Here are the main factors driving the ASX this week according to portfolio manager PETE DAVIDSON. Reported by portfolio specialist Chris Adams

Banking sector concerns are receding and there is now greater confidence on the US interest rate outlook.

This has helped support equities.

The S&P/ASX 300 gained 3.2% last week. The S&P 500 was up 3.5% and the NASDAQ 3.4%.

We also seeing some merger and acquisition activity, notably in the small-cap resource sector.

A sense that rates may be near their peak — and growth is slowing — could support further corporate activity.

US banking

The Fed’s weekly balance sheet data showed a decline of about $US28 billion last week, compared to an expansion of about $US94 billion the week before. 

This suggests bank liquidity requirements have decreased, and pressure from deposit outflows may have eased.

At the height of the banking crisis, withdrawals from the Fed’s discount window reached GFC levels.

Last week’s withdrawal remains large in absolute terms. But the market is interpreting the fact that they have rolled over and are declining as a sign the banking crisis has peaked.

Inflows into US money market funds have also decelerated,

After spiking to about $US120 billion in each of the prior two weeks, last week saw about $US66 billion inflows.

Concerns about deposit safety at smaller banks also appear to have eased.

Data shows the banking system as a whole is losing deposits. But last week’s outflows came from large and international banks, while small banks held steady and saw a marginal increase in deposits.

Right now small bank credit growth remains strong at around 8% per annum. Commercial real estate (CRE) loans remain a concern and an area to watch.

Small, regional banks dominate CRE lending. Weakness in office assets could be a potential risk, since physical occupancy in US office markets remains low as a result of work-from-home.

But underneath all this, US and European banks are well-regulated and capitalised and the response from policy makers so far has been decisive. 

Corporate credit

Corporate credit spreads widened in response to the banking crisis, but have now started narrowing again. This reflects improved confidence in US banks.

Australia’s corporate bond market was effectively closed to new issuance and secondary liquidity for two weeks due to concerns about the overseas banking sector.

But swift action by policy makers seems to have restored confidence and the local corporate bond market has re-opened.

Last week ANZ issued a large three-and-five-year deal.

Toyota Australia issued $625 million of debt. Volkswagen Australia and Worley (WOR) are also looking to issue new bonds. 

Secondary market liquidity has been somewhat challenged, but is improving by the day.

US macro data

Last week was largely uneventful on the data front.

The Fed’s preferred measure of inflation — the Core Personal Consumption Expenditure (PCE) index — came in at +0.3% month-on-month for February versus +0.4% expected and +0.6% in January.

A +0.3% monthly rate annualised is just a touch below 4%, which is probably not low enough for the Fed to feel comfortable in pausing rates.

But it indicates inflation is moving in the right direction.

As of March 23, the market was implying a peak in rates of 4.9% in May 2023, with rates at 4.1% by the end of 2023.

This is down from a March 8 reading of a 5.7% peak in September and 5.5% at year-end.

Markets

The S&P/ASX 300 end up 3.3% for the first quarter of 2023, courtesy of a rebound in the last week.

The S&P 500 was up 7.5% and the NASDAQ 17.1% for the quarter.

Bond yields rose as confidence improved last week, with US two-year yields up 26bps. They end the quarter 40bps lower, while 10-year Treasuries are 41bps lower than they started, at 3.47%.

The Safeguard Mechanism legislation was passed last week, requiring most facilities directly producing more than 100,000 tonnes of annual CO2-equivalent emissions to reduce their pollution significantly by 2030.

This poses a challenge for the mining sector, given its heavy reliance on diesel and the potential for higher costs.

Last week resource companies led the market, on the back on stronger commodity prices and M&A activity. The lithium sector rebounded sharply following US giant Albemarle’s all-cash $A5.5 billion bid for local lithium miner Liontown (LTR, +73.2%).

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About Pete Davidson and Pendal Focus Australian Share Fund

Pete is Pendal’s head of listed property and a portfolio manager in our Aussie equities team. For more than 35 years, he has held financial markets roles spanning portfolio management, advisory and treasury markets.

Pendal Focus Australian Share Fund is Crispin Murray’s . Find out more about Pendal Focus Australian Share Fund here.

Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management. 

