Market Pulse: A Year of Two Halves?

Have we averted a global recession, and is the global banking sector on the verge of collapsing? 

Join our host Adam Hunt, Head of International Wealth and Investment, as he quizzes our Head of Portfolio Management, Chris Stead, on the factors driving markets in 2023, and what we can expect this year from inflation and interest rates. 

Listen to this episode to find out more and subscribe to keep up to date with the latest market insights.

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Transcript

[00:00:00.650] - Adam Hunt
Hello and welcome to the Melville Douglas Podcast with myself, Adam Hunt, Head of International Wealth and Investments, and Chris Stead, Head of Melville Douglas International. Morning Chris.

[00:00:13.740] - Chris Stead
Morning Adam.

[00:00:15.570] - Adam Hunt
I've got a few questions for you that we see top of mind for clients of late. Firstly, of course, interest rates, we know interest rates are used to combat inflation, but it also has both the intended and unintended consequences. One of those unintended consequences of the sharp rise in interest rates is the banking crisis now that's been dominating the market for the past few weeks. But should we be worried about systemic risk and perhaps even a repeat of the 2008 global financial crisis?

[00:00:52.290] - Chris Stead
Yes, great question, very topical. We've had a good number of clients sort of engaging with us concerned that after one of the most aggressive interest rate hiking cycles in recent history, we have to really go back to the 1990s. We last seen such a quick sort of hike in interest rates and the unintended consequences of those higher interest rates are sort of exposing areas in the market, in the financial system, that haven't managed to cope with the risk of such a hike, the extent of the interest rate hike, and the speed of the interest rate hikes. So yes, we've had in March we had three US banks very quickly go under. Banking is a trust business and if you lose trust in your banker, you wish to withdraw your capital out of that bank. And there isn't any bank that would be able to repay all their depositors overnight because they use the short table money that we put on banks balance sheets and deposits and they lend them out and invest them elsewhere. So there is a timing issue. So very quickly we had Silicon Valley Bank and two other US banks go under, surprised the market very very quickly.

[00:02:30.220] - Chris Stead
And to your question, Adam, the global financial crisis in 2008, which was some 15 years ago already, still feels very, very fresh in one's mind. And concerns that are we having a repeat of that? And then we want the return on our money. So to answer your question, are we entering another 2008 global financial crisis situation? Our view is no, very slim chance of that happening. Few reasons why the financial system, global banks, the big traditional banks have very, very strong tier one capital. They've been very well regulated, they have not got concentrated risk in only a few sectors and a few clients. They have got diversified loan books and the loans in the lending books are very well risk managed, which was unlike what we saw in 2008 where banks were taking on far too far too much risk in the form of mortgages which were packaged up and sold. So the financial system, the traditional banks are in rude health, but it is the smaller regional banks, specialised banks like Silicon Valley Bank, that have got themselves in trouble because their client base were more in the sort of the startup technology businesses.

[00:04:18.130] - Chris Stead
And those clients of theirs were awash with cash because it was a zero interest rate world and investors were throwing cash at these businesses, they were depositing it with like Silicon Valley Bank. Silicon Valley Bank didn't have like a traditional bank, a big lending book, diversified lending book, so they used those deposits and bought AAA US Treasuries, which was a good decision. However, a lot of that are US Treasuries because short dated Treasuries only a year ago were yielding 0.3-0.4%. So they went longer dated bonds and with interest rates rising to such a speed over the last twelve months, there was on the longer dated loan book, they had substantial losses and those losses wiped out the bank's capital. They came to the market and asked to raise some capital equity and that the capital investors wouldn't fund them anymore and the bank quickly went under and so did others. So is there systemic risk? I think there is systemic risk in the smaller regional banks, not only in the US, across the world that are very specialised. I'm sure there is going to be some more smaller banks and other businesses coming under pressure.

