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Brooks Macdonald daily investment bulletin

Please see below article received from Brooks Macdonald today 30/03/2023 which provides their views on recent global market events:

What has happened

Equity markets managed to retain their calm from earlier in the week yesterday and as risk appetite returned, US and European equity markets saw a broad rally. With yesterday’s rally, the US equity market has now closed above the level set before Silicon Valley Bank entered the newswires. US technology outperformed, with the sector set for a strong Q1 barring any major issues in the next few days.

Central Bank Speakers

Fed Speakers yesterday stuck to the data dependent script with Barr saying that the Fed would make a ‘meeting-by-meeting judgement on rates’ that would evolve as the data unfolded. The bond market began to settle down yesterday, pleased to hear the data dependent messaging reiterated and now the market expects just over 50bps of interest rate cuts after the terminal rate is reached at May’s meeting. The calm in the bond market reflects the fact that much of the post SVB rally in sovereign bonds has unwound over the last trading week. It was a similar message from the ECB yesterday as Kazmir stressed that members of the ECB governing council had ‘agreed we will not give guidance about May ECB policy meeting’ as the bank observes incoming data. Kazimir added that the ‘ECB shouldn’t back down on rates but maybe slow the pace.’

UK data

There was some stronger UK data yesterday as both consumer credit and mortgage approvals beat market expectations. Whilst consumer credit data could show a stretched consumer reliant on credit to meet the cost-of-living squeeze, the mortgage approvals are more unambiguously positive. The Bank of England’s Mann said that the UK economic outlook had improved given lower wholesale energy prices and the associated energy price caps. Of course, robust economic demand could put the Bank of England under pressure to hike rates further however it does push back against market expectations of a UK recession.

What does Brooks Macdonald think

A recession in the UK and Europe has been a consensus view amongst many investment strategists since the start of the year. Indeed, that expectation, combined with disinflationary data, helped equities to rise in January of this year as investors hoped that a short recession would help eliminate any demand-led inflationary pressure. The robust economic data globally pushes back against this recessionary expectation but at the same time risks inflation staying higher-for-longer which may necessitate more aggressive central bank action down the road to unanchor any increases in consumer inflation expectations.

Please check out blog content for advice, planning issues and the latest investment, market and economic updates from leading investment houses.

Adam Waugh

30/03/2023

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Markets in a Minute – Stock markets shrug off banking sector woes

Please see below article received from Brewin Dolphin yesterday afternoon, which provides a cautiously optimistic market update despite high inflation and banking sector concerns.   

Stock markets ended last week in the green as hopes of interest rate cuts outweighed recent concerns about the banking sector.

In the US, the S&P 500 and the Nasdaq added 1.4% and 1.7%, respectively, as the Federal Reserve hiked interest rates in line with expectations. The Fed’s ‘dot plot’ – a chart which summarises the central bank’s outlook for interest rates – suggested officials expect to stop raising rates after one more hike in May.

The FTSE 100 added 1.0% after UK retail sales recorded their largest monthly gain since October and business activity expanded for a second consecutive month, demonstrating resilience in the UK economy.

The pan-European Stoxx 600 gained 0.9%, despite a sharp decline in banking stocks. Eurozone business activity was stronger than expected in March, driven by growth in the services sector.

In Asia, China’s Shanghai Composite edged up 0.5% and the Hang Seng climbed 2.0% as analysts predicted policymakers would maintain an accommodative monetary policy in light of the banking sector turmoil.

Investors cheered by Silicon Valley Bank deal

Stocks started this week in the green, with the FTSE 100, Stoxx 600 and S&P 500 gaining 0.9%, 1.1% and 0.2%, respectively, on Monday (27 March). Banking stocks, in particular, were boosted by news that First Citizens Bank had agreed to buy the deposits and loans of Silicon Valley Bank, the US regional bank which collapsed earlier in the month. There are hopes that the turmoil in the banking sector has now peaked.

In economic news, a survey by the Ifo Institute showed German business sentiment unexpectedly improved in March. The business climate index rose to 93.3 from 91.1 in February, marking the fifth-consecutive monthly increase.

Fed suggests rate hikes are nearing an end

Last week, the Federal Reserve pressed ahead with a quarter percentage point increase in interest rates – its ninth-consecutive rate hike since March 2022. As ever, investors were more interested in the Federal Open Market Committee’s (FOMC) post-meeting statement than the rate hike itself, which had been widely anticipated.

Unlike previous statements which referred to “ongoing increases” in interest rates to bring down inflation, this latest statement said that “some additional policy firming” may be appropriate. Projections indicated that a majority of officials expect only one further rate hike this year.

Fed chair Jerome Powell said the FOMC had considered a pause in rate hikes because of the troubles in the banking sector, but went ahead with the increase due to inflation data and the strength of the labour market. Powell also stated that rate cuts were not in the Fed’s base case for the remainder of 2023. However, futures markets are nonetheless pricing in a more than 90% chance that rates will end the year lower than the current Federal funds target rate of 4.75% to 5.0%, according to the CME FedWatch Tool.

BoE lifts UK base rate as inflation soars

The Bank of England (BoE) also increased interest rates by a quarter of a percentage point last week, marking its 11th consecutive rate hike. The increase has brought the base rate to 4.25%.

UK base interest rate

The BoE’s meeting came a day after figures from the Office for National Statistics (ONS) showed the rate of inflation unexpectedly accelerated in February to 10.4% year-on-year, up from 10.1% in January. Economists had been expecting the rate to decline to 9.9%. Prices of food and non-alcohol drink rose by 18.2%, the steepest pace in more than 45 years, as high energy costs and bad weather led to shortages of salads and vegetables.

Data indicates UK economic resilience

Other data released last week suggested the UK economy may be more resilient than previously thought, despite high inflation and borrowing costs. Retail sales volumes rose by 1.2% in February from the previous month, with sales returning to their pre-pandemic levels. The increase was well above the 0.5% rise forecast by analysts.

S&P Global’s flash UK purchasing managers’ index (PMI) showed business activity expanded for a second consecutive month in March. The main composite output index measured 52.2, down from February’s eight-month high of 53.1 but still comfortably above the 50.0 mark that separates growth from contraction. Manufacturing production decreased slightly, whereas services sector activity picked up for the second month running.

Chris Williamson, chief business economist at S&P Global Market Intelligence, said the UK economy looks to have returned to growth in the first quarter, and that the improvement in order book growth “adds to signs that a near-term recession has been avoided”.

Meanwhile, research company GfK’s consumer confidence index rose two points in March to -36. Within that, consumers were more positive about the general economic situation over the next 12 months. However, they were more pessimistic about their personal financial situation – a measure which Joe Staton, client strategy director at GfK, said “best reflects the financial pulse of the nation”.

Please check in again with us soon for further relevant content and news.

Chloe

29/03/2023

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Brooks Macdonald Weekly Market Commentary

Please see the latest Weekly Market Commentary from Brooks Macdonald received this morning:

Banking fears characterised last week with concerns culminating in questions over Deutsche Bank’s creditworthiness

Despite the UBS and Credit Suisse deal, last week was characterised by high levels of banking sector volatility, culminating with fears over Deutsche Bank’s credit worthiness on Friday. Words from regulators and officials over the weekend have helped to calm market concerns setting a better backdrop for European financials this week.