Contact a Pendal key account manager here

This year Australian investors should be aware of government influence in four areas, says Pendal’s head of equities, Crispin Murray.

• Government policy poses risks for investors
• Wages, banks, energy, climate
• Find out about Pendal Focus Australian Share fund
• Watch Crispin’s latest Beyond The Numbers webinar

A GROWING trend toward government policy intervention in business is becoming an issue for investors, says Pendal’s head of equities, Crispin Murray.

Murray was speaking at his biannual Beyond The Numbers webinar.

“As investors our focus is on the practical reality of market environment we are operating in,” he says.

“One key shift we have seen is the number of companies referencing the growing influence of government policy on their outlook.”

Investors should be aware of government influence over the companies in their portfolios from four perspectives:

1. Determining award wages
2. Industrial policy, including regulating the big banks
3. Power and gas policy
4. The carbon reduction pathway

Below, Crispin goes into detail:

Award wages

Higher wages will impact the profitability of companies with a high share of domestic labour costs like the supermarkets and there are signs the government will push for a real wage increase.

A decision on the minimum wage and award wages is due mid-year, in a process that is normally tied to inflation in the March quarter.

“Will the government push for real wages to be protected? Which could lead to wage increases of 6 or 7-plus plus percent?” says Murray.

“The challenge is that maybe inflation is set to fall over the course of this year and may head back towards 4 or 5 per cent — and so perhaps a 5 to 6 per cent wage increases is more appropriate.

“This is a battle that will need to be determined.”

Industrial policy

Industrial policy is also an emerging risk for investors.

“Our recent meetings with the banks had a very different tone,” says Murray.

“The banks have moved from being reasonably relaxed about the fact that rising interest rates were going to help support their margins.

“Now, they’re much more concerned about the backlash that this is creating in the community and from government.

“What we’re seeing, I believe, is anticipation of potential intervention by the government.”

Early intervention in the banks’ interest rate settings is already occurring, he says.

The Australian Competition and Consumer Commission is investigating how banks set interest rates for savers and some banks have already lifted savings rates to head off the inquiry.

“We also may see potentially an increase in the bank levy”, which is a quarterly tax on the largest banks calculated as 0.015 per cent of liabilities.

“The signal that sends to other companies is [to be] very mindful about using their pricing power.

“The government is saying ‘inflation is an issue — real wages have gone down — the corporate sector should absorb some of these inflationary pressures themselves.

“‘And if you’re not prepared to do it, we might find a way of intervening to make you do it’.”

Power and gas policy

Electricity and gas policy is also an area of intervention for the federal government.

“Clearly there’s been issues with policy in Australia for many, many years.

“But right now, we’ve got a real challenge — like it or not, we’re going to need gas for the next 10 years to help firm renewables.

“That is the lesson that the rest of the world has learned as a result of the Ukraine invasion.”

Australia is beginning to wake up to the fact that if there is no reliable domestic gas supply at a reasonable price, power prices have to go up, he says.

But the government’s attempt to cap gas prices is just leading to a breakdown in the marketplace: “There are no contracts being signed. And as a result of that, no one’s going to look to develop gas.

“This is again a key issue for companies in that sector.

“We’re hopeful that perhaps a little shifting of positions can occur that will solve this problem.

“If it doesn’t, then power costs will be going up, and it will hit households and it will hit corporate profits.”

Carbon reduction

The carbon reduction pathway and the safeguard mechanism is another area of government influence on business.

The safeguard mechanism requires companies that emit more than a certain amount of greenhouse gases to reduce their emissions each year or face financial penalties.

Export exposed companies get favourable treatment to ensure they are not put at a competitive disadvantage.

(Pendal’s ESG credit analyst Murray Ackman explains more here.)

“It is still in consultation phase. The government is seeking feedback.

“But as it stands today, what we’re hearing is certain companies are saying ‘we’re not going to qualify for being export-exposed’.

“For example, steel — because of the way it’s been measured — is not being considered export sensitive.

“Which means for those companies, they’re going to have to be reducing the carbon emissions between 4% and 5% a year through to 2030.

“Their current plans are maybe around 1%.”

The challenge is that the technology to solve for that kind of accelerated reduction pathway does not exist anywhere in the world, says Murray.

