Banking sector stress: 5 key wake-up calls for investors

LAST month, flailing US regional banks were thrown lifelines to salvage depositors and shore up investor confidence. This was followed by the severe stress in the Swiss banking sector, culminating in the historic acquisition of Credit Suisse by UBS.

In the wake of banking stresses, the US Federal Reserve (Fed) and five other central banks announced that they would boost liquidity in their standing USD swap arrangements. Since then, relative calm has returned to the markets, as regulators stepped in with various forms of intervention, ranging from new credit facilities, deposit insurance and policy clarifications.

A severe banking crisis is not our base case given the regulatory efforts since the 2008 global financial crisis (GFC). Bank balance sheets have been shored up in terms of liquidity coverage, funding and capital ratios. However, the confluence of recessionary risks, tighter credit conditions and an interest rate regime calibrated to tame inflation and tighten employment conditions can result in unintended outcomes, such as what occurred in the banking sector.

As we wake to a new dawn, how should we adjust our sails for the rest of 2023 and beyond as investors?

5 key wake-up calls

1. Likely recession and implications on interest rates

In a major reversal of sentiment, the recent banking stress has prompted a reset of expectations with investors expecting the Fed to cut rates and reverse quantitative tightening (QT) in response to rising recession risks. Major central banks – the Fed, European Central Bank and Bank of England – still proceeded with rate hikes in March, avoiding surprises to the market. Butthey painted a cautious stance going forward.

As smaller US banks continue to defend deposit outflow to larger banks and money market funds, illiquid banks have tapped the Fed’s funding facilities including the new Bank Term Funding Programme, causing a sudden rise in the Fed’s balance sheet.

Reduced risk appetite and tighter lending standards by banks imply that companies which are already facing rising refinancing costs may struggle to access capital. Tightening financial conditions could then worsen the drag on growth.

This phenomenon is not new. In 2017 and 2018 when the Fed reduced its balance sheet to unwind three earlier rounds of quantitative easing (QE) after the GFC, liquidity tightened, and commercial bank reserves deposited at the Fed declined sharply. The ensuing banking stress prompted the Fed to stop its 2015-2018 cycle of rate hikes and end QT in 2019.

As US recession risks rise, we forecast a contraction in US GDP in 2H23, as interest rate hikes sap activity. Hence, we expect only one further 25 basis point (bps) rate hike in May, lifting the fed funds rate to 5 to 5.25 per cent. We also cut our longstanding call for 10Y US Treasury (UST) yields over the next year from 3.5 to 3.25 per cent.

2. Beware weak links and US debt ceiling

Weak links can be exposed in a period of higher credit costs, declining business conditions and margin pressure. Hence, highly leveraged companies, unprofitable business models and rