With the failure of the US bank Silicon Valley Bank (SVB) this week, we saw the largest banking collapse since the financial crisis of 2008, sending alarm bells ringing across financial markets. By Arun Sai, senior multi asset strategist at Pictet Asset Management.
While there is no doubt that financial markets across the US and Europe faced a tumultuous week, SVB’s demise is symptomatic of the economic strains caused by rapidly rising interest rates. SVB is a high-profile casualty of central banks' battle against inflation. Its downfall is a reminder that interest rate hikes have a nasty habit of operating with a lag.
However, where 2008 exposed certain systemic risks across our financial markets, the collapse of SVB did not. SVB was in a uniquely precarious position, where it was vulnerable on two fronts in particular.
Firstly, it was far less diversified than many of its global peers. SVB was a specialist lender whose deposit base was almost entirely composed of early-stage technology companies - firms that had enjoyed substantial capital infusions in 2021 but whose inflows later dried up. Secondly, SVB’s risk management controls were weak. It was unable to grow its loan book as quickly as it was taking in deposits, so it chose to park its clients’ funds in longer-maturity US treasuries and mortgage-backed securities. However, SVB did not hedge the duration risk of those assets, meaning that it made such investments while failing to insure itself against any losses it might incur in the event of interest rate hikes.
This oversight led to a mismatch in the duration of its liabilities – deposits – and its assets. So, when the US Federal Reserve raised interest rates and SVB’s clients began withdrawing money, the bank was forced to sell its bonds at a heavy loss. Those losses eventually equalled the bank’s equity, triggering its demise.
None of this suggests the world is about to witness a credit squeeze. SVB’s lack of diversification and weak risk management are not characteristic of the banking industry as a whole. In the US, large, systemically important banks are subject to much tougher regulations governing risk management and the reporting of portfolio losses. In Europe, all banks are required to carry out regular mark-to-market adjustments to their investment portfolios. Furthermore, the backstops put in place by US regulators - including measures to protect SVB deposits in full - materially reduces but do not eliminate the risk of further bank runs. A more comprehensive solution offering protection to all depositors across the US banking system would require bipartisan political support, for which there is little appetite or indeed need as things stand.
The collapse of SVB will continue applying pressure on central banks to consider the impact of interest rate hikes on the stability of the financial system. The ECB has further leeway on this front, given the more conservative regulatory framework the region’s banks operate in, as evidenced by their interest rate hike on Thursday. In the US, we expect an earlier end to quantitative tightening (the running down of central bank bond portfolios) than previously anticipated. One reason for this decision is that quantitative tightening disproportionately impacts smaller banks. A 50 basis point interest rate hike by the Fed at its next meeting now looks out of the question. We expect a 25 basis point rise, but we don’t rule out the US central bank from keeping rates on hold in March.
SVB’s demise is a standing reminder of the lagged economic effects of interest rate hikes; it signals that recession is more likely than investors previously thought. The negative impact that rising interest rates had on the economy was delayed by both the excess savings consumers had built up and the lines of credit businesses could access easily during the Covid pandemic.
But SVB’s demise shows that rising borrowing costs are now beginning to feed through to the economy, albeit punitively so in specific sectors. A recession is now, on the margin, more likely than many investors had previously thought.
Many areas of the financial market have yet to adequately price in the risk of recession. We have argued that the market continues to view this cycle as an "inflation cycle" and not a "growth cycle”. This has meant that the risks of a recession have not been sufficiently baked into asset valuations. Growth-sensitive asset classes across the board - cyclical equities, small-cap stocks and high-yield bonds - appear vulnerable. As markets begin to price in growing risks to the economy, we anticipate a transition in stock market dynamics. Quality stocks, which have struggled through the cycle so far (because markets considered inflation as the primary risk rather than a decline in growth), should begin to outperform. As disinflation continues, we expect the equity-to-bond correlation over the medium term to turn negative, taking pressure off balanced funds. The attraction of gold also increases as real rates stabilise and grind lower alongside a weakening US dollar. Emerging markets continue to be a bright spot, with China reopening on track.
© 2023 funds europe