“That may mean that they start having to think about not investing in their businesses,” he says.

“We need to be very clear on that and make sure that we’re not caught out by that in our investments.”

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About Crispin Murray and Pendal Focus Australian Share Fund

Crispin Murray is Pendal’s Head of Equities. He has more than 27 years of investment experience and leads one of the largest equities teams in Australia. Crispin’s Pendal Focus Australian Share Fund has beaten the benchmark in 12 years of its 16-year history (after fees), across a range of market conditions.

Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management. 

Find out more about Pendal Focus Australian Share Fund  

Contact a Pendal key account manager

Here are the main factors driving the ASX this week according to portfolio manager Jim Taylor. Reported by portfolio specialist Chris Adams

THE US Fed has discovered that when you push harder and faster than ever before, it’s likely something will break.

It’s taken time, but the market has found the weakest link in the form of shortfalls in bank asset-liability matching.

Bank asset-liability matching is when a bank ensures it has enough money to cover its obligations by balancing its assets and liabilities.

The likelihood of a full-blown banking crisis is relatively low, given better capitalisation of the US banks and relatively low loan-to-value ratios of US mortgages.

A “Goldilocks” scenario is also possible, where growth slows due to credit tightening as a result of pressure on banks – meaning rates don’t need to go to 6%.

But the full implications of this issue are yet to be seen, and the market last week was looking for guidance from treasury secretary Janet Yellen.

Her mixed messaging prompted some sharp market reactions.

The Fed raised rates by 25bps, largely in line with expectations (which ranged from 50bps to no hike at all).

Fed chair Jay Powell signalled that peak rates were close, but he maintained the mantra of “higher for longer”. The market says otherwise, with rate cuts baked into implied pricing for the back end of 2023.

Overall equity markets have performed reasonably well over the past couple of weeks, given what has been thrown at them. The bears would certainly be feeling quite short-changed.

The S&P/ASX 300 was off 0.58% last week and is down 3.36% for the month to date. The S&P 500 gained 1.41% for the week and is up 0.16% for the month.

Notwithstanding all the postulating over the course of the week, we have three open questions on the US banking issue:

1. The outcome for First Republic Bank
2. The FDIC’s sale of Silicon Valley Bank
3. Congressional action on deposit insurance

US banking

After delivering a 25bp hike in rates, Powell acknowledged that “recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation. The extent of these effects is uncertain.”

As a result, it was too soon to determine the effects and how monetary policy should respond. 

He noted that the rate-setting Federal Open Market Committee (FOMC) had considered a pause. But the hike was supported by a “strong consensus” with a change in guidance around additional hikes.

The “dot plots” graph which outlines future expectations continues to suggest higher for longer.

When quizzed on the market’s implied 125bps of rate cuts due to the banking issues, Powell said the Fed didn’t see rate cuts this year. (Though this was based on how the Fed now sees the economy evolving).

There was greater focus on Secretary Yellen’s comments.

On Monday she said US regulators might act to protect bank depositors if smaller lenders were threatened.

The government was ” resolutely committed” to mitigating financial stability risks where necessary. But she did not address the issue of whether Federal Deposit Insurance Corporation (FDIC) coverage could be expanded to cover all deposits.

On Wednesday, Yellen said she had “not considered or discussed anything having to do with blanket insurance or guarantees of all deposits” in response to a question on whether Treasury would circumvent Congress and insure all deposits.

The market took exception to this and on Thursday Yellen walked this back, saying:

“We have used important tools to act quickly to prevent contagion. And they are tools we could use again. The strong actions we have taken ensure that Americans’ deposits are safe. Certainly, we would be prepared to take additional actions if warranted.”

Meanwhile the Fed’s balance sheet continued expanding (though at a slower rate than the previous week), as banks move to shore up funding.

The total balance sheet grew US$94 billion, on top of US$300 billion the previous week. This included (among other items):

• $37 billion in guaranteed lending to the FDIC (vs +$143 billion the previous week)
• $42 billion drawn from the new Bank Term Funding Program (vs +$12 billion)
• $43bn decrease in discount window borrowing (vs +$148 billion)

Breaking down growth by the 12 Federal Reserve banks is instructive.

Growth in Fed assets is concentrated in the New York and San Francisco regions, which are up US$35 billion and US$24 billion for the week, respectively.  There were modest increases across most other banks. But the continued concentration in just two districts gives the market some comfort around the risk of wider contagion.

There is still a clear and significant shift in deposits from smaller to bigger banks.

There is also a reduction of about US$100 billion in net deposits, which is feeding into some US$120 billion of flows last week into money market funds, on top of a similarly strong week before.

US interest rates

The FOMC statement and press conference suggest the Fed now sees risks to the economic outlook as more balanced than earlier in the month.

Banking sector stress adds downside risks to growth, employment and inflation.

But despite already tightening conditions, recent data shows inflation has not yet cooled sufficiently to be consistent with Fed targets.

The real interest rate (nominal rates minus inflation) is now near 0.9%, which is nearing the 1% that Powell previously indicated was “restrictive territory”.

The Fed is navigating a fine line by raising rates 25bps (versus the 50bps some were expecting prior to Silicon Valley Bank’s collapse) and keeping the terminal rate consistent at 5.1%.

It recognises that inflation remains too high, but also accepts the economic outcome from the current banking crisis has a long way to unfold, with obvious risks to the downside.

Prior to the Fed’s meeting, markets were pricing an 82% chance of a 25bps hike – with cuts starting in November.

During Powell’s post-announcement press conference, the probability of a June cut increased from 55% to 80%.

US macro data

Existing US home sales surged 14.5% in February, the most since mid-2020.

The median selling price of a pre-owned home fell 0.2% from a year earlier.

The jump in February sales follows 12 straight months of decline, but still leaves monthly sales 27.8% below the peak in January 2022.

The rate on a new 30-year conventional mortgage was 6.18% at the start of February – nearly 100bp lower than the recent peak in October. But it’s since risen sharply to 6.71% last week. 

Mortgage payments for a new purchaser of a median-priced existing single-family home was equal to 51% of disposable income in February.

That’s down from the recent peak of 55% in October, but significantly above the 30% to 35% before Covid.

Rates are likely to remain elevated for some time, so a meaningful improvement in affordability will need to come via a decline in home prices.

Layoffs continue to grow without any reflection in unemployment claims. This probably reflects generous severance packages and ease of regaining alternate employment.

Australian macro

Growth in advertised rents in Australia has significantly outstripped growth in the CPI measure of rents for all rental housing since the onset of the pandemic in 2020.

So, unlike in the US where leading indicators are improving, there seems to be no relief coming domestically in the rent component of CPI.

European macro

The Bank of England pushed ahead with another rate hike, increasing by 25 bps to 4.25% – the highest since 2008.

The central bank believes UK living standards will remain flat this year and left the door open to further increases.

Further details were hammered out for the Swiss government’s solution to the Credit Suisse issue.

European Central Bank president Christine Lagarde ensured there was no ambiguity in her message regarding impact from the Credit Suisse crisis on policy.

“In such an environment, our ultimate goal is clear. We must – and we will – bring down inflation to our medium-term target in a timely manner,” she said.

In this regard, she has been helped by the fact that EU gas prices continue to fall and are down 45% this year.

Markets

Bonds yields fell in the aftermath of the Fed meeting.

The two-year and 10-year curve has steepened, with short-term yields falling more than long. But the cash rate/10-year curve has become even more inverted.

In US equities, large-cap technology and defensives have outperformed, while leveraged exposures like banks and property trusts have underperformed.

The US dollar has weakened. Commodity sector performance has been rather mixed.

The S&P/ASX 300 saw reasonable performance over the week. There was an expected weakness in REITs and financials while gold companies performed well.

There was limited company news.

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About Jim Taylor and Pendal Focus Australian Share Fund

Drawing on more than 25 years of experience investing in top-performing Australian companies and a background in accounting, Jim manages our Long/Short Fund and co-manages our Imputation Fund. He is a Chartered Accountant with membership of the Australian Institute of Chartered Accountants.

Pendal Focus Australian Share Fund is managed by Crispin Murray. The fund has beaten its benchmark in 14 years of its 18-year history (after fees), across a range of market conditions. Find out more about Pendal Focus Australian Share Fund here.

Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management. 

Contact a Pendal key account manager here

Fed signals rates pause | Tips for managing volatility | ASX CEO exodus | Climate policy change

The Fed has finally signalled it’s ready to pause rate hikes. Meanwhile we’re all watching for the next signs of stress after almost 5% in a year, says Pendal’s head of government bond strategies TIM HEXT

• Find out about Pendal fixed interest funds

IT’S now been a year since the US Federal Reserve started hiking rates.

Since then the pace has been relentless, with a total of 4.75% of hikes in nine meetings.

At every opportunity, the Fed’s message has been “more are coming” and “rates need to be higher to contain inflation”.

Finally, the Fed today gave some hope the end of hikes is getting close, leaving the door open to a pause shortly.

As expected, the Fed today hiked 25 basis points to a target range of 4.75% to 5%.

The accompanying statement also featured a softening of language.

Future hikes no longer “will” be needed but now “may be appropriate”. Finally, the door is ajar for a pause.

The rest of the statement contained the usual language around a strong commitment to returning inflation to the 2% objective.

The “dot plot” – which shows where the 11 members of the rate-setting Federal Open Market Committee think rates are going – suggests one more hike this year, peaking at 5.125%.

The consensus is 4.4% for the end of next year and 3.25% at the end of 2025. Neutral is viewed as 2.4%.

Economic projection revisions were small. GDP was lowered slightly to 0.4% for this year despite a strong Q1.

No wonder recession risks and concerns remain high.

Response to banking wobbles

Chair Jay Powell’s press conference contained some interesting insights.

Despite maintaining a brave face, it seems this month’s banking wobbles did rattle the Fed.

We learned a pause was on the table for this meeting amid potentially tighter credit conditions.

The European Central Bank’s logic in hiking 50 basis points last week – that to resist would suggest lack of confidence in the banking system – was not at play here.

Market response

Bond markets rallied modestly on the FOMC statement but were given a decent boost by Powell’s comments.

US 10-year yields are back below 3.5% and near the lows from last week’s turmoil, despite the banking crisis having passed (for now).

Markets are now well ahead of the Fed, pricing in almost 1% of cuts by year end.

US two-years are sub 4%, indicating rates nearer 3% than 5% next year.

What’s next?

We are now all on “break watch”.

Where will we see the next signs of stress after almost 5% of hikes in a year?

The field is wide open. Commercial property, private equity and the non-bank financial sector are a few of the areas that thrived in the zero-rate environment.

A largely fixed-rate loan market in the US has dampened the impact of the hikes so far – but that will end.

Equities have largely taken it all in their stride. Stresses may be offset by lower rates, meaning it may be a case of picking the sector winners and losers more than the overall market direction.

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About Tim Hext and Pendal’s Income & Fixed Interest boutique

Tim Hext is a Pendal portfolio manager and head of government bond strategies in our Income and Fixed Interest team.

Tim has extensive experience in banking, financial markets and funding including senior positions with NSW Treasury Corporation (TCorp), Westpac Treasury, Commonwealth Bank of Australia, Deutsche Bank, Bain & Co and Swiss Bank Corporation.

Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.

Find out more about Pendal’s fixed interest strategies here

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About Pendal

Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.

In 2023, Pendal became part of Perpetual Limited (ASX:PPT), bringing together two of Australia’s most respected active asset management brands to create a global leader in multi-boutique asset management with autonomous, world-class investment capabilities and a growing leadership position in ESG.

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The Pendal MicroCap Opportunities Fund’s (Fund) average performance fee for the last five financial years ending on 30 June 2022, disclosed in the Fund’s Product Disclosure Statement issued on 11 January 2023 was incorrectly stated as 1.48% p.a. of the assets of the Fund.

The correct average annual performance fee over that period is 1.58% p.a., a difference of 0.10%.

Based on the estimate of 1.58% p.a. for an investment of $50,000 in the Fund, the performance fee would be $790 ($50,000 * 1.58% p.a. = $790), and not $740 as stated in the PDS. Please note that this is an estimate based on historical performance for illustration purposes only and does not reflect actual fees which may be charged in the Fund.

There has been no change to the way performance fees are calculated and the correct fees have been charged to the Fund at all times.

