Stock market and economic commentary March 2023

“You need to keep learning if you want to become a great investor. When the world changes, you must change.”

Charlie Munger of Berkshire Hathaway in the 2022 Annual Report to Investors.

Economic Update

Fear is engendered not so much by the danger in plain sight but by what we cannot see or understand. The danger we imagine, the danger we are often eager to find, the danger that lurks around the corner and worst of all, the danger that appears suddenly and unexpectedly from somewhere we thought was safe and secure.

What applies so well to horror movies also works for financial markets. When faced with danger, investors often react irrationally.

Just as the global economic outlook was starting to improve, along comes danger in the banking sector. In less than a fortnight, three mid-sized US banks failed, and Credit Suisse was fast-tracked into a takeover by rival Swiss bank, UBS.

The events of early March represent the most challenging moment for the banking system since the early days of the Great Financial Crisis (GFC) in 2008. As has happened so often before, a combination of rising interest rates and slowing growth are testing the financial system.

The big lesson from 2008 is that the authorities need to move swiftly, and in scale, to counter a banking crisis. The response from the authorities in the US and Switzerland has been forceful, but thus far it has only partly restored confidence and calmed financial markets. Banking is about confidence and trust; lose them and you are in trouble. Lord Mervyn King, the former Bank of England Governor, encapsulated this when he observed that it made no sense to start a run on a bank but once one has started you should join in.

The demise of Silicon Valley Bank (SVB), America’s 16th largest bank, on 9 March was the biggest bank failure since the 2008 financial crisis. The tech companies who were its main customers, facing a more difficult climate, had sought to draw down on their facilities. To meet demand for cash SVB was forced to liquidate holdings of US Treasuries and mortgage-backed securities at a loss, raising the possibility that the bank would be unable to fulfil its commitments. Investors took fright and rushed to withdraw their funds, forcing the regulator to take control. SVB’s failure came the day after Silvergate Capital announced the liquidation of its bank and two days before Signature Bank was taken over by regulators. In the age of digital bank accounts, where rumours spread like wildfire across the internet, bank runs can happen very quickly.

To reassure markets and limit contagion, policymakers introduced two measures. First, to reduce the risk of further bank runs, the US Treasury lifted the $250,000 bank deposit guarantee for SVB and Signature Bank, ensuring all deposits at these institutions will be covered in full. Second, the Federal Reserve boosted the value and the liquidity of bank assets by undertaking to provide one-year loans to banks against the par value of holdings of US Treasuries and certain other related assets such as mortgage debt.

The par or face value is above the current market value of these assets and US banks rushed to avail themselves of the offer, taking over £300bn of loans from the Fed in the week following the failure of SVB. After almost a year of quantitative tightening, in which the Fed shrunk its balance sheet by selling bonds it has bought since 2008, the Fed’s balance sheet is expanding again.

Other banks have also supported the financial system. In a show of confidence, a group of major US banks deposited $30bn with First Republic Bank which had suffered a flight of deposits and a precipitous decline in its share price following the failure of SVB.

In terms of financial stability, the response of the US Treasury and the Fed, and the support offered by the big banks, is “shock and awe” stuff – support that was sadly lacking in the early stages of the GFC.

Zurich-based Credit Suisse is a global bank totally different in scale and business model from SVB in California. But profitability has been poor and Credit Suisse’s standing has been tarnished through, for instance, involvement with the collapsed financial services firm Greensill and the hedge fund Archegos. Even before this latest crisis, in late February Credit Suisse shares were trading 80% below their value of two years earlier.

The emergence of weaknesses in the US regional banks prompted investors to look elsewhere for frailties. The timing could hardly have been worse for Credit Suisse, coinciding with an announcement from the bank that it had found ‘material weaknesses’ in its financial reporting. Then came the news that the bank’s biggest shareholder, Saudi National Bank, would not provide it with more capital.

Credit Suisse shares dropped immediately by almost 30%, only to bounce back a day later following the announcement by the Swiss National Bank that it would provide over $50bn of liquidity. Renewed selling, with the share price down a further 10% and the loss of further deposits, led to the takeover of Credit Suisse by UBS at a price 99% below the peak in 2007. The take-over terms, whilst safeguarding deposits in full, were truly awful for creditors and shareholders alike.

Several European leaders, including the German chancellor Olaf Scholz, ECB president Christine Lagarde and Dutch prime minister Mark Rutte, expressed their confidence in the European banking sector following the subsequent declines in the share price of some prominent European banks, particularly Deutsche Bank, after a spike in the cost of insuring against default on its debt reignited banking sector fears.

So, what happens next and what does this mean for the global economy?

