The Credit Suisse Effect
In the March 20 edition of Macro Monday – a weekly macroeconomic overview – Investec Wealth & Investment's chief investment strategist, Chris Holdsworth gives an overview of the GISG’s positioning of keeping its risk budget score at -0.5 (on a scale of -3 to +3). We also cover the developments at Credit Suisse and its sale to UBS.
UBS buys Credit Suisse
UBS is paying CHF3bn (US$3.3bn) in shares for Credit Suisse in a government-brokered deal. The Swiss National Bank is offering CHF100bn liquidity assistance to UBS and the Swiss government is granting a CHF9bn guarantee for potential losses. So far the market response has been muted. US futures have been flat on the news.
The most intriguing part of the deal is that Credit Suisse’s additional tier 1 (AT1) debt is being written down to zero, while the equity is not. The AT1 market is unlikely to take the news well at all. The size of AT1 market is US$2.8 trillion.
Meanwhile, the Federal Reserve, European Central Bank, Bank of Japan, Bank of England, the Swiss National Bank and the Bank of Canada have announced a coordinated plan to increase US dollar liquidity.
The inevitable outcome of these developments, and to restore trust and rebuild confidence in the banking system, will be a harsh tightening of regulations. At the same time, events like these spur meaningful changes in depositor behaviour. While it is early days, we suspect that:
- Banks will have to move quickly to increase deposit rates to restore the risk/reward views of depositors.
- Borrowing costs for corporates and individuals will rise to protect margins and account for asset quality risks emerging against the increased volatility in the system and economy.
- The harsh reminder of the tail risks associated with investing in banks will drive a higher cost-of-equity for the sector and banks’ borrowing costs in the AT1/Tier 2 market are likely to rise, placing further pressure on margins.
- The cost to comply will inevitably rise, likely reducing profit margins.
Credit Suisse, Silicon Valley Bank and the current global banking situation
In this Breaking Views video, Chris Holdsworth, chief investment strategist at Investec Wealth & Investment, summarises the current global banking crisis and what this means for markets. He discusses the two primary risks emanating from the situation in the US, namely a run on regional banks and possible contagion in the commercial real estate sector.
Summary of the GISG positioning
While the US Federal Reserve has so far successfully contained the risk to the US banking system, it has in effect also bought itself space to hike further. Even before taking into account any further hikes, we expect a recession in the US and this does not yet seem to be reflected in consensus earnings forecasts. While inflation is coming down – partly due to reduced demand – we do not think it will come down quickly enough to prevent the Fed from pushing the US into recession. The US market still screens as expensive too, while equities in the rest of the world look much more attractive, as does fixed income outside of high-yield credit. As a result, the GISG has kept the risk budget score at -0.5 (on a scale of -3 to +3) in its Global Investment View report for Q1 2023.
Explaining the GISG rationale
Central banks will support banks
One of the legacies of the Global Financial Crisis is that central banks are quick to provide support to failing large banks. So far, this latest period has not been any different. There may be some longer-term unintended consequences from the Silicon Valley Bank (SVB) collapse – such as a rush to larger banks and a more concentrated banking sector – but we expect little short to medium-term risk of financial instability in either the US or Europe. Banks in general however may be even more cautious – already lending standards surveys were pointing to a tightening of standards even ahead of the run on SVB – which will not be supportive of faster GDP growth over the short to medium term.
US to go into recession
The leading indicator, the yield curve, consumer expectations relative to the current position, and defaults all point to a recession starting soon in the US, if it has not already started. While still significant excess savings imply the recession will be of the milder variety, there will nonetheless likely be a decline in real economic activity in the US. At the same time, lower inflation and low growth imply much lower top-line growth for US corporations and the possibility of negative operating leverage. Given this scenario, the consensus forecast of mid-single-digit earnings growth for the S&P 500 this year and next seems too optimistic.
Growth remains weak, alongside low levels of liquidity
Six-month US M2 money supply is running at -1.7%, the lowest reading in at least 40 years. US growth is weak too. The 12-month period from Q3 last year to Q3 next year is likely to see US GDP growth of just 1.5%, implying 12-month growth in the bottom 22% of observations since 1980. The combination of weak GDP and money supply growth supports a continuing risk-off position.
Europe is likely to go into recession
Surprisingly warm weather in Europe has meaningfully contributed to reducing the demand for gas – and a precipitous fall in gas prices, despite the ongoing Russian invasion of Ukraine. The fall in gas prices may have been sufficiently large to allow for energy prices to no longer be a binding constraint on growth in Europe. However, core inflation continues to increase and is uncomfortably high at 5.6%. The net result has been a recent 50bp (0.5 of a percentage point) increase by the European Central Bank (ECB) and we expect that the ECB will continue to hike over the short term – providing a strong headwind for growth in Europe.
China is set to rebound
Chinese inflation, at 1%, is well below the central bank target of 3% and allows for the possibility of further stimulus should the Chinese economy slow. In the meantime, money supply growth in China is running at close to 13% (vs -1% for the US) and the three-month average of total social finance is up year-on-year – implying stronger growth over the coming nine months. Chinese manufacturing activity has already started to meaningfully rebound – and we expect will be strong over the year ahead. Still tight commodity inventories in China imply support for commodity prices over the year ahead, despite the slowdown in developed market economic activity.
