Industry Voice: Multi-asset allocation views — perfect storm or storm in a teacup?

Recent concerns over the banking sector seem to have eased, but have raised uncertainties around the availability of credit and the path of interest rates. Aviva Investors' Head of Multi-Asset Funds, Sunil Krishnan, assesses the consequences for multi-asset investors.

clock • 12 min read
Industry Voice: Multi-asset allocation views — perfect storm or storm in a teacup?

Read this article to understand:

  • Why the mini banking crisis looks to be contained
  • Central banks' balancing act to ensure bank lending is not crushed but inflation is tamed
  • The implications for multi-asset portfolios

March and April were overshadowed by the failure of US bank Silicon Valley Bank (SVB) and ongoing struggles at Credit Suisse and First Republic, raising concerns over a possible domino effect across the banking sector. Governments quickly stepped in, the US deciding to guarantee SVB's deposits, while the Swiss authorities asked UBS to purchase Credit Suisse for $3.25 billion and JPMorgan Chase acquired First Republic in a $10.6 billion deal brokered by the Federal Deposit Insurance Corporation (FDIC).

Several central banks also announced a coordinated effort to keep money flowing through the global financial system (and therefore keep credit flowing to households and businesses), using standing dollar swap lines at least until the end of April.[i] Markets remain on the lookout for further weaknesses in the economy, but the bank fragility fallout seems to have been contained for now.  

Figure 1: Equity markets have recovered (28/02/2023 = 100)

Source: Bloomberg, as of April 17, 2023.

For multi-asset investors, this raises four key questions: Is there any risk of a Lehman-style financial crisis? What is the medium-term impact on the credit cycle? What does it mean for policy? And what are the investment implications?

Is there a risk of a Lehman-style crisis?

Problems at SVB and Credit Suisse partly stemmed from the rise in in interest rates, but the precise reasons offer reassurance we are not on the cusp of a systemic banking crisis (also see Ask the Fund Manager).

Briefly, banks have assets, such as securities they hold and loans on which clients pay interest, and liabilities which, interestingly, include deposits people make into the bank. When clients make a deposit, they become creditors of the bank. And they are creditors governments are concerned about because if there's a risk of them losing money, a) they are not all rich and sophisticated individuals, and b) there is the potential for economy-wide confidence to be damaged. Nothing makes people want to queue up outside a bank for their money more than seeing people queuing up outside a bank.

This is why governments in all major economies have introduced deposit insurance: up to £85,000 in the UK, €100,000 in the euro area and $250,000 in the US. The intention is to protect savers' money, but also to help banks to rely on this money as a source of funding. If depositors have confidence in the safety of their savings, then it is a stickier funding source than, for example, the short-term wholesale funding banks used in the run-up to the global financial crisis (GFC).

The problem with SVB and Credit Suisse was that a relatively small portion of their deposit funding was as sticky as it might be for a regular bank. Firstly, both relied mostly on companies and wealthy individuals for deposits. This meant the value of the government guarantee was too low to protect most clients' deposits. Only three per cent of SVB's deposits were small enough to be covered by the $250,000 guarantee. Therefore, the guarantee wouldn't stop savers from moving their money out.

Secondly, the two banks were not necessarily attractive places to save. We have seen a sharp rise in yields on money markets, while some challenger banks are offering better deposit rates. Established banks haven't kept pace with the yields available on those competing assets. Credit Suisse had suffered deposit outflows for many years - over CHF100 billion in the fourth quarter of 2022 alone - so it could hardly be considered sticky money.[II]

These issues were compounded by the fact bank runs can now happen virtually. Concerns can arise on social media and withdrawals made online in a couple of clicks. Although this could happen to other banks, SVB and Credit Suisse were outliers compared to their peers in that they were significantly more reliant on flighty deposit money.

For example, although we also saw social media noise and investor concerns around Deutsche Bank in March, a much smaller proportion of that bank's funding comes from uninsured deposits (c. 70 per cent of its retail deposits are insured).[III]

Credit Suisse and SVB were also specific cases in terms of assets

Assets were another source of Credit Suisse and SVB's difficulties. Banks' balance sheets tend to have a large pool of liabilities (funds they've borrowed from savers or markets) and a large pool of assets. The equity is the small sliver of difference between these two pools.

SVB had invested most of its assets in fixed-income securities, whose value had fallen steeply as interest rates rose, creating large unrealised losses. When it was forced to sell assets to meet redemptions from depositors, those losses became realised and crystallised the bank's insolvency.

The issue with Credit Suisse was one of confidence, which dictated market valuation of the assets. Credit Suisse has suffered serious risk failures in recent years, such as with Greensill and Archegos.[IV] That impaired confidence in the value of the bank's assets, thereby reducing the value of that thin sliver of equity - and causing the share price to plummet to $0.88 (from a post-COVID high of $14.49 on February 26, 2021).[V]

In principle, if there was a big markdown in assets, that kind of concern could arise even in a bank with a stable deposit base. The question would then be whether that bank has enough capital (chiefly equity) to protect the firm's solvency against the markdown.

But if one thing was a focus of regulators post-GFC, it was ensuring banks have stronger capital bases, particularly in Europe. They are in a much better position today to withstand volatility in their assets or realising losses than in 2007.

For Deutsche Bank, the source of investors' concern was that it was one of the European banks most exposed to commercial real estate, an asset class that looked challenged in March. But, as a proportion of Deutsche Bank's overall asset base, commercial real estate isn't particularly large, so its capital buffers should be comfortably sufficient for this specific risk.[VI]

Given SVB and Credit Suisse were such outliers in terms of their sources of funding and banks' capital levels are much more secure than before the GFC, the scope for a near-term Lehman-type domino effect appears limited.

What will be the medium-term impact on the credit cycle?

In terms of medium-term consequences, higher interest rates may increase banks' funding costs, which could impact their appetite to lend, but the impact of the SVB and Credit Suisse failures seems limited otherwise.

Most banks have benefited from higher interest rates, for example by increasing mortgage rates, while not necessarily offering higher deposit rates. This cannot go on indefinitely, but banks may not want to attract a lot of deposits remunerated at a higher rate, in which case they will not be able to expand lending by much either.

In the markets, the way Credit Suisse was resolved involved big losses for creditors who had invested in "Additional Tier 1" capital securities, which were not expected to lose out ahead of equity (see Figure 2). That has generated uncertainty and volatility for this source of capital for banks.[VII]

Figure 2: Order of priority for bank creditors

Source: BondAdviser, Aviva Investors, as of April 19, 2023.

The main concern is whether higher funding costs and potentially lower risk appetite affects the supply of credit from banks to the broader economy. It is too early to gauge the precise risks to growth because we don't know how banks will respond, or whether sectors like commercial real estate will find other sources of funding. But it clearly is an important point to watch.

What does it mean for policy?

Strong jobs and inflation numbers in February pushed up market expectations for the path of interest rates, particularly in the US. But the uncertainty around bank lending means the private sector may now be tightening monetary conditions so central banks don't have to raise interest rates as much as expected.

The difficulty is no one, not even central bankers, know how much more policy tightening may or may not be necessary. What will credit conditions be in three- or four-months' time? How high will inflation be? Both are open questions right now.

If credit conditions are not severely affected and inflation proves stubborn, interest rates may need to continue rising. However, central bankers know they will have to move gradually to have time to assess the knock-on effects of tightening, especially if those are in hidden corners of the financial system.

In the US, interest rate futures are implying a cutting cycle but probably reflect the middle of two outcomes; one where the central bank can keep rates fixed or even raise them slowly; and the other where it is forced into rapid cutting because bank lending declines significantly.  

Figure 3: US Fed Funds interest rate futures yield (percentage)

Source: Bloomberg, as of April 17, 2023.

Investment implications

Last year, the rise in bond-market volatility, decline in bond prices and loss of bond/ equity diversification benefits caused headaches for multi-asset investors. Today, not only does the distribution of bond returns look more favourable, but bonds should be a better diversifier from equities again, whatever the path of interest rates.

If rates continue to rise gradually, bond values may not necessarily decline: yields may have already peaked. In the US, for example, the ten-year US Treasury yield has not yet returned to the high reached four hikes ago.[VIII] On the other hand, if equity markets were impacted by an economic slowdown, central banks would likely begin cutting rates, which would support bond performance.

As a result, we are more constructive than we have been for some time on bonds. We have positions in gilts across portfolios and closed underweights to US Treasuries around the ten-year point.

From an equity perspective, there are still risks, such as a credit-inspired hard landing. However, this risk is heavily debated by investors and was behind a significant amount of the recent pullback. Events might now break more positively than investors expect.

Figure 4: Investors are focused on financial risks (28/02/2023 = 100)

Source: Bloomberg, as of April 17, 2023.

Moreover, market sentiment is improving slowly, volatility has moderated for bonds and equities, and banking sector stresses have been contained (even though a reduction in lending remains likely). This combination is creating a more supportive environment for equities. From a sentiment and valuation perspective, there is some margin of safety, particularly in more value-driven sectors.

Figure 5: Market volatility is returning to normal (31/12/2021 = 100)

Source: Bloomberg, as of April 17, 2023.

In March, cyclical sectors fell almost in unison with banks, creating interesting opportunities. The skew of possible returns now offers more meaningful upside if the economy proves resilient, particularly in sectors like resources. This will be helped by the continued reopening in China and signs of recovery in the Chinese property market.[IX]

Since the scare in March, conditions already seem to have settled down, with markets obsessing over inflation again. Nevertheless, it was a timely reminder that higher interest rates can expose areas of vulnerability in the economy. Although we are now cautiously constructive on bonds and equities, investors should remain alert.

 



[I] Press release, 'Coordinated central bank action to enhance the provision of U.S. dollar liquidity', Board of Governors of the Federal Reserve System, March 19, 2023. https://www.federalreserve.gov/newsevents/pressreleases/monetary20230319a.htm

[II] Elliot Smith, 'Credit Suisse shares sink as ‘material weaknesses' found in financial reporting', CNBC, March 14, 2023. https://www.cnbc.com/2023/03/14/credit-suisse-finds-material-weaknesses-in-financial-reporting-says-outflows-not-yet-reversed.html

[III] 'After Credit Suisse's demise, attention turns to Deutsche Bank', The Economist, March 24, 2023. https://www.economist.com/finance-and-economics/2023/03/24/after-credit-suisses-demise-attention-turns-to-deutsche-bank

[IV] Elliot Smith, 'Credit Suisse shares sink as ‘material weaknesses' found in financial reporting', CNBC, March 14, 2023. https://www.cnbc.com/2023/03/14/credit-suisse-finds-material-weaknesses-in-financial-reporting-says-outflows-not-yet-reversed.html

[V] Source: Bloomberg, as of April 6, 2023.

[VI] 'After Credit Suisse's demise, attention turns to Deutsche Bank', The Economist, March 24, 2023. https://www.economist.com/finance-and-economics/2023/03/24/after-credit-suisses-demise-attention-turns-to-deutsche-bank

[VII] Thomas Hale, 'Additional tier 1 bonds: the wiped-out debt at centre of Credit Suisse takeover', Financial Times, March 20, 2023. https://www.ft.com/content/47168c08-f09e-4ddb-905f-3c368c4f2b05

[VIII] Sarah Min, Tanaya Macheel, Sophie Kiderlin, '10-year Treasury yield declines as Fed hikes rates', CNBC, February 1, 2023. https://www.cnbc.com/2023/02/01/us-treasury-yields-ahead-of-fed-interest-rate-decision.html

[IX] Andrew Mullen, 'China's economic recovery ‘on track' as services activity hits 12-year high in March', South China Morning Post, March 31, 2023. https://www.scmp.com/economy/economic-indicators/article/3215489/chinas-factory-activity-growth-slowed-march-economy-still-showing-signs-recovery

 

 

Important information

THIS IS A MARKETING COMMUNICATION

Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (AIGSL). Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. Some data shown are hypothetical or projected and may not come to pass as stated due to changes in market conditions and are not guarantees of future outcomes. This material is not a recommendation to sell or purchase any investment.

The information contained herein is for general guidance only. It is the responsibility of any person or persons in possession of this information to inform themselves of, and to observe, all applicable laws and regulations of any relevant jurisdiction. The information contained herein does not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorised or to any person to whom it would be unlawful to make such offer or solicitation.

An Aviva company. In the UK, this document is by Aviva Investors Global Services Limited. Registered in England No. 1151805. Registered Office: St Helens, 1 Undershaft, London EC3P 3DQ. Authorised and regulated by the Financial Conduct Authority. Firm Reference No. 119178.

415600 30/04/2024 

 

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