The return of inflation means some Orwellian logic for investors - good is bad.
Positive economic activity means demand, jobs, higher wages, higher prices. A risk of spiral. Existentially, central banks have to fight it: they hike interest rates, and markets suffer. Lower bond prices, lower equity multiples, more economic uncertainty was the story of 2022, terrible for all asset classes.
The first quarter of 2023 is tumultuous. January started on a perfect scenario of declining inflation and resilient growth. But then, February shocked with stronger activity, a booming US employment, and persistent inflation. Markets sold-off, preparing to more brutal action from central banks.
March added a new headache. Three US banks collapsed. Crypto-heavy Silvergate, start-up specialist SVB and New York-based Signature faced massive withdrawals, and authorities took control. The storm then moved to Switzerland.
Credit Suisse, already in the middle of a restructuration to fix the consequences of past issues, came under immense pressure. Swiss authorities stepped in and brokered a takeover by their giant rival and Paradeplatz neighbor UBS.
This is obviously scary. Were these banks in such an extremely distressed situation?
Taking on two spirals
From a static perspective, probably not: it’s not about toxic assets or credit losses meeting insufficient capital. It looked manageable over time. But in the digital age, a loss of confidence is lethal: deposits are withdrawn at a meteoric pace, especially the large ones who exceeds government insured levels. When banks cannot provide liquidity anymore, it’s panic, and a risk of contagion.
This is the other spiral keeping central bankers up at night. Of course, tools exist to solve liquidity issues: collateralized loans, fresh cash in exchange for a right on banks’ assets. What about inflation? Can central banks fight two spirals at the same time?
Especially as steep rate hikes, the weapon against inflation, are one of the factors behind these bank failures?
The March policy meetings from the ECB, Fed, BoE, SNB all happened in the last 7 days. All four hiked interest rates. The message?
There is no trade-off between price stability and financial stability. The former is countered with rate hikes, to moderate the real economy. For the latter, they will provide liquidity, backed by their potentially infinite balance-sheets.
Flowing within financial system
Of course, this looks contradictory. But first, the commitment could be enough to restore confidence. Second, the money created for this purpose (the Fed ‘printed’ $300 billion last week alone) should hopefully stay within the financial system, with limited impact on inflation.
Basically, anxious depositors transfer their money to a safer place, they don’t rush to shopping malls. There is anyway little alternative for central banks.
What does it mean for investors?
Bad news first. The moderation of credit supply from the stress in banks increases the risk of a recession in the west, in addition to the impact of monetary tightening. It doesn’t sound great for some stock markets, but it is deflationary, good news for the future friendliness of central banks.
A slowdown ahead is being reflected by lower interest rates, which supports the price of quality bonds, and is also positive for the mark-to-market value of banks’ portfolio assets. Finally, but crucially: the world is not just the West.
Many regions, including Asia and the GCC, are doing very well. Of course, there are limits to decoupling, even in a shrinking globalization, and a systemic financial crisis would know no border. This looks very unlikely: an overwhelming majority of banks have no capital or credit concern, and the last thing they want is to disappear over a weekend.
Less of the AT1s, of course
Liquidity issues for sound banks, again, can be handled by central banks.
One direct implication for investments is high volatility for some time, due to complexity, unpredictability, and a torrid pace of events. This is why we overweight cash over alternative investments: there is simply no better uncorrelated asset now, with appreciable risk-free return.
We are neutral on both equity and fixed income, but with clear preferences. For stocks, we definitely favor emerging markets. For bonds, we limit credit risk, underweight on the riskiest segments, from high yield to EM and including of course most of AT1 bonds from banks, with some, but few, exceptions.