[00:05:53.660] - Chris Stead
With interest rates going up next week, there's every chance that US rates will go up again next week and UK rates to follow. So yes, we think there will be more casualties. Already you're seeing at the moment, we're seeing First Republic in the headlines. Over the last few days, share prices collapsed. Depositors have withdrawn 100 billion in the last few weeks, they're needing propping up, so no surprise, the ripple effects after three US banks going bust. There is pressure, however, is there systemic risk in the large banks, traditional banks like JPMorgans or HSBCs, Barclays and things like? The answer is no. So we do not believe there's a repeat of the global financial crisis.

[00:06:49.720] - Adam Hunt
So given that, looking at Credit Suisse and what happened there, would we say that's actually a different problem? It may be connected through sentiment and what was going on in the market at the time, but it was a different problem.

[00:07:03.640] - Chris Stead
Yeah, Credit Suisse, great thing that's closer to home for our European clients. Credit Suisse, a fantastic name, long standing institutional name. Credit Suisse has been in trouble for many, many years. Well known, well flagged, and yes, there was obviously a knock on effect from there. It came across from the US to Europe to look at sort of weaker banks and because one knew that Credit Suisse certainly was very solvent and whatever, no, not a problem. But again, because of this very thin divide between sort of trust, confidence in a bank and no confidence, Credit Suisse unfortunately suddenly saw a run on their deposits and then over that weekend, only a few weekends ago, UBS came in and acquired Credit Suisse with the backing of the Swiss National Bank. That has underwritten a lot of the sort of potential sort of losses. So they have found a new home in UBS. So that was not because Credit Suisse was insolvent or anything like that. It was just really again, that was a bit of systemic risk on just the trust on a bank, a big, big behemoth of a business that had been in trouble ever since 2008.

[00:08:31.800] - Chris Stead
And that trust, with depositors moving away, forced the sale of Credit Suisse to UBS. We don't see that anywhere else in other large European, US, UK, global banks. We see them very well capitalised as I said before, so we think that is now passed. But as I said before, some of the smaller regional banks, finance houses. We wouldn't be surprised to see some more come into difficulty in the weeks and months ahead.

[00:09:13.970] - Adam Hunt
Thanks. And I guess the other real question for everybody is did we have exposure to any of the US banks, the three US banks potentially Republic Bank as well and or Credit Suisse?

[00:09:27.350] - Chris Stead
We did Adam. Avid readers, clients of ours, we did put out a note to clients in March covering this topic on exposures and did we think it was systemic and the start of a global financial crisis and where did our portfolios hold any exposure to these banks? The answer is we do have exposure or did have exposure, but it was negligible, and I mean very negligible.

[00:10:57.870] - Chris Stead
We go to market with two main sort of ways of managing money. Our Focused, our growth at a reasonable price portfolios. We had no exposure to the US banks, three US banks that went under in the Focus Solutions. Our only US bank holding is the largest US bank which is JPMorgan largest bank by assets. So no exposure there. In Focused in the fixed income and the multi asset portfolios. In the fixed income element of Focused we had some very negligible exposure, indirect exposure by some of the corporate bond exchange traded funds ETFs and some of the bond funds of Credit Suisse they had some exposure but it works out at something like 0.07% of a multi asset portfolio so not even sort of a rounding number. Our other solutions, our Multi Manager solutions come under Diversified Portfolio Solutions. There was a very small holding in Silicon Valley Bank held by one of our global equity managers that was less than 0.12% of portfolio's equity exposure and that would be natural given the style neutral or neutral style of approach of our diversified solutions. We would expect to have greater exposure across financials than in our Focus Solutions.

[00:11:42.890] - Chris Stead
But within Diversified the bias is to the traditional, large and well-capitalised banks, rather than smaller regional banks. But we did have, as I say, one of the managers had a very small position in Silicon Valley Bank. Also as with our Focus Solutions in the fixed income weightings, same thing we had negligible exposure to Credit Suisse indirect through those corporate bond funds and exchange traded funds. So where we've done a lot of work on what is the sort of financial loss in percentage time these strategies. So US mandates you're looking, depending on risk per profile, a top of 0.15 percent of a portfolio and for sterling mandates, 0.07% at most. So it's not zero, but it's very close to zero exposure to the US banks and Credit Suisse. It's something that we are actively continuing to monitor. To answer your first question, that, is it systemic? As I say, we would not be surprised to see more ripples and more banks come under smaller banks, specialised banks come under pressure not only because of the interest hikes. One thing that is in the news at the moment is, where is the other risk with interest rate hikes?