This week sees important US and European inflation readings including the US Federal Reserve’s preferred measure

While investors have been focusing on the banking sector risks in the short term, inflation will quickly return as a major driver of market sentiment. This week sees the release of the US Personal Consumption Expenditure (PCE) inflation numbers, the preferred measure of the US Federal Reserve. Core PCE is expected to have expanded by 0.4% on a month-on-month basis, keeping the year-on-year figure flat at 4.7%. Within the PCE release will be the US personal consumption and income lines which are both expected to decline after strong results in January. These barometers of consumer demand will also be supported by the releases of the Conference Board’s consumer confidence survey as well as the Michigan Sentiment survey. Europe will also see a fresh set of inflation data with Germany’s preliminary inflation readings released on Thursday before the Eurozone wide release on Friday. The market expects the annual rate of Eurozone Core Consumer Price Index (CPI) to pick up from 5.6% to 5.7%, pushing back against hopes of a rapidly falling inflation picture.

With the communication blackout concluded, Fed officials will now be able to comment on the volatility of the last few weeks

Throughout the banking turmoil of the last few weeks Fed speakers have largely been unable to comment given the pre-meeting communication blackout. This week sees a range of Fed speakers as they are now able to comment on not only the Fed’s 25bp hike last week but also the broader contagion risks in the banking sector. The market ended the week expecting only a 25% chance of a 25bp rate at the May meeting, with bond investors increasingly favouring the chances of no change at all. With 88bps of interest rate cuts priced in, how Fed speakers comment on this pricing will be an important bond market force this week.

With sentiment so fragile currently, it is perhaps no surprise that speculation and rumour around the health of major US and European banks can trigger such a strong risk-off response. Authorities and investors will be hoping however that the market can return to focusing on the fundamentals this week such as inflation and the state of the consumer, rather than another round of banking fears.

Please continue to check our Blog content for advice and planning issues and the latest investment, markets and economic updates from leading investment houses.

Andrew Lloyd DipPFS

28/03/2023

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Tatton Investment Management – Monday Digest

Please see below, an article from Tatton detailing the key news from markets around the globe over the past week. Received this morning – 27/03/2023

Swiss parochialism backfires

March continues to provide investors with the opposite of the ‘steady-as-she-goes’ environment of January and February. It appeared that global banking sector turmoil had eased after Swiss authorities officiated over a classic ‘shotgun’ marriage between Credit Suisse and UBS. Indeed, for a few days, stock markets and bond yields recovered somewhat, but the uneasy equilibrium was unbalanced once again after the US Federal Reserve (Fed) raised rates by another 0.25% to a range of 4.75%-5.0%.

Fed chair Jay Powell acknowledged the stresses on banks would likely tighten financial conditions, meaning the Fed may not need further rate rises to pursue its policy goals. Given it was aggressive monetary tightening that had weakened banks’ capital base, the obstinance of the rate decision saw focus return to other names in the banking sector. Germany’s Deutsche and Commerzbank came under renewed pressure, as well as some French and Italian banks.

No doubt much of the banking sector is suffering collateral damage from the central banks’ war against inflation over the past 12 months. But the manner in which the Swiss authorities hammered out the UBS takeover of Credit Suisse may well have amplified the returning weakness. The ‘rescue’ of Credit Suisse came at the expense of holders of its Additional Tier 1 (AT1) bonds (aka contingent convertible ‘CoCo’ bonds) which were written down to zero, while its equity shareholders (ranked below bond holders in the capital structure) were spared a similar fate. This preferential treatment of equity over bond holders is without precedent and deeply concerning. The principle is not that AT1 bond holders should be protected from loss, but that the capital structure as investors understand it must be upheld to re-establish trust in – and investor appetite for – the banking sector.

We should make clear that Tatton has no particular ‘skin in the game’ here. Our investment portfolios have minimal exposure directly to these issues, if any – and where we do, it is mostly through index tracker funds. The point is rather that instead of re-establishing trust among banking sector clients and investors, the Swiss authorities did the opposite, supposedly in the name of speed of action and financial stability. The aftermath still reverberates around markets, and we suspect last weekend’s actions have substantially eroded the Swiss banking sector’s international standing.

Banking sector rout squeezes the little guys

As noted last week, a rate rise cycle as dramatic as this one is bound to reveal cracks in the system. But no matter how much you mitigate systemic risks, each bank run increases the chances of another one. Almost every bank, no matter how well positioned, will take precautionary action as a consequence. Lenders will be more cautious, reducing capital available to corporations. As such, analysts suspect a general credit crunch in corporate America is now all but certain.

Storms are always worse for smaller boats, and small and micro-cap firms will be particularly hard hit. We are already seeing this play out, with investors pulling out of small businesses. In particular, positions in highly-leveraged companies have plummeted through March. Credit spreads – the premium companies have to pay for borrowing above those the government enjoys – are now expected to see their largest monthly increase since last September. Companies that rely on regional banks for funding will be very worried. According to Bloomberg, US commercial property owners will see nearly $400 billion of debt mature this year, requiring refinancing, with another $500 billion set to mature in 2024. With the financial and economic backdrop as it is, many could struggle to find banks willing to provide new loans. Those that secure refinancing will do so at sharply higher costs.

Those scarred by memories of 2008 will no doubt be alarmed by problems spreading higher up the credit chain. But we maintain our broad assessment from last week: this classic liquidity squeeze will cause problems for many, but systemic failure is highly unlikely. Policymakers are doing a good job of filling in the cracks before anything shatters. We welcome the relative calm of the past week, but further troubles are inevitable, potentially even for bigger players. We should have a safe landing in the end, but the rollercoaster is not finished yet.

UK inflation makes an unwelcome comeback

Last week’s announcement from the Office for National Statistics (ONS) that consumer prices index (CPI) inflation had crept up from 10.1% year-on-year in January to 10.4% in February came as an unwelcome surprise. Before this news, things were looking better for the UK economy, albeit only slightly. Falling fuel prices, easing global input costs and a small but consistent slide in monthly inflation had suggested ‘peak’ inflation was behind us, a view even endorsed by the Bank of England (BoE). But the latest inflation print poured cold water on hopes that the central bank might slow down or even suspend its interest rate rising cycle. Instead, the BoE increased its base rate by 0.25%, taking it to 4.25% in the 11th rise since December 2021.

Food, drink and clothing were the main culprits according to the ONS, with food and non-alcoholic drink prices rising 18% in February, the fastest pace in 45 years. This was despite food prices outside of the UK generally falling over the last few months, suggesting this particular problem is specifically British. Even disregarding the food element though, prices were still higher than expected. Core inflation – which strips out more volatile elements like food and fuel – came in at 6.2%, higher than January’s 5.8%. This is a measure the BoE pays close attention to, as it is an indicator of more persistent ‘stickier’ inflationary trends. Along those same lines, inflation in the services sector rose to 6.6% from 6.0% the month before, suggesting stronger-than-expected wage pressures. The BoE was concerned enough to raise the base rate to 4.25%. Since prices started soaring, policymakers’ biggest concern has been the threat of a wage-price spiral, where employees react to higher prices with higher wage demands, which in turn cause businesses to raise prices again.

However, the rise in food and clothing prices is notable. We think this is a sign companies – particularly supermarkets – are taking the opportunity to rebuild their profit margins, banking on the belief that consumers have become acclimatised to elevated inflation expectations, thanks to the prolonged period of rising prices. This may be good news for investors in supermarket shares, but less so for consumers and central bankers. If supermarkets tell us they’re doing well in their next trading reports, one might expect some pushback.

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Alex Kitteringham

27th March 2023

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Evelyn Partners Update: BoE March Review

Please see below an article from Evelyn Partners, which was published and received earlier today (23/03/2023) and covers their views on the Bank of England’s monetary policy decision to raise interest rates by 25bps:

What happened?

The Bank of England increased rates by 0.25% today at their March monetary policy meeting, which is in line with market and economic expectations. This takes the base rate to 4.25%, its highest level since 2008. The Monetary Policy Committee (MPC) voted 7-2 in favour of 25bps – 0bps respectively so policymakers continue to have diverse view on the best course for rates, although to a lesser extent than the 3-way split seen in December.