We apologise for any inconvenience. Please contact 1300 346 821 if you have any questions.

The Pendal Focus Australian Share Fund’s (Fund) average performance fee for the last five financial years ending on 30 June 2022, disclosed in the Fund’s Product Disclosure Statement issued on 11 January 2023 was incorrectly stated as 0.09% p.a. of the assets of the Fund.

The correct average annual performance fee over that period is 0.14% p.a., a difference of 0.05%.

Based on the estimate of 0.14% p.a. for an investment of $50,000 in the Fund, the performance fee would be $70 ($50,000 * 0.14% p.a. = $70), and not $45 as stated in the PDS. Please note that this is an estimate based on historical performance for illustration purposes only and does not reflect actual fees which may be charged in the Fund.

There has been no change to the way performance fees are calculated and the correct fees have been charged to the Fund at all times.

We apologise for any inconvenience. Please contact 1300 346 821 if you have any questions.

The Pendal Australian Long/Short Fund’s (Fund) average performance fee for the last five financial years ending on 30 June 2022, disclosed in the Fund’s Product Disclosure Statements issued on 3 October 2022 and 11 January 2023 was incorrectly stated as 0.14% p.a. of the assets of the Fund.

The correct average annual performance fee over that period is 0.26% p.a., a difference of 0.12%.

Based on the estimate of 0.26% p.a. for an investment of $50,000 in the Fund, the performance fee would be $130 ($50,000 * 0.26% p.a. = $130), and not $70 as stated in the PDS. Please note that this is an estimate based on historical performance for illustration purposes only and does not reflect actual fees which may be charged in the Fund.

There has been no change to the way performance fees are calculated and the correct fees have been charged to the Fund at all times.

We apologise for any inconvenience. Please contact 1300 346 821 if you have any questions.

Here are the main factors driving the ASX this week according to our head of equities Crispin Murray. Reported by portfolio specialist Chris Adams.

• Find out about Pendal Focus Australian Share fund

NEWS headlines are full of bank runs and bailouts, emergency weekend policy-maker meetings and record declines in short-end yields.

These are signs of the system stress that often accompanies periods of financial tightening.

Last week this was reflected in dramatically lower bond yields as US two-year government bond yields fell 75bps. Brent crude oil was off 11.9% and gold gained 5.8%.

The S&P 500 gained 1.4%, while Australia (S&P/ASX 300 -2.8%) and European equities (EuroSTOXX 50 -3.8%) lost ground. 

The common thread was a market view that financial shocks would trigger a recession, requiring central banks to reverse course quickly.

Concerns over economic growth and an expectation of lower rates saw a rotation away from resources and cyclicals to growth and bond sensitives.

The consequences for financial markets are too early to call.

Policy makers face a complex challenge of balancing the apparently conflicting objectives of preserving financial stability and fighting inflation.

The impact on equities will be determined by the ability of policy makers to contain risk and the flow-on effects on rates and economic growth.

Potential scenarios

Potential outcomes range between two poles:

1. Moderate additional financial tightening, which helps reverse the economy’s stronger momentum this year. This scenario could see economic growth fall by 25bps to 50bps and take out a rate hike without derailing the soft-landing story. Equities therefore hold up in current trading range.
2. A substantial credit crunch as capital flees smaller banks, removing liquidity for small businesses and commercial real estate. This could trigger a significant recession, affecting earnings and forcing central banks to dramatically cut rates. Under this scenario equities make new lows, though we would likely see a rotation to growth.

It is natural to compare this situation with the Global Financial Crisis, but there are significant points of difference, which suggest far less risk for markets.

Bank capital ratios and liquidity buffers are far greater than they were in the GFC.

Banks generally are profitable and have scaled back their more volatile business streams.

Policy makers have the available tools and playbooks to respond and there is far better transparency over the interconnected exposures of financial institutions.

There will be companies with weak or more vulnerable franchises. We are likely to see more of these flushed out in coming weeks.

But that does not equate to a systemic crisis.

The key for markets is whether the policy response can restore confidence beyond just patching up funding in the short term, as has so far been the case.

Two key issues

There are two separate financial issues, occurring simultaneously: 1) Credit Suisse and Europe and 2) US banking issues

1. Credit Suisse and Europe

In Europe, pressure on Credit Suisse culminated in a takeover by rival UBS in a government—brokered deal at the weekend.

Credit Suisse had pre—existing issues. It was undergoing a turnaround plan established late last year alongside a capital raising.

There were continuing outflows from the private bank and asset management business. Clients were losing confidence and shifting assets to other groups or into government bonds.

This reduced profitability, crimping Credit Suisse’s ability to wear losses likely to come from running down the troubled investment bank (which was the source of its issues). 

The question is now whether the takeover deal restores confidence or whether we begin to see concerns over UBS.

It’s worth noting that UBS is far more profitable and has a much smaller investment bank.

It is important to note that this is not currently being viewed as a broader European banking crisis.

Capital and liquidity requirements are far stronger than they were in the GFC.

After years of restructuring, banks are less exposed to financial market volatility and are more profitable.

There is an estimated EUR400 billion equity buffer in the system compared to requirements.

As a result, credit default swap (CDS) spreads for big global banks have not surged in tandem with Credit Suisse’s.

At this point we don’t expect the Credit Suisse issue to trigger a systemic problem in Europe, leading to a recession.

This could change, but it would require a significant policy failing.

2. US banking issues

The second issue is in the US and has potentially more structural implications.

The issue is a fundamental weakness in the US banking system relating to a high reliance on uninsured deposits for funding and a lower level of regulation on sub-$250 billion balance sheet banks.

The US banking system is highly fragmented.

The biggest banks — those with more than $100 billion in assets — account for about half the asset base.

Then there are about 100 regional banks with $10 billion to $100 billion in assets and some 3500 community banks with less than $10 billion.

The issue is that smaller banks are not heavily regulated. Just over half of all US deposits are insured under a Federal Deposits Insurance Corporation (FDIC) scheme that promises to cover up to $250,000 of a depositor’s funds.

The fundamental problem is that corporate treasurers and high net worth individuals who are “uninsured” are now being far more careful with who they leave their money.

As a result, we have seen substantial deposit runs, with withdrawals continuing even after the FDIC announced that all deposits would be protected.

This is evident in money market funds which saw US$116 billion in inflows this week. It was the fifth-biggest week on record (dating back to 1992).

It can also be seen in use of the Fed discount window, which is the way the Fed provides a liquidity backstop to the financial system.

Last week banks borrowed $153 billion — an all—time record. The week before it was $4.6 billion.

This reflects depositors withdrawing funds and banks needing to seek alternative funding.

The Fed has announced emergency funding to backstop depositors at Silicon Valley Bank and Signature Bank and the creation of a Bank Term Funding Program (BTFP).

This shouldn’t be seen as quantitative easing. It isn’t creating new money and technically it’s lending — not buying.

It should help stabilise markets, but illustrates that the Fed balance sheet is proving hard to shrink.

Treasury secretary Janet Yellen has tried to calm concerns by drawing on provisions that enable the Fed to act in the face of a systemic financial crisis and by insuring SVB and Signature depositors.

This requires a super majority of the FDIC, Federal Reserve, the Treasury Secretary and the President to agree.

This is clearly meant to represent an implicit guarantee on all depositors in banks with more than $120 billion on their balance sheet.

The challenge is they do not have the authority to make that an explicit guarantee. This can only come from Congress.

That is unlikely to happen any time soon. It would probably come with new rules on regulation and be a complex process to legislate.

The problem is no one knows how far potential support from policy makers would extend.

Yellen got tied up in knots in congressional testimony while explaining why depositors in community banks should not move their money to big banks.

The pressure on these smaller banks is likely to prevail, which leads them to draw on the discount window and the new Fed facility which uses par value (not market value) in assessing collateral.

This is not a sustainable solution.

The next bank in the firing line is First Republic which received a $30 billion deposit influx from the largest US banks, which were effectively recycling the deposits they were receiving as First Republic’s customers were leaving. 

This is an effort to demonstrate that they believe the deposit guarantee is there.

At this point we are waiting to see which form the solution takes.

What does this mean for the US?

The key issue here is not so much contagion risk, as the other banks are receiving extra liquidity and there are not large direct credit exposures to these banks.