[00:13:17.830] - Chris Stead
It’s really in commercial property, there's a lot being written about and concerned about after a decade of zero interest rates, there's a lot of lending and commercial development gone on and how can, now interest rates have gone up 5%, how can this be funded? So we've been looking very closely at commercial property lending in these banks. The good news again is your large traditional banks, there is exposure, they don't all default on day one. It's going to be over many years. It's very contained. So we don't think there's contagion within commercial property on top of some of these regional banks specialised clients that have found themselves in trouble. So we monitor the situation as we do all the time. So we acted in the actively managed portfolios and we do not believe there is systemic risk akin to a 2008 situation. The market is also telling us that it's not just us. The market, look what the markets are doing. The markets this year are hitting highs for the year or close to, despite these concerns, where there is exposure and problems in some of these smaller regional banks.

[00:14:41.860] - Adam Hunt
Yeah. Thanks, Chris. I think you've just called it there. With the highs in the markets that we're seeing at the moment, and I think off the back of last year, which was very challenging, we've seen a good rally in equities fixed income so far this year, but the backdrop to that is interest rates continuing to increase, inflation really not going away. We keep thinking it's going to come down, but actually it's stubbornly high. What do we think for the rest of the year? Are we fraught with too much risk or not looking too bad?

[00:15:15.850] - Chris Stead
Yeah, again, very topical question from clients. It has been a very favourable first four months. Very challenging 2022. Don't forget, markets are discounting tools. They're not looking at things today, they're looking at what life is like to be in the economy, financial markets, a whole host of inputs of where life is like to be in the next twelve, nine to twelve months. So they're discounting where we're like to be now at the end of the year. It's been a favourable first four months for a number of reasons. One of the big sort of drivers of the rebound in risk assets has been the reopening of China. It came by surprise in November of last year. Reopening after COVID, where everybody was forced to stay at home and then they went on the streets, which is unlike Chinese, they changed their policy and reopened. Why has that been such good news for the market? And that is largely due to the fact it's two pronged - One, Chinese will be coming out of COVID so there'll be a lot of demand as Chinese go into services. So they'll start travelling again, go to cinemas, go to restaurants and get on with their lives.

 [00:16:44.310] - Chris Stead
I read the other day that the Chinese have over 4 trillion of excess savings, $4 trillion of excess savings. Not all of that will be spent overnight, but basically that's going to find its way in the markets at some stage. And basically, with China reopening, we can then say with that demand, China will not be going into recession. And in fact, China's economic growth will pick up this year again, so we can rule out a global recession this year. So markets like that. Not only that, China is a big manufacturer to the world and part of the inflation problem has been supply issues. When China is locking down COVID led lockdowns, factories are closed so supply of lots of goods weren't getting into the economy. And if there's more demand than supply, then you get inflation. So that should help inflation metrics ease as we go through this year. So that's one of the reasons why we've had a good first four months. We've had more stability in energy prices and we had a mild European winter. So, middle of last year, where energy prices were, gas and oil price have collapsed from those sort of prices that would have stayed there over the winter months, the European winter months.

[00:18:07.730] - Chris Stead
You would have certainly seen horrible recessions in Europe because basically the consumer would have had to spend most of their discretionary spend on heating their homes and fuelling their cars and so forth. So that abated. So that's been very good news. There's also an increased belief that inflation has peaked almost everywhere. US, it seems to have peaked middle of last year. Europe, it's a bit more stubborn, and UK certainly is stubborn, but it looks as though it's starting to head down. Markets, as I said before, are big discounters. So although still far too high and causing huge problems, because the trend is now down, the markets are now discounting. With inflation now starting to fall, there is the strong possibility that interest rates will find their terminal rate, either peak rate in the coming few months and will actually be falling by the end of this year or early next year. So markets are already discounting, that’s good news. Lower interest rates, lower inflation will be very good for risk assets and has also been favourable for the bond market. So the bond markets have had a good start to the year as well.

