Banking sector turmoil raises three interrelated, but different issues: bank solvency, bank liquidity, and bank profitability. (UBS)

The S&P 500 closed 1.8% higher and the KBW regional banking index gained 2.6% on Thursday, benefiting from initial reports that major US banks were preparing a government-approved backstop to support First Republic Bank. This was later confirmed after the close, with 11 Wall Street firms including JPMorgan, Citi, Bank of America, and others jointly depositing some USD 30bn into the lender.

In Senate testimony, Treasury Secretary Janet Yellen said, “I can reassure the members of the committee that our banking system is sound, and that Americans can feel confident that their deposits will be there when they need them.” However, Yellen said that recent action by regulators did not mean there was a blanket government guarantee for all deposits.

Bond yields, which had sold off sharply in recent days on the turmoil in the banking sector, recovered some ground. The 2-year US Treasury yield rose 32 basis points to 4.2%, while the 10-year yield gained 12bps to 3.57%. Federal funds futures markets priced in a higher terminal rate at around 4.9%, but policy rates are still seen peaking in May, and just under three rate cuts are expected between the 5 May meeting and the end of the year.

On Friday, the Hang Seng index advanced 1.6%, while the Stoxx Europe 600 rose 0.5% in early trade. That follows Thursday's 1.2% rally for the Stoxx Europe 600 index, and a 1.1% rise for the banking sub-index after Credit Suisse detailed plans to borrow up to CHF 50bn (USD 54bn) from the Swiss National Bank (SNB) to “pre-emptively strengthen its liquidity.”

The European Central Bank delivered on its commitment made in February and raised the deposit rate by 50 basis points to 3%, despite concerns about the recent turbulence in the banking sector. ECB President Christine Lagarde noted that downside risks to the economy have clearly increased and subsequent policy moves will be dependent on the data. But she also said that “inflation is projected to remain too high for too long.”

What do we expect?

Banking sector turmoil raises three interrelated, but different issues: bank solvency, bank liquidity, and bank profitability.

Overall, we think bank solvency fears are overdone, and most banks retain strong liquidity positions. So, depositors in the vast majority of institutions remain well-protected. This is particularly the case for global systematically important banks (G-SIBs), which have been tightly regulated since the 2008 financial crisis to ensure they have a more-than sufficient surplus of assets over liabilities, even in stressed economic scenarios. However, we think a small number of individual banks may require central bank liquidity support if funding conditions remain challenging for an extended period.

Recent action by the Federal Deposit Insurance Corporation to guarantee deposits, and by the Fed to lend to banks that require funds, should solve liquidity-related risks for US banks as well as for US branches of foreign banks, in our view. Swiss authorities appear to be seeking a similar outcome, with the coordinated response from regulator FINMA and the Swiss central bank aimed at alleviating liquidity issues and addressing market concerns.

However, headwinds to profitability are mounting. Some banks will be forced to further increase deposit rates to reduce the risk of deposit outflows, and wholesale lenders may also demand higher rates of return, increasing funding costs. Banks may opt to refrain from issuing new loans in order to boost their liquidity, and a weaker economic outlook may require banks to take more provisions against future loan losses.

Recent events in the banking system have increased the risk of a hard landing. Banks are a key conduit for transmitting central bank interest rate policy into the broader economy. Lending standards may tighten or borrowing costs may rise in response to higher bank funding costs. All else equal, these factors should lower economic growth in the coming quarters, as, at the margin, consumers opt to save rather than to spend, and businesses choose to forgo investment opportunities due to the higher cost of funding.

Adding to the pressure, central bank tightening is continuing. The ECB’s hike on Thursday and its commitment to fighting inflation point to a high likelihood of another, albeit smaller, increase in interest rates of 25bps at the May meeting. If, as we expect, core inflation is showing no signs of abating by the middle of the year, we see a further 25bps hike in June, lifting the deposit rate to what we believe will be a peak of 3.5%.

Attention will now turn to the Fed’s interest rate decision next week, where the outcome is uncertain. The backward-looking data is pointing to further hikes, with the GDPNow estimate for 1Q23 standing at 3.2%, payrolls up 815,000 over the last two months, and inflation still well above target. That said, the Fed has already raised rates a long way, lending standards have been tightening rapidly, and recession risks were seen as very high even before this new banking shock.

One option would be to pause hikes at next week’s meeting, but signal that they still expect to raise rates further in subsequent meetings. The bank may also use its balance sheet to address financial stability concerns. This would give the Fed at least a few weeks to gauge the impact of the banking shock.

How do we invest?

As the effects of interest rate hikes conducted so far become more apparent, we believe markets will increasingly start to price in interest rate cuts over the next one to two years. That will make attractive fixed-rate returns on cash and fixed income assets harder to come by in the future. We recommend investors lock in current high yields and manage timing risk by doing so progressively.

With all-in yields still high, we see high-quality fixed income as an attractive asset class in the current environment. We think fixed income allows investors holding cash the possibility of diversifying their credit risk, as well as the opportunity to lock in yields at a time of uncertainty about the future path for interest rates. We like high grade and investment grade bonds, and the defensive fixed income themes that we favor have gained strongly in response to the recent fall in rates. In our view, they should continue to gain if markets price a greater possibility of recession or deeper future interest rate cuts.

From an equity market perspective, we think that investors with excess exposure to bank equities (the MSCI All Country World Index holds around 15% in financials) should diversify their exposure into other sectors. We are neutral on European financials and least preferred on US financials. In equities, we have US stocks as least preferred. The Fed faces an increasing challenge balancing its battle with inflation, and risks to growth and financial stability, reducing the probability that it will be able to achieve a “soft landing.” We prefer emerging market stocks, where valuations are lower than in the US and as China’s reopening offers support. At a sector level, we like global consumer staples, where relative earnings momentum is positive and strengthening. We also favor strategies that switch direct equity exposure into capital preservation strategies, to help hedge equity market risks.

Main contributors - Mark Haefele, Vincent Heaney, Jason Draho, Dean Turner, Jon Gordon

Content is a product of the Chief Investment Office (CIO).

Original report - Equities rally on more decisive support for banks, 17 March 2023.