First, the good news. The banking sector is more tightly regulated than it was 15 years ago. Banks are better capitalised, hold higher levels of liquidity and have been subject to rigorous stress tests to gauge their ability to cope with shocks. Medium-sized European banks have not had the easier regulatory regime of their US counterparts. The authorities are on high alert and are determined to move quickly and decisively. This feels different from 2008.

Now for the bad news. These events show that investor sentiment can quickly turn and that deposits are footloose. Problems can migrate quickly and unexpectedly from one part of the system to another. Even aggressive policy interventions, through the provision of liquidity and the protection of deposits, do not always turn the tide. Sometimes, as in the case of Credit Suisse, more radical change is needed.

Material stress in the banking system tends to dampen business confidence and leads to a tightening of financial conditions. Banks pull back on lending and falling equity and bond prices translate into a higher cost of capital. Even before the current problems in the banking sector emerged, credit conditions had tightened significantly. That process may have further to run, and it adds to the risks to growth.

But this leads to more good news. Central banks have been trying to slow down growth to reduce inflationary pressures by raising interest rates aggressively and, some would say, too quickly. Financial markets have interpreted the latest turmoil in the banking sector as a deflationary shock that will slow growth and may encourage central banks to slow the pace of future interest rate increases. At the recent rate setting meetings of the Bank of England, the Federal Reserve Bank of America and the European Central Banks, there were strong hints that rates could be at or close to the peak of this rate hiking cycle.

Stock Markets

“It’s déjà vu all over again” … Not quite!

Yogi Berra was a baseball catcher for the New York Yankees. He won the World Series championship 10 times, more than any other player in baseball history. If this was not enough, he was also a provider of humorous and profound quotations, many of which have resonance as an investor.

The quote above can be interpreted in several ways but is often taken to mean that history does indeed repeat itself.

There is no denying that recent events – a couple of bank failures, others under significant pressure, and the whole financial system seemingly at risk of collapse – appear more than vaguely familiar. But have we really been here before, not just somewhere like it? The differences are clear.

This is not a financial crisis but a crisis of confidence. Notwithstanding the reportedly questionable risk management and controls at SVB, and reported weaknesses in financial reporting at Credit Suisse, little has changed since the aftermath of the Great Financial Crisis, which included an overhaul of bank capitalisation. But they also still rely on depositors depositing and borrowers borrowing, and those depositors not all withdrawing all their deposits and those borrowers not all defaulting on their payments at the same time. Nothing about this simple model has changed since 2010. Indeed, not much has changed since the 18th century and the Bank of Babylon.

This is not about borrowers’ inability to pay the interest on their loans. It is about confidence in the system to the extent that depositors are happy that, when they do eventually need cash, they can get it. The only aspect of recent events that could be referred to as being systemic, is the size, and importance of some of the banks under the spotlight, such as SVB, Credit Suisse, and more recently Deutsche Bank.

Interest rates are rising. Still rising. The broad expectation has been that inflation will fall, and it will, but it is being stubbornly persistent; in the UK, the most recent monthly CPI inflation figure was so shockingly high that it pushed the one-year figure unexpectedly higher (10.4% from 10.1% versus 9.9% expected).

Were it not for the need to keep fighting the war against inflation, however, raising rates would be the last thing central banks would want to do in an environment in which the banking sector is under such stress as it is now. It had been thought that, as corporate and retail banks compete for new depositors (and to keep existing ones on board) and, consequently, balance their books on their lending business, they would raise their rates and central banks would have some of their work done. But, over the last week or so, each of the ECB, US Federal Reserve and Bank of England have raised rates. Central banks would rather not be raising rates at all. This combination is unlike any combination we have faced in the past.

We have not been here before. If we had been, perhaps we could relax in the knowledge that we would know what to do. Instead, we need to rely on the expertise of the central bankers to navigate this untrodden path between high inflation and banking stress (not to mention the risk of recession).

Stock markets are likely to remain volatile in the coming weeks and as with most events of significance, they will only be fully understood in the fullness of time.

“When you come to a fork in the road, take it.”

The complexity of the variables impacting markets was already high, with SVB and Credit Suisse now bringing something else to consider. At the core of the dilemma facing investors is the ability to define the long-term outlook for three of the key variables in investment decision-making: growth, inflation, and interest rates.

These three variables are of course linked and solving one of them makes the other two more predictable. As we stand today though, it is not clear to investors where these three elements will land. Will we have a recession? Will inflation fall back to the targets set by central bankers? At what level will interest rates peak? These are all questions to which the answers will become clearer as 2023 progresses but, for now, they remain the subject of much debate.