What does it mean?

When making their decision, committee members would have been weighing the fragility of the banking sector against the need to bring inflation back to target.

On one hand the recent turmoil in the banking sector, which began with collapse of Silicon Valley Bank (SVB), will remind central banks that things can break when monetary policy is rapidly tightened. Although contagion risks look to have receded for the time being, the BoE will need to tread carefully if they decide to further tighten monetary policy from here. The BoE recently acknowledged: ‘more sharp moves in asset prices could expose weakness in parts of Britain’s financial system’ in a letter to law makers.

On the other hand, yesterday’s CPI print showed that inflation re-accelerated in February with both headline and core CPI posting a gain of 1.1% and 1.2% respectively for the month. On top of this the labour market continues to remain tight putting pressure on wage growth which could further stoke inflation and cause it to become entrenched.

Moreover, recent UK economic data has been surprising on the upside: February’s PMI readings came in well above consensus with the composite figure reported at 53.0, consistent with a recovery in economic growth. Growth expectations are likely to get a boost as falling energy prices feed through to a reduction in household expenditures, boosting real incomes and stimulating the economy. A boost to growth could cause inflation to decelerate slower the than the BoE’s forecasts currently expect, which may cause monetary policy to remain tighter for longer in response.

In sum, today’s decision to increase the base rate indicates two things. First, the battle against inflation is not yet won. Second, the Bank is confident in its ability, and tools, to maintain financial stability.

Bottom Line

Today’s 25 basis point rate hike by the BoE signals there is still more work to be done to tame rampant inflation, as well as highlighting the banks need to remain cognisant of the risks over-tightening can pose to the economy. 

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Carl Mitchell – Dip PFS

Independent Financial Adviser

23/03/2023

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Evelyn Partners Update – March Fed rate decision

Please the below article from Evelyn Partners providing an update on the Federal Reserve decision on interest rates received yesterday, 22/03/2023.

What happened?

The Federal Reserve met today and chose to increase rates 25bps. This was in line with the latest market expectations and takes the target range to 4.75% – 5%. The Fed also published their quarterly ‘dot plot’ which shows where committee members see rates heading in the future. It showed rates peaking this year at a level of 5.1%, the same level they had thought at its last publication in December. The Fed’s quantitative tightening programme continues at its previous pace of up to $95 billion a month.

What does it mean?

Less than two weeks ago Fed chair Powell was suggesting that it may be appropriate to increase rates by 50bps at this meeting if the data continued to show strength. Since then, February’s 300k job growth and 0.5% MoM core CPI inflation bolstered this case, and the meeting may have delivered it were it not for problems in the banking sector. The failure of Silicon Valley Bank in the US and Credit Suisse in Europe caused market participants and the Fed alike to reconsider the path for interest rates in the US.

Futures markets had expected interest rates in the US to peak at around 5.5% in July and remain at this level for the foreseeable future. SVB hit the headlines on 10 March and investors digested the likely fallout over the weekend. By the close of business on Monday, markets were pricing in a peak of just 4.75% as soon as May and a full percentage point of reductions by the year end – a remarkable turnaround. Since then, those expectations moved back higher, and earlier today the peak was expected at around 5% in May before declining to around 4.5% by the end of 2023. Expectations for today’s meeting declined from a 50bps increase to 25bps prior to the announcement, although at one stage markets were suggesting the most likely outcome was no change.

The unusual level of volatility in expectations prior to today’s meeting shows the market’s changing expectations for how the Federal Reserve was going to balance the pressing need for financial stability alongside its mandate of price stability. Clearly stress in the banking sector has added to uncertainty and made the Fed’s job more difficult. In the statement today, they remark “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.”

