Market commentary: 1 January 2023 – 31 March 2023

BANK COLLAPSES

Another month, another banking crisis. Plus ça change, plus c’est la même chose.

We discussed the story in our “Spotlight” note of 23rd March but let us re-examine two of them; Silicon Valley Bank (SVB) and Credit Suisse. There is a Shakespearean element to these tales, because they are as old as time and reveal human folly and psychology. Banks make money by charging higher rates of interest than they have to pay. They increase their profits by investing their deposits in higher return (higher risk) assets, but when these risks get too high, they are vulnerable to shocks and, when those shocks eventually come, it kills them.

There is a continual tension between ambition and caution, between rising profits and security, and between the pay of those running the bank and the best interests of the owners. These are not new stories.

For SVB, their ambition drove them to focus on one sector (never a good idea) and then have a deeper focus on start-ups and early stage companies in that sector (an even worse idea). A rational person might have concerns that there would be circumstances when their depositors (small tech companies and the venture capital firms that funded them) may wish to withdraw funds in large amounts. Last year’s collapse in the value of tech companies and the consequent funding drought has been one such circumstance.

In order to balance this risk, you might conclude that having your investments in short duration sovereign US treasuries would be the best solution; they are guaranteed and their market price before expiry fluctuates little. This way when your depositors want their money you can sell your assets immediately with risk of minimal loss. How very boring.

The temptation is that longer duration treasuries pay more but have much higher volatility.  Who can select the right course, when one path leads to prudent low profits, and the other path leads to far higher profits but with some more risk? Perhaps clever employees, who may benefit from higher risk levels being taken, may persuade those in charge, who also might benefit from high levels of profit and risk, that the chance of failure is low.

It would take someone with steely resolve to examine, in even the briefest of detail, the story of pretty much every bank collapse to resist going down that route. The board of SVB, alas, did not possess such resolve; and now they are bust. They also had an insufficient capital base in a period of rising interest rates, which will be the death knell for other smaller banks that couldn’t resist the same temptations that brought down SVB.

We expect many other non-systemic banks to fail or merge or be bought out or recapitalised but we do not believe this will amount to anything like the global financial crisis.  Most of the systemically important banks have much deeper capital bases than in 2008.  And the willingness of governments and their central banks to intervene to avert systematic risk has grown, not diminished, since then.

Credit Suisse’s demise is less of a tale of basic banking errors and more of a tale of managerial incompetence. Allowing Credit Suisse to own an investment bank was about as prudent as giving teenagers unlimited cocaine. Since 2002 Credit Suisse has paid fines to regulators, pretty much every year, totalling $11.7bn. Contrast that to the $3.25bn that UBS paid to acquire them.

[source thekobeissletter.com]

Credit Suisse’s incompetence is both wide ranging and highly innovative: bribery in Mozambique, internal spying scandals, Greensill collapsing, Archegos defaulting and Bulgarian money laundering to name but a few. The last summarised scathingly by the FT: “The case centred on Credit Suisse’s role in accepting millions of Euros in deposits from a group of Bulgarian clients between 2004 and 2008. Judges ruled that the bank ignored obvious red flags – including huge sums of cash being brought in suitcases and two assassinations – that hinted at the possible criminal origins of the funds.”

Those with a nervous disposition might choose to ignore that the Credit Suisse CEO, Tidjane Thiam, told investors in 2016 that he had “fundamentally derisked” the bank.

However colourful these stories may be, the state of the banking system is much more robust than it was in the run up to the global financial crisis. Other banks will go under but the systemic risk is lower. Banks keep going bust because they make more money by having less capital and because businesses and depositors would rather get cheaper loans or higher interest than worry about capital ratios. “The banks, they seem to have thought, were in honour bound to supply….them with all the capital which they wanted to trade with”. Adam Smith’s thoughts from1772 reinforces the repetitive nature of banking failure.

We have no exposure to either of these, or indeed any other bank with material investment banking operations, for our clients as detailed in our recent note.

OTHER NEWS

Since the end of 2022 interest rates have risen to, belatedly, mitigate persistent inflation. As we have often stated, central banks were slow to raise interest rates because of the economic pain it causes. So they misunderstood and mishandled the threat of high and persistent inflation – which is what we have now. The recent inflation rise due to food prices is starting to ease – the direction of inflation is downwards to between 6% and 7% – as last year’s energy and supply shortage inflation drivers fall out of the picture. But interest rates at current levels will not bring inflation down to the Bank of England’s desired level of 2%. The underlying inflation is mostly service and wage inflation and this will persist.

The banking failures detailed above reveal the fragility of some institutions when interest rates rise and this will act as a further disincentive to central banks to raise interest rates. Central banks are now unlikely to risk a level of interest rates that would reduce inflation. They have chosen market stability over price stability. Investors now must accommodate the following context: inflation will persist, interest rates will not rise much more, but these levels of interest rates will be maintained for many years.

We now turn to our favourite two-word question: so what? The “so whats” are:

1. Recession risks have risen and we expect the reporting season to reveal data below market expectations.
2. This is not the time to be seeking longer duration debt or debt that has credit risk. We will stay ultra-short term, ultra-safe.
3. Property looks especially exposed as interest rates define the profitability of many transactions. [We sold the last elements of our property exposure during the quarter].
4. That the peak of interest rates is now expected to be lower than previously thought is a support for equities and risk assets. There is an earnings headwind, and valuation challenges persist but we should not ignore this support.
5. Gold, up 8% so far in 2023 and 18% over the last year, is defending us from market volatility and inflation, as expected.

Over the last quarter we have made modest changes to our clients’ portfolios with the direction of travel being more cautious. This approach has proved highly beneficial in protecting our clients’ wealth in a difficult economic environment and as we enter spring we will continue our focus on selecting safe, liquid and secure assets in favour of chasing returns and taking on risk.