In recent months we have seen markets flit between different outcomes for these variables. December was a month of recession worries (lower growth, lower inflation, lower interest rates), January and February were months of immaculate disinflation (steady growth, lower inflation, lower interest rates), whereas early March has seen a stronger economic outlook (higher growth, higher inflation, higher interest rates) but for now, we are back in the recession mode of last December, with the added ingredient of turmoil in the banking sector.

The portfolios required for each of these scenarios are quite different, not just in asset allocation but also within each asset class. This suggests a degree of breadth and open-mindedness is needed when considering how best to position funds. As Yogi Berra noted, when you come to a fork in the road you do ultimately need to take it, and at some point, markets will. For now, they are still deciding.

“If the world were perfect, it wouldn’t be.”

The investment equivalent of this saying is that you pay a high price for a cheery consensus. Put another way, an investment environment with no uncertainty is one of no opportunity. Investments become mispriced, thereby presenting opportunity, when things are not certain. We saw this during the pandemic, which in hindsight was a significant opportunity to buy great businesses at low prices.

The acceptance of future returns being dependent on the current level of uncertainty, and the ability to operate in a contrarian way relative to this, is perhaps the most underestimated and important skill in investing.

The events of the last few weeks may not have created an opportunity on the scale of the pandemic, and it will take longer than a few days or weeks to understand fully the implications of these events, but there could be opportunities which we will be open-minded and balanced in considering.

Decades of problems in only three years

In the last three years, we have seen a pandemic, a collapse and then a recovery in equity prices, a war in Europe, a move in bond yields and inflation of historic proportions, a collapse in speculative technology investments equal to the technology bust of the late 1990s, a meltdown in liability-driven investment strategies in UK pension funds, and now banking failures in the US and Switzerland. As the saying goes, there are decades when nothing happens, then months when decades happen. Here are some of the things we have witnessed and learnt:

What seems defining in the moment is much less so with the passing of time. The societal impact of financial crises, pandemics and inflation spikes is there for us all to see. But even these events, and others such as world wars and depressions, do not in the fullness of time stop the steady improvement in society and the growing profitability of those companies which operate within it.
That the future changes all the time should not be an impediment to successful investing. Some things are constant, whether they be the brands we see in supermarkets, the desire to experience new things, or the ingenuity of companies to adapt to whatever problems are thrown at them. The roadmap for the future is the human desire for a more prosperous, healthier, safer, and more inclusive society. Each of these variables has been demonstrably positive generation after generation and it is highly likely it will remain so in the future.
No one can consistently predict the future. Whilst there are many views as to how the future will turn out, the last three years have clearly shown the perils of forecasting.
Reward happens slowly, risk happens fast. Some investments, particularly more speculative ones, can perform extremely well for many years, making their owners look astute, but can lose all these gains in months.
Successful fund management is an accumulation of sensible decisions, not single big calls. It would have been possible to take big positions on macro events for logical reasons and for them to be entirely wrong, for example in the initial stages of the pandemic.

There will be many more events in the coming years, the most important of which will likely not be largely forecast. We are hopeful we can take what we have learnt in the last three years and use it in a productive way.

Investment diversification remains the key to future success.

And finally, a memo from the fund management suite

“One of the privileges of working in fund management is access to CEOs across a range of industries and geographies. Despite perceptions otherwise, they are normal people who have achieved abnormal things in their professional lives. The majority are decent and committed managers of large and complex organisations who must deal with many of the issues we see in everyday life.

“What has come through in recent meetings and discussions is a sense of determination and optimism that is sometimes lost in investment markets. Many of these CEOs have led their companies through the pandemic, the Ukraine war and soaring inflation but treat problems like puzzles; they are there to be solved. Some ask us to stop reading the newspapers, which are often glass half empty in their interpretation of events.

“All believe the best years for the companies they manage are ahead of them, something we should all remember as the events of 2023 and beyond unfold.”

We thank you for your continued support and we look forward to updating you regularly throughout 2023. Please get in touch if you have any questions.

Keith W Thompson

Clarion Group Chairman

March 2023

Creating better lives now and in the future for our clients, their families and those who are important to them.

Risk Warnings

The content of this article does not constitute financial advice and you may wish to seek professional advice based on your individual circumstances before making any financial decisions.

Any investment performance figures referred to relate to past performance, which is not a reliable indicator of future results and should not be the sole factor of consideration when selecting a product or strategy. The value of investments, and the income arising from them, can go down as well as up and is not guaranteed, which means that you may not get back what you invested. Unless indicated otherwise, performance figures are stated in British Pounds. Where performance figures are stated in other currencies, changes in exchange rates may also cause an investment to fluctuate in value.