Instead, it is the transmission mechanism to the broader economy, since smaller banks are major providers of credit.

Banks with less than $250 billion in assets provide around half of total commercial and industrial loans and 80% of commercial real estate lending. Smaller banks also dominate residential lending.

The concern is these funding pressures could trigger a credit crunch on top of existing tighter financial conditions — driving the economy into recession.

A more benign outlook may be that this credit tightening equates to 25-50bps of a slowdown in GDP growth, helping deal with an economy that has been running too hot. In this scenario the flow-on effects might be limited given tight labour markets.

This could mean that one of the expected 25bp rate hikes from the Fed is removed.

A more bearish view seems to be dominating at the moment given the sharp drop in two-year US government bond yields.

This move was greater than that seen in the GFC and around 9/11. It’s seen by many as a warning bell for recession.

The consensus for US rates now implies no more rate hikes and 100bps of cuts by year’s end.

A number of other signals support a more bearish view:

• As measured by the “Move” index, bond market volatility is back to levels not seen since the GFC.
• Historically, the first cut in a rising rate cycle has been a poor near-term indicator for the economy or for equity markets, though the latter generally recovers relatively quickly.
• Once it starts steepening from a point of maximum inversion, the yield curve is often a signal for upcoming recession.

The exception to a number of recessionary signals is the most recent one — where there would not have been a recession if it were not for Covid.

A lot of people are wary of betting against history.

It is worth stepping back and thinking about why these historical relationships apply.

Essentially, it is a function of the Fed raising rates too hard for too long, effectively over-tightening and creating a recession and large earnings drop.

Initial rate cuts are therefore a reflection of the weakness rather than a positive for the market.

This cycle is somewhat unusual as we have an overlay of the pandemic, excess savings, extremely tight labour market and a recovering China.

While a recession is probably more likely than not, it is still a more complex issue than some traditional indicators would suggest.

The other — more bearish — complexity in this cycle is that the Fed still has not dealt with inflation.

Historically, Fed pivots have usually come when inflation was running between 1 and 2% — not above 4% as it is today.

US inflation and the Fed

The latest US CPI data — lost in the noise last week — did not provide relief.

Headline CPI is better at 6% year-on-year as energy declines and three-month annualised is 4%.

But monthly core CPI was firm at +0.45%, underpinned by +0.6% monthly growth — the highest since September 2022.

If you overlay lead indicators on rents, it’s possible to see inflation falling to 4% — but remaining sticky there. That is just not low enough for the Fed to declare victory.

So, this week’s meeting is lineball on a 25bp move. There is a view that deferring a potential hike to May costs very little on the inflation side but could make a big difference on the financial stability side.

For the equity market, the banking issues are bad for financials, but the prospect of fewer rate hikes is good for growth stocks, helping prop up the market last week.

Central banks

The ECB’s expected 50bp rate hike also got lost in the noise.

It was notable that the forward guidance moved from saying rates need to rise significantly higher for an extended period, to now being data dependent.

In China, the PBOC sneaked in an unexpected cut to the bank reserve ratio requirement on Friday as well. This is seen as an important signal towards supporting growth

Finally, in Australia rate expectations have stepped down materially from 4.15% to 3.40% at the end of 2023, implying no more hikes. 

Markets

Credit spreads have been widening out, but not yet signalling something more concerning.

There are pockets of stress emerging in some areas, notably commercial mortgage-backed securities (CMBS).

In terms of equities the US, the S&P 500 has held the 3800 support, but still does not look too healthy.

Commodity Trading Advisers — which are used as an indicator of marginal players in equities — have moved quite underweight in US equities, with potentially more to go into quarter end.

The other feature of the market worth noting is the rotation back to growth as expectations have shifted on the risk of recession and the path of rate hikes.

The S&P/ASX 300 underperformed the US due to the fall in resource and energy stocks on global growth concerns.

 

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About Crispin Murray and Pendal Focus Australian Share Fund

Crispin Murray is Pendal’s Head of Equities. He has more than 27 years of investment experience and leads one of the largest equities teams in Australia. Crispin’s Pendal Focus Australian Share Fund has beaten the benchmark in 12 years of its 16-year history (after fees), across a range of market conditions.

Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management. 

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