[00:19:26.170] - Chris Stead
So to answer your question, that's why we've had a good start to the year. Where are we going for the rest of the year? We're cautiously optimistic. Are we believers in the soft landing narrative that's going around where soft landing is a, you know, a meaningful slowdown without sort of only mild recessions, rather than the hard landing, which is a nasty recession, deep recession? We believe that the markets have kept up with events, so where equities are priced today, they're offering fair value. They're not overly cheap, but they're not overly expensive. They have certainly re-rated over the last couple of years because earnings have gone up and prices have come down, so they're not as expensive as they were when we came out of COVID. But basically our view is that they're up with events and it's all going to be data dependent. When, at what level will interest rates peak and when will interest rates start falling? We think core inflation is going to remain more stubborn. And when we say core inflation, that's excluding food and energy. So the price of a haircut, just everything you do, has gone up very high steps.

[00:20:57.600] - Chris Stead
And this inflation is going to take quite some time to get core inflation down to the targeted levels of 2% to 3%. And that means interest rates, although they may peak, and we think they will peak in the coming month or two. So another quarter percent hike or two in the US, same in the UK and same in Europe, but then they'll be done. But unfortunately we don't think core inflation is about to sort of drop off a cliff and get back to target levels and interest rates around the world fall back to 2% or 3%. So we think core inflation is going to be more stubborn, interest rates will peak, but they will be held higher for longer and that will cause markets that are already up with events to be range bound. So we're not negative. We think there just needs to be more time for these markets to adjust to a higher interest rate, more stubborn inflationary environment. And when we say more time, we're talking about three to six months. So over the summer months we'd expect a bit more sort of volatility, a few more sort of creaks coming through with regard to businesses that are highly leveraged, got too much debt, badly managed and can't deal with a slowdown in economic growth and higher costs, so that unfortunately there will be some more casualties.

[00:22:22.890] - Chris Stead
We need to see unemployment rise a bit as well. So if unemployment rises, your friend loses your job, one of your family loses a job, you're not going to go out and make a big ticket acquisition. That will slow inflation, it'll slow the economy, it'll hurt corporate profits to some degree, so corporate profitability will come under pressure. All that is already priced in. But it's with that backdrop, we don't see that this market is off to the races again. We think it's the next three months, we'd be very happy if it sort of moves sidewards within a tight trading range before we get into later this year. And then I think the markets will be starting to discount sometime in 2024, the new cycle, economic cycle, and then we will be more positive. So, in the short term, in the next three to six months, expect more volatility, expect range bound markets, but we are not negative. We do believe patient investors should expect a much more favourable outcome for 2023. So all our client mandates that follow our discretionary portfolios, whether you're in a bond portfolio or whether you're equity or balanced or whatever, are all usefully up this year.

[00:23:49.980] - Chris Stead
We do believe this will be a positive year for investors who are patient, who can live with the ongoing volatility that's always with us. So I hope that answers your question.

[00:24:02.770] - Adam Hunt
Thanks Chris. In this world I think sort of my takeaway from that perhaps would be to keep building up some cash to add into the portfolio so we're ready when we see those dips in the market and remembering it's all about being in the market, not trying to time it.

[00:24:21.850] - Chris Stead
Yeah, absolutely. Timing the market is very difficult at the moment. By the dips, I'm sure we'll have them. And if you have liquidity events, work with the wealth managers, the investment teams, and we'll be able to deploy cash, hopefully at appropriate times.

 [00:24:40.750] - Adam Hunt
Superb. Look, I could, I'm sure, ask you many more questions, but I'm going to pause at that stage. And thank you very much as ever, for your time. I will be back over the coming weeks and months just to put a few more questions to you. But until then, thanks a lot.

 [00:24:57.620] - Chris Stead
Thanks, Adam. Cheers.