Monday digest
Posted 27 March 2023
Overview: Swiss parochialism backfires
March continues to provide investors with the opposite of the ‘steady-as-she-goes’ environment of January and February. It appeared that global banking sector turmoil had eased after Swiss authorities officiated over a classic ‘shotgun’ marriage between Credit Suisse and UBS. Indeed, for a few days, stock markets and bond yields recovered somewhat, but the uneasy equilibrium was unbalanced once again after the US Federal Reserve (Fed) raised rates by another 0.25% to a range of 4.75%-5.0%.
Fed chair Jay Powell acknowledged the stresses on banks would likely tighten financial conditions, meaning the Fed may not need further rate rises to pursue its policy goals. Given it was aggressive monetary tightening that had weakened banks’ capital base, the obstinance of the rate decision saw focus return to other names in the banking sector. Germany’s Deutsche and Commerzbank came under renewed pressure, as well as some French and Italian banks.
No doubt much of the banking sector is suffering collateral damage from the central banks’ war against inflation over the past 12 months. But the manner in which the Swiss authorities hammered out the UBS takeover of Credit Suisse may well have amplified the returning weakness. The ‘rescue’ of Credit Suisse came at the expense of holders of its Additional Tier 1 (AT1) bonds (aka contingent convertible ‘CoCo’ bonds) which were written down to zero, while its equity shareholders (ranked below bond holders in the capital structure) were spared a similar fate. This preferential treatment of equity over bond holders is without precedent and deeply concerning. The principle is not that AT1 bond holders should be protected from loss, but that the capital structure as investors understand it must be upheld to re-establish trust in – and investor appetite for – the banking sector.
We should make clear that Tatton has no particular ‘skin in the game’ here. Our investment portfolios have minimal exposure directly to these issues, if any – and where we do, it is mostly through index tracker funds. The point is rather that instead of re-establishing trust among banking sector clients and investors, the Swiss authorities did the opposite, supposedly in the name of speed of action and financial stability. The aftermath still reverberates around markets, and we suspect last weekend’s actions have substantially eroded the Swiss banking sector’s international standing.
Banking sector rout squeezes the little guys
As noted last week, a rate rise cycle as dramatic as this one is bound to reveal cracks in the system. But no matter how much you mitigate systemic risks, each bank run increases the chances of another one. Almost every bank, no matter how well positioned, will take precautionary action as a consequence. Lenders will be more cautious, reducing capital available to corporations. As such, analysts suspect a general credit crunch in corporate America is now all but certain.
Storms are always worse for smaller boats, and small and micro-cap firms will be particularly hard hit. We are already seeing this play out, with investors pulling out of small businesses. In particular, positions in highly-leveraged companies have plummeted through March. Credit spreads – the premium companies have to pay for borrowing above those the government enjoys – are now expected to see their largest monthly increase since last September. Companies that rely on regional banks for funding will be very worried. According to Bloomberg, US commercial property owners will see nearly $400 billion of debt mature this year, requiring refinancing, with another $500 billion set to mature in 2024. With the financial and economic backdrop as it is, many could struggle to find banks willing to provide new loans. Those that secure refinancing will do so at sharply higher costs.
Those scarred by memories of 2008 will no doubt be alarmed by problems spreading higher up the credit chain. But we maintain our broad assessment from last week: this classic liquidity squeeze will cause problems for many, but systemic failure is highly unlikely. Policymakers are doing a good job of filling in the cracks before anything shatters. We welcome the relative calm of the past week, but further troubles are inevitable, potentially even for bigger players. We should have a safe landing in the end, but the rollercoaster is not finished yet.
UK inflation makes an unwelcome comeback
Last week’s announcement from the Office for National Statistics (ONS) that consumer prices index (CPI) inflation had crept up from 10.1% year-on-year in January to 10.4% in February came as an unwelcome surprise. Before this news, things were looking better for the UK economy, albeit only slightly. Falling fuel prices, easing global input costs and a small but consistent slide in monthly inflation had suggested ‘peak’ inflation was behind us, a view even endorsed by the Bank of England (BoE). But the latest inflation print poured cold water on hopes that the central bank might slow down or even suspend its interest rate rising cycle. Instead, the BoE increased its base rate by 0.25%, taking it to 4.25% in the 11th rise since December 2021.
Food, drink and clothing were the main culprits according to the ONS, with food and non-alcoholic drink prices rising 18% in February, the fastest pace in 45 years. This was despite food prices outside of the UK generally falling over the last few months, suggesting this particular problem is specifically British. Even disregarding the food element though, prices were still higher than expected. Core inflation – which strips out more volatile elements like food and fuel – came in at 6.2%, higher than January’s 5.8%. This is a measure the BoE pays close attention to, as it is an indicator of more persistent ‘stickier’ inflationary trends. Along those same lines, inflation in the services sector rose to 6.6% from 6.0% the month before, suggesting stronger-than-expected wage pressures. The BoE was concerned enough to raise the base rate to 4.25%. Since prices started soaring, policymakers’ biggest concern has been the threat of a wage-price spiral, where employees react to higher prices with higher wage demands, which in turn cause businesses to raise prices again. However, the rise in food and clothing prices is notable. We think this is a sign companies – particularly supermarkets – are taking the opportunity to rebuild their profit margins, banking on the belief that consumers have become acclimatised to elevated inflation expectations, thanks to the prolonged period of rising prices. This may be good news for investors in supermarket shares, but less so for consumers and central bankres. If supermarkets tell us they’re doing well in their next trading reports, one might expect some pushback.