They also changed elements of language in the statement from last month “ongoing increases in the target range will be appropriate” to the softer “some additional policy firming may be appropriate”. Markets’ initial reaction to the statement was dovish, with the yield curve steepening and stock prices broadly increasing. Given the robust economic numbers coming out of the US, some commentators had expected a move higher in the ‘dot plot’ which did not come.

Bottom Line

Today, the Fed followed the European Central Bank in delivering an expected interest rate increase at their March meeting – we expect the Bank of England will do similarly tomorrow and increase their base rate by 25bps. Clearly central banks believe that fight against inflation is not yet won and while recent turbulence in the banking sector is of concern, it is not enough for a significant change of course. After the statement, market expectations are for rates to peak at the next meeting in May, and we continue to suggest increasing duration in government bond portfolios as the Fed comes ever closer to the end of this hiking cycle.

Please check our blog content for advice, planning issues and the latest investment, market and economic updates from leading investment houses.

Adam Waugh

23/03/2023

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Evelyn Partners Update – February UK CPI Update

Please see the below article from Evelyn Partners providing an update on the February UK CPI. Received this morning 22/03/2023.

What happened?

UK February annual headline CPI inflation was reported at 10.4% (Reuters consensus: 9.9%), up from 10.1% in January but down from a recent peak of 11.1% in October. In monthly terms, CPI was up 1.1% (consensus: +0.6%), compared to a fall of -0.6% in January.

February annual core inflation (excluding food, energy, alcohol, and tobacco) was 6.2% (consensus: 5.7%), versus 5.8% in January. In monthly terms, core CPI increased 1.2% (consensus: 0.8%), compared to a fall of -0.9% in January.

What does it mean?

Inflation appears to have re-accelerated in February. In monthly terms, headline CPI accelerated by a sharp 1.1%, while the headline annualised rate has increased slightly (shielded to a certain extent by the base effect). This stickiness has been especially prevalent in core inflation which gained 1.2% on the month, it’s largest month-on-month acceleration since 1993.

Looking at the contribution components to inflation, a large part of February’s acceleration can be attributed to restaurants and hotels, with the category increasing at its fastest annual rate since 1991. Food and non-alcoholic beverages also contributed heavily with their annual rate the highest for over 45 years, vegetables were a notable mention, with a poor crop yield in Europe and Africa reducing supply.

Tightness in the labour market continues to put pressure on wage growth. The risk is that rising wages will feed through to inflation, causing it to become entrenched. The latest data shows that underlying wage rates (ex-bonuses) have re-accelerated to 6.5% on a 3-month moving average, near its highest rate since the summer of 2021.

Bottom Line

With the inflation re-accelerating in February, we’re still a long way off the Office for Budget Responsibility’s (OBR) forecasts of inflation reaching 2.9% by the end of 2023. While inflation continues to remain elevated, the Bank of England (BOE) have a fine line to tread between restoring price stability and limiting additional pressure on the banking sector when they vote on the next monetary policy decision tomorrow.

Please check our blog content for advice, planning issues and the latest investment, market, and economic updates from leading investment houses.

Alex Clare

22/03/2023

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Brewin Dolphin: Markets in a Minute

Please see this weeks Markets in a Minute update from Brewin Dolphin received late yesterday afternoon:

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Andrew Lloyd DipPFS

22/03/2023

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Brooks Macdonald: Weekly Market Commentary – Credit Suisse takeover sets a new precedent

Please see below, Brooks Macdonald’s ‘Weekly Market Commentary’ which provides a brief overview of the key market events for the past week. Received yesterday afternoon – 20/03/2023

US regional bank concerns move to Europe as Credit Suisse is bought by UBS

The banking sector issues started with Silicon Valley Bank (SVB), moved into the US regional banks but finally became a far wide issue of banking confidence when Credit Suisse’s creditworthiness was called into question last week. Over the course of the weekend UBS and Credit Suisse have agreed a deal which seals the fate of one of the best-known European banks.

