Crisis, consolidation and credit selection

The banking crisis we have seen over the past six months is a direct consequence of the pace and rate of interest rate policy and it raises two big questions for investors. Is the crisis systemic? And what impact will it have on central bank policy?

The crisis revolves around banks’ vulnerability to deposit flight. The availability of higher paying money market alternatives has led to banks like America’s SVB having to crystallise losses on their asset base. That is where we have seen banks disappearing or being taken over.

We still sit in the shadow of the banking crisis 15 years ago and so the thing that people worry about most is contagion. What has happened in the US has sharpened the focus on other weak players like Credit Suisse and Deutsche Bank.

As I sit today the evidence is building that what we are looking at is idiosyncratic risk. Banks are carrying more capital and less inter-dependant than they were 15 years ago. It is difficult to believe that the Global Financial Crisis began with a housing crisis in the US and spread across the world so quickly. The capacity of the broader banking infrastructure to play an active part in supporting the system taking on these weaker banks reinforces this point and suggests what we are looking at is not systemic.

Since 2012 there have been 124 banks failures in the US (513 if you go back to 2009). Under the Trump presidency post-crisis banking regulations began to be eased. That has not been the case in Europe. Indeed, in the UK the criticism is that the regulatory regime has made banks here less competitive. The high capital requirements and the greater diversification of the deposit base, mean UK banks look better placed than most to cope with current conditions. 

We might take that one step further. It this hypothesis proves correct over the next six months the ceiling on valuations of stronger banks may rise. The fact that they have successfully negotiated this period of stress will instil greater confidence.

But we are not there yet. The lifting of rates so sharply after a decade of cheap debt was bound to have consequences and many of these will take time to emerge.

Interest rates

So what impact will all this have on central bankers? Recent events will certainly give them reason to reflect. They have a difficult line to tread between inflation risk and the health of the economy. I think the pressure being put on the banking system will mean we are more likely to see the Fed slow or pause the planned tightening.

That does not mean we are going to see a quick turn in the cycle. Inflation is not going away soon. The probability of an economic slowdown in the US has increased. The credit impulse from the banks has shrunk as they seek to manage themselves through this period and that will have an impact. But to counter that we have the fiscal stimulus of the Inflation Reduction Act (IRA) and other legislation from Biden, which will see $2 trillion pumped into the US economy over 10 years. American presidents have a poor record of getting their legislation through, so Biden’s success in this quarter has taken politicians on this side of the Atlantic aback. The UK chancellor announced in his Spring budget that he would give more details this Autumn on how the government here will respond to the challenges created by the Act – Jeremy Hunt says this is no longer just about tackling climate change but also a matter of national security, to protect us from future price hikes with “cleaner, cheaper, home-grown energy”. In Europe there is talk of an equivalent IRA. It remains to be seen how big a stimulus that might be.

Meanwhile, China is emerging from its Covid lockdown which will release spending momentum as it did in Europe and the US. That should be good for the global economy – and especially Southeast Asia – but it is also an inflationary pressure.

I believe we are facing a complex environment that does not neatly align with the traditional economic cycle of tightening and loosening we are used to. The “least worse” scenario for central bankers may be accepting a higher level of inflation and for longer than they would have liked. 

The story of the next three to five years could therefore be an extended bear market. I am not suggesting that markets in aggregate are going to go down, but they may go sideways. And I do anticipate that markets will go through a phase of consolidation. We will see versions of what we have seen in the banking sector in H1 this year in other industries. In such scenarios the weak fall and the strong get stronger. I expect in particular we will see consolidation in sectors like manufacturing industrials.

So how do investors flourish in markets like this? Dividends become a more significant contributor to returns. What you pay for a security becomes as important as ever. And so does credit selection. I believe this fits into our strengths as a business and means Artemis is in a good place to support our investors.