What happened?
European banks led a global equity market sell-off on Wednesday. The S&P 500 closed down 0.7%, Stoxx Europe 600 2.9%, and the European bank subindex 6.9%. Within the sector, Credit Suisse fell 24%, BNP Paribas 10%, and Societe Generale 12%.
Sentiment in the European banking sector had already been negative following the collapse of Silicon Valley Bank in the US. But comments from the chair of the Saudi National Bank, Credit Suisse’s top shareholder, suggesting it would not provide additional capital for Credit Suisse if needed, drove the sector lower.
Fixed income markets moved swiftly to price in more dovish central bank policy. German 2-year Bund yields fell 48 basis points, Swiss 2-year yields 35bps, and US 2-year yields 36bps. The European Central Bank meets this Thursday and had been widely expected to hike rates by 50bps. The Swiss National Bank and Federal Reserve meet next week. The dollar also rallied sharply against the euro, as investors sought safe havens.
What’s the context?
In the aftermath of last week’s collapse of Silicon Valley Bank, markets are grappling with three interrelated but different issues: bank solvency, bank liquidity, and bank profitability.
In short, we think bank solvency fears are overdone, and most banks retain strong liquidity positions. As such, depositors in the vast majority of institutions remain well protected. However, a small number of individual banks may require central bank liquidity support if funding conditions remain challenging for an extended period, and profitability headwinds for the sector are mounting.
Bank solvency—the degree to which a bank's assets exceed its liabilities—is a key metric for depositors and for regulators, because it represents a bank’s fundamental ability to repay deposits. This was an issue at Silicon Valley Bank, which had invested a high proportion of its assets in securities whose value subsequently dropped. That vulnerability was then exposed when it had to sell assets to repay depositors who requested their funds.
However, we do not think that solvency is an issue for the vast majority of other banks. 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. It is also worth remembering that at G-SIBs, securities designated as “available for sale” are regularly marked-to-market against regulatory capital requirements.
Bank liquidity—the degree to which a bank can meet its obligations in a timely way—is also a key metric. Regulators regularly test banks for their ability to repay their obligations on time, even during periods when outside funding is temporarily unavailable. But if a bank is unable to inspire sufficient confidence to retain deposits or attract wholesale lenders over a very sustained period, a liquidity crisis can still emerge. While this does not necessarily affect a bank's ability to pay creditors eventually (i.e., its solvency), it may require a “lender of last resort” to step in to resolve mismatches between the duration of assets and liabilities.
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. The lack of a similar announcement in Europe contributed to the weak sentiment in the sector in recent trading sessions, though the Swiss National Bank did announce after market close on Wednesday that it would “provide liquidity...if necessary.”
Finally, bank profitability—the degree to which a bank’s revenue can sustainably outstrip its costs—is a final key metric because profitability represents a bank's ability to deliver sustainable returns to shareholders and providers of capital.
For more information, see CIO Alert " US bank turmoil: FAQ and investment implications," 13 March 2023.
It is important to recall that European banks had rallied by more than 20% at the start of this year on hopes that higher interest rates would boost profitability through higher net interest margins. And even following Wednesday’s move, the sector is still marginally up year-to-date. In this context, the sell-off can also be viewed through the lens of “dashed hopes.”
Nonetheless, we have to acknowledge that 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.
How to invest?
We think that solvency fears about leading banks are overdone. Strong capital positions and tight regulatory oversight of the G-SIBs mean that we do not foresee solvency issues at leading banks. Actions from the FDIC and the Fed should also alleviate liquidity risks for US banks and US branches of foreign banks, and the liquidity positions of most European banks are very strong. In this context, the risk to depositors in the vast majority of institutions is extremely low, in our view.
At the same time, however, tighter funding conditions do increase liquidity risks for a small number of individual banks, and headwinds to bank profitability are also mounting more broadly. 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.
More broadly, we see high-quality fixed income as an attractive asset in the current environment. 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. They should continue to gain if markets price a greater possibility of recession or deeper future interest rate cuts.
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 China’s reopening offers support. At a sector level, we like the global consumer staples sector, 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.
In currencies, while the US dollar is attracting safe-haven inflows in the near term, we believe it is overvalued and will weaken against most G10 peers over the longer term. As such, we think investors should use periods of dollar strength to reduce allocations to the currency. Investors worried about the risk of a financial crisis can consider diversifying into other traditional safe havens like the Swiss franc and gold. For those with more risk appetite, we still think it is likely that the Fed is closer to the end of its tightening cycle than the ECB, which should favor the euro. And for investors who believe that China’s domestically driven consumption recovery can continue, despite events in the US banking system, we recommend the Australian dollar, our most preferred currency.