The takeover of Credit Suisse bypasses a shareholder vote and sees ‘CoCos’ written down to zero

On Sunday it was announced that UBS would buy Credit Suisse for $3.3bn, a significant discount to where the shares were trading on Friday. The merger is being pushed through without shareholder approval which sets a precedent that systematically important banks can be sold or merged with minority shareholders unable to push back. In practical terms this was designed to avoid a high-profile deal being thrashed out, then voted on, all in the eye of financial markets that are skittish after the events of the last week. The other feature of the deal is that owners of ‘contingent convertible bonds’ (CoCos), a debt security designed to convert to equity during a crisis, will be written down to zero. While Credit Suisse is clearly under major pressure, its actual solvency ratios have been robust, this will undoubtedly raise strong objections from owners of the CoCo securities which have had a worse outcome than equity holders despite appearing to be more senior in the bank’s capital structure.

This week the Federal Reserve needs to weigh up the size of its next interest rate hike amidst the banking volatility

There will be much debate in the coming weeks about what the correct yield is for CoCo bonds going forwards. In the post financial crisis world, they have become an important part of bank regulation which sees a pool of debt capital designed to take losses during a major banking event (rather than just equity holders taking the pain then the government stepping in). The fair price for such securities going forwards will be questioned given the Credit Suisse precedent. Investors will be looking to the ECB and Federal Reserve for confirmation of whether this precedent will only apply to Swiss banks or the wider sector. A consortium of central banks (including the Federal Reserve, Bank of England and European Central Bank) has announced that they will increase the liquidity that they provide to the financial system to help provide a backstop during the current volatility. Later this week attention will turn to the latest Federal Reserve meeting where markets expect only around a 70% chance of a 25bp interest rate hike given the current banking turmoil.

At a macroeconomic level the Credit Suisse/UBS merger reduces market risk and is likely to put a line under the near-term risks of Credit Suisse’s creditworthiness given it comes alongside a large amount of liquidity support from the Swiss National Bank. Credit Suisse has been an outlier amongst European banks for some time, with elevated yields, questions over its management and involvement in several high profile issues (including Archegos and Wirecard). The reduction in the risk of Credit Suisse contagion is good news for financial markets today, however the implications of the rapid deal which has run roughshod over market laws and conventions will have more impact on how banks fund themselves going forwards.

Please continue to check our Blog content for advice and planning issues and the latest investment, markets and economic updates from leading investment houses.

Alex Kitteringham

21st March 2023

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Tatton Monday Digest

Please see below article received from Tatton Investment Management this morning, which reflects on the market’s reaction to global banking issues over the past week.

Overview: Bank stress-testing in real-time 


Following the run on Silicon Valley Bank (SVB), fear has spread. The nervousness of market participants over recently elevated stock and bond valuations found its focal point and so the stock index of the aggregate global bank sector had a very bad week. SVB has become the first sizeable victim of the steepest rise in rates since the 1970s, but its close affiliation with tech, healthcare and crypto is particularly notable. After seeing a near tripling of money deposited by start-up companies and their affiliates during the good times (namely the 2020/2021 tech and healthcare boom), those deposits were heavily drawn on recently when those same companies required funds to bridge the financial strains of these distinctively more challenging times.

Taking into account how much better capitalised and less credit risk exposed banks are today when compared to the run up to the GFC, they seemed an unlikely target and victim this time, but it turns out banking sector trust had never been fully rebuilt. Given SVB specific weakness was an outlier, with its losses from its long maturity government bonds wiping out its equity base, it was right that central banks stepped in to stop the self-enforcing avalanche of mistrust. That stock markets continued their highly volatile trading into the latter part of the week goes to show that once confidence is dented investor are more open to consider that there is the possibility for a much worse than the ‘steady as she goes’ scenario that could play out this year.

The lesson from the past few days is that the pain caused by the rises in rates is hitting small and micro-cap firms particularly hard, even if they are strictly speaking growth stocks whose valuations would otherwise benefit. But we should be heartened that this week proved central banks are reactive to issues of financial instability. The centre of the storm moved to Europe and particularly Switzerland as Credit Suisse came under pressure. The European Central Bank (ECB) still raised rates by 0.5% on Thursday as it had promised at its previous meeting, but President Christine Lagarde was notably reticent about offering any further indications of rate moves.

To top it all off, the market is now pricing in the strong likelihood that March will see an end to all the rate rises in the Western world, and that rates could be cut everywhere by year-end. This week, the Federal Reserve (Fed) and the Bank of England (BoE) meet. Despite the turmoil, markets on balance expect a 0.25% move from both. We have revised our views as well and see a 0.25% move in the US where data remains strong enough to justify it, but we expect the UK will not move. So, for the shorter term it appears that central banks’ objective to tighten financial condition to bring down inflation has suddenly been significantly accelerated through market action.

Is this a banking crisis? And if so, could it get as bad as last time?

 
What makes a crisis a crisis? Ernest Hemingway said bankruptcy happens “gradually, then suddenly”. Weaknesses build up over time, and wider economic circumstances add pressure on them. But for any given company, the full extent of its weaknesses is only revealed when things get so bad those weaknesses cannot stay hidden. The nature of banks means the financial system is more vulnerable than other sectors. Often the first bank failures in a downturn don’t precipitate a crisis but they do reduce the system’s overall willingness to tolerate risk. When the next set of bad news gets out, confidence plummets and financial problems spiral. We saw this a decade and a half ago with Bear Stearns and later Lehman Brothers. Cracks emerge slowly, but shattering happens all at once.

Over the last year, interest rates have risen at the fastest pace in a generation. Meanwhile, economic growth has slowed dramatically. That means higher capital costs with lower aggregate returns, a difficult environment for banks as a whole. When crypto hub FTX collapsed last year, we said this was a sign of the times – opaque high-risk investments being exposed – and that further casualties down the line were likely. That is exactly what happened with Silvergate Capital l, and then SVB. 

The fact that troubles have spilt over to Credit Suisse is a sign that contagion is still very possible, though. Even if the US tech banks can fail in a relatively isolated fashion, a bank as big and important as Credit Suisse is a different matter. Moreover, European banks are much more tightly linked than US counterparts. If Credit Suisse had been allowed to collapse, shockwaves would have been felt far away, and weaknesses at other banks would certainly be exposed. The Swiss regulators’ decision to wipe out holders of Credit Suisse Coco bonds as part of the UBS ‘shot-gun’ marriage deal may still prove too much for the system, with a need to address the failout in some way. That being said, there are two key differences to the events of the global financial crisis. First, the policy response has been swift and decisive. In the US, the Biden administration effectively bailed out depositors of a bank considered too small to be systemically important, as soon as troubles began. Meanwhile, SNB provided billions in liquidity to Credit Suisse on the same day its stock sunk. The long-term merit of these moves is debatable; indeed, European lawmakers are reportedly angry about the US flouting bailout rules they helped create. But they undoubtedly make short-term financial contagion less likely. Second, crises spiral when unknown risks come to light, but most of the current risks exposed at Credit Suisse were already in the light, and known about for some time. We should not underplay the troubles that could spread from such a big institution, but it is important to note that many other banks will have already reduced their exposure to the investment bank. 

We have no doubt that further problems – at different, as yet unknown banks – will become known in the weeks and months ahead. Such is the nature of a monetary tightening cycle. Those institutions that end up in trouble will be those with opaque or misleading balances of assets and liabilities. In that respect, we also expect financial hardship at some (probably recent entrant) private equity or private debt funds (private meaning not available to the general public and therefore not part of Tatton’s portfolios). It may be that such hardship catches only a very small number, and will be seen as idiosyncratic and containable as the demise of SVB, but it is something of which investors should be wary. 

Please check in again with us shortly for further market updates and news.

Chloe

20/03/2023