Banking sector stress, not a crisis

Many investors will have had uncomfortable flashbacks of the Global Financial Crisis (GFC) over the last few weeks. The rush of policymakers and financial institutions to provide stability before Asian markets open does bring back unpleasant memories. However, we would describe the current period of financial turbulence as a period of banking sector stress, not a crisis. There are important differences between what is happening in 2023 versus 2007-08.

We don’t want to downplay the current challenges plaguing the banking system, but rather put them in perspective. First, the banking system in both the US and Europe is much better capitalized, and has much less leverage than in the GFC. Second, the issues in the banking sector are largely about liquidity as opposed to solvency. Deposit flight is a confidence problem which is easier for policymakers to deal with than a pile of toxic assets scattered across an opaque web of counterparties. Third, policymakers are more prepared for these kinds of events than they were 15 years ago. And lastly, nominal growth is much higher, so we are entering this period from a starting point of economic strength. For example, the US unemployment rate is near record lows, whereas in 2007 we were already in a recession.

While we view a systemic crisis as highly unlikely, there are negative growth effects that will result from the current banking stress. Credit is the lifeblood of the economy and recent developments will reduce its supply and increase its cost on an aggregate level. And one less helpful difference from 2008 is the problem of high inflation, which will prevent central banks from easing as quickly as they might have in response to this slower growth.

At this point it is difficult to gauge just how much credit standards will tighten and how much they will affect the economy. The range of macroeconomic outcomes has widened and shifted in a negative direction. On the other hand, a sooner pause in Fed tightening is likely, which should provide some cushion for markets and the economy. Given still strong household and corporate balance sheets, we are unconvinced the economy is heading for an imminent recession.

The rates market is now pricing in 75 basis points of easing this year, starting in the summer. To us, this pricing is more consistent with a systemic shock than a gradual slowing of growth, which remains our view. We see room for yields to re-price higher, which would weigh on expensive US growth stocks. We prefer allocating to China, where the stage of the economic cycle and policy bias are more supportive for asset prices.

The failures of select US banks provided an urgent catalyst for depositors to move money from regional banks into larger banks they perceived as safer. Or alternatively they prompt switching into products like money market funds that have much higher yields than their checking accounts at the regional banks.

In response, the Federal Reserve swiftly made it easier for banks to meet their depositors’ requests with a new liquidity facility that allows securities to be pledged at par in exchange for reserves. This allows banks to avoid incurring severe losses/hits to their capital bases during this period of deposit pressure. We are encouraged by indications from bank management teams, as well as Federal Reserve Chair Jerome Powell, that deposit outflows have largely slowed or stabilized.

One consequence of this deposit pressure, however, is that it is likely that loan growth is going to slow and the cost of accessing financing will rise. This should contribute to slower economic growth going forward. But because nominal growth has been high, and credit concerns relatively subdued, we expect this to be a gradual drying up of liquidity rather than a freeze. Regional banks have a particularly large footprint in commercial real estate, so that segment of the market is likely to be most negatively impacted.

The FDIC, Federal Reserve, and Treasury Department are unable to extend deposit insurance to all banks above USD 250,000 unilaterally. For that, an act of Congress would be needed. But, in our view, key officials have provided strong indications that they aim to fully protect depositors on a case-by-case basis should there be further bank failures. This is in line with actions taken to date.

More clarity on what to expect for uninsured deposits and a resolution process for the more obviously stressed financial institutions would likely provide a strong signal to markets that policymakers are acting as proactively as possible. We firmly expect this messaging to prevent stress from spreading into a crisis, but lingering uncertainty will weigh on lending and economic activity over time.

European banks, meanwhile, are in a better position than their US counterparts. In aggregate, these institutions are more regulated, have a higher capital base, better liquidity coverage ratios, and far less exposure to unrealized losses in their securities portfolios.

We anticipate that bank deposits will be stickier in Europe than the US, in part because of the smaller footprint of alternative options such as money market funds. This should lead to fewer concerns about the liquidity position of European banks, as well as less downward pressure on net interest margins.

In our view, the banking stress in Europe is fairly isolated. We are closely monitoring banks that may be more susceptible to deposit flight to confirm this continues to be the case. There is much less reason for European banks to face liquidity or solvency concerns. But if these arrive, they are better equipped to weather the storm.

As such, we expect a milder impact on lending and growth in Europe compared to the US. And already tight regulations in Europe compared to that covering small- and medium-sized banks in the US means incremental regulatory uncertainty should have a bigger impact stateside. We therefore have more confidence that European banks and equities are likely to reverse more of their recent underperformance compared to US banks.

Global nominal growth is high, and US and European corporate and household balance sheets are in a strong position, in aggregate. Last week’s PMIs showed global growth actually accelerating into this period of stress while declining oil prices continue to boost disposable income and spending. This provides a substantial cushion for US activity to slow without triggering an outright economic contraction.

We also see the pricing of imminent rate cuts as overdone given the robust economic starting point and continued high inflation. While there is uncertainty, we think the speed at which tighter lending standards weaken the economy will be slower than bond markets seem to indicate. A repricing of yields higher would likely coincide with a rotation from growth back into value.

We continue to prefer Chinese equities and view the policy-induced economic rebound there as most insulated from banking stress in the West. In credit, we prefer emerging market debt to US high yield, which is relatively more expensive and exposed if the US growth outlook turns out weaker than our expectations. We continue to expect US dollar weakness as the Fed approaches the end of its tightening cycle and China rebounds, enabling some rebalancing of global growth away from the US to the rest of the world.

The chart below shows the views of our Asset Allocation team on overall asset class attractiveness as of March 24, 2023. The colored squares on the left provide our overall signal for global equities, rates, and credit. The rest of the ratings pertain to the relative attractiveness of certain regions within the asset classes of equities, rates, credit and currencies. Because the ACA does not include all asset classes, the net overall signal may be somewhat negative or positive.

Source: UBS Asset Management Investment Solutions Macro Asset Allocation Strategy team as of March 24, 2023. Views, provided on the basis of a 3-12 month investment horizon, are not necessarily reflective of actual portfolio positioning and are subject to change.

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