This came after a Silicon Valley lender warned of sharp losses on bond sales to meet unusually large customer withdrawals. Shares in SVB Financial Group fell 60% (and a further 20% in extended trade) after it said it launched a stock and convertible bond offering to shore up its balance sheet.
The problems at SVB Financial Group raised worries over potential losses on the bond holdings of US banks, many of which invested heavily in long-duration Treasuries following an influx of deposits during the pandemic. The value of these securities has fallen as the Federal Reserve has raised rates. The FDIC recently warned that US lenders face USD 620bn in unrealized losses in their securities portfolios. Meanwhile, investors appear to be concerned that clients could withdraw deposits in favor of higher yielding short-duration bonds.
Anxiety over the banking system also led to a 15-basis-point decline in 2-year US Treasury yields, as investors weighed the possibility that recent developments could tilt the Federal Reserve toward a slower pace of rate rises at its meeting later this month. The developments came ahead of the release of the US employment report for February, which is expected to show the jobless rate remaining close to a 69-year low of 3.4%.
What does it mean for investors?
The financials sector accounts for 15% of the MSCI ACWI index, and we are neutral on it globally. Within that space, we are neutral on European financials and have held a least preferred view on US financials for some time due to concerns over rising fund costs, risks around credit costs and rising unemployment, and weak capital market activity. But we believe the headwinds to the sector can be managed.
We are not currently seeing classic signs of contagion, such as stress in the interbank market. Meanwhile, the USD 620bn of estimated unrealized losses compares to total equity of USD 2.2 trillion for the industry and total realized losses last year of USD 31bn, according to the Financial Times.
Since the Global Financial Crisis, banks have been required to keep their liquidity coverage ratio above 100%, holding enough high-quality assets to meet deposit outflows. In practice, this has meant they hold significant quantities of US Treasuries. The banks are allowed to hold these bonds in ‘Available For Sale’ and ‘Held to Maturity’ accounts at cost and are not required to recognize mark-to-market losses immediately if the bonds lose value. Banks might have to crystalize losses if they have significant deposit outflows that need to be met. But such outflows could also be stemmed by raising deposit rates, though this would reduce earnings. In addition, the value of the unrealized losses will shrink if rates fall.
That said, the latest developments reinforce our negative view on US financials. In addition, concerns over bank earnings and balance sheet worries also add to the negative sentiment for the equity market more broadly.
How do we invest?
We remain least preferred on financials in our US strategy, and recommend that investors that have above benchmark weights in global financials (15%of the MSCI ACWI) revisit their exposure. Instead, we favor switching the excess exposure into more defensive areas given the increasing risks to the US economy. We prefer the global consumer staples sector, where relative earnings momentum is positive and strengthening.
In addition, we currently favor the high quality space within fixed income. We think that all-in yields in fixed income remain appealing, particularly relative to opportunities in other asset classes. Investor demand for fixed income exposure has also increased. We maintain a preference for high grade (HG) and investment grade corporate bonds (IG). In corporate high yield (HY), slower economic growth and earnings in developed economies suggest higher default risk in the future, and we have a least preferred stance on HY.
Main contributors - Mark Haefele, David Lefkowitz, Christopher Swann, Vincent Heaney, Jon Gordon
Content is a product of the Chief Investment Office (CIO).
Original report - Concern over banks unsettle US market, 10 March 2023.