually helps with the latter, diversification is the way to go and, staging your investments over a period of time remains a highly attractive option because it reduces the chances of buying at the wrong moment and has the potential to capitalise on short term shifts in sentiment.
Leftfield events like the SVB collapse and the rescue of Credit Suisse underline the importance of thinking about the consequences of being wrong about where we, personally, think markets are heading next. Over-optimism can lead to a portfolio that is too concentrated; too much pessimism can trigger sales that leave an investor underexposed when markets bounce back.
Sources:
¹ US Bureau of Labor Statistics, 14.03.23
² China.org.cn, 14.03.23