Inflation is declining and likely to continue to surprise on the downside
US money supply growth is negative for the first time in over 50 years. Money supply growth is slowing materially in Japan and Europe too. In addition, global container shipping costs are down 85% year-on-year and wheat and oil prices are materially below their recent peaks. All of these factors point to a material slowdown in inflation over the year ahead. In addition, the reopening of the Chinese economy, while likely to provide support for commodity prices, will further reduce supply chain constraints. A recession in the US, and possibly Europe, will further ease any remaining inability of supply chains to meet current demand. The consensus forecast is for US inflation to average 4.1% this year and 2.5% next year. We think these forecasts are too high.
There are signs that the US labour market is about to soften
Job resignations have been in decline, the National Federation of Independent Business (NFIB) hiring survey has been trending down and US manufacturing has been weak – all of these point to a forthcoming slowdown in the US labour market. Having said that, the US labour market has been consistently stronger than market expectations over the past year and the Fed is likely to wait for clear signs of a slowdown before taking its foot off the brake.
Will the Fed hike further?
Despite the clear signs of slowing economic activity in the US, the extent to which the Fed was able to successfully nip a bank run in the bud may have given it licence to continue to hike, given still elevated core PCE inflation. The market is pricing in a 50% chance of no further rate cuts – and for the Fed to start cutting from June this year. There is a material chance that the Fed tightens by more than the market currently expects.
The consequences of rate hikes have yet to be established
The current rate hiking cycle has been the steepest in at least 40 years. In addition, we have recently been through a period of sizeable cross-currency volatility. We are only now starting to see the consequences of the recent monetary tightening and there will probably be a few more bumps in the road over the coming six months.
We expect both the US and Europe to shortly go into recession. This is likely to be accompanied by material downward revisions to earnings expectations, leading equities to underperform fixed income by 5-10%, in our view.
Higher rates will have fiscal effects
The moves in developed market yield curves over the past two years will start to have an effect on the fiscal position of governments. Given that inflation has started to recede, the Fed and other developed market central banks will need to follow shortly or we will see both fiscal and monetary tightening happen simultaneously.
The US housing market is slowing
Mortgage applications remain at the lows of the Covid-19 pandemic while there is still a near-record number of homes under construction. The prospect of a slowdown in the labour market and further rate hikes from the Fed imply further headwinds for the US housing market. High-frequency estimates already imply US house prices are 13% down off their peak. We expect that further weakness in the US housing market will act as a headwind for US equities.
The US dollar is likely to weaken
The trade-weighted, inflation-adjusted US dollar is still close to the strongest it has been in over 40 years. As global inflation continues to recede, we expect the US dollar will weaken. A weaker US dollar should prove helpful for emerging markets and commodity exposure.
The US market is expensive
Our dividend-based model shows the US market to be +-20% overvalued. The HOLT-based implied discount for the US market is still low too. The forward P/E of the US market is just under 18, a 5% premium to the 15-year median and we expect earnings to be downgraded. Whichever way one looks at it, the US market is still expensive and offers little margin of safety.
US equities are set to underperform Treasuries over the coming three months
The prospect of a US recession and earnings downgrades, with little margin of safety in equity valuations, implies a significant chance of the US equity market underperforming treasuries over the short term.
The rest of the world (outside of the US) is looking more attractive
Both earnings and dividend-based models show Europe, UK, and emerging markets to now be at or below fair value. Emerging market GDP growth will likely accelerate this year on the back of the China reopening and given the still low inflation in China, meaning that Chinese authorities have further scope for policy stimulus. A weaker US dollar should support the performance of the rest of the world over the US.
US bond yields are set to decline over the coming 18 months
US Treasuries screen as cheap in our view. Inflation is heading lower and we expect US Treasuries to provide effective insurance should the probability of recession in the US escalate further. Implicitly, we expect a much lower correlation between equities and bonds over the coming 12 months as the focus shifts from inflation to growth.
Commodities to do well
As China continues to reopen and the US dollar continues to weaken on the back of lower-than-expected inflation, we expect that commodities will rally despite the slowdown in developed market GDP growth. Commodity inventory levels are low in China and we expect even small increases in demand will be supportive for commodities given continuing supply discipline.
The debt ceiling is a material risk
There is a non-negligible chance that Congress will be unable to timeously raise the debt ceiling and we get a repeat of the 2011 US government shutdown. The market appears to be attaching a low probability to what could be a material slowdown in the next six months.
Mediocre returns ahead
We expect to see relatively weak returns for aggregated asset classes over the coming 18 months. However, there is likely to be large dispersion within each asset class and the opportunity for generating alpha probably lies with sector selection, rather than asset allocation. While fixed-income returns will likely not be spectacular, they will still likely be materially better than in the recent past.
The war in Ukraine is unlikely to end soon
We do not expect to see an end to the war in Ukraine in the near future but we also believe that the peak of food and energy prices is behind us.
Climate change and government/private sector responses will lead to higher inflation over the long run
The energy transition is going to be very metal intensive while mining companies are showing an unusual commitment to supply discipline. The net result is the potential for sustained higher commodity prices and ultimately structurally higher inflation. In addition, ESG investing itself will have real-world consequences and likely lead to larger asset class/sectoral dispersion.
More pros than cons in the market outlook
In conclusion, there are more ‘cons’ than ‘pros’ to the market outlook. Tallying up the pros and cons of the market outlook gives a list heavily weighted toward cons. There is still ample reason for a cautious approach. Having said that, the early part of the cycle is typically the most rewarding and we are getting closer to the point at which we expect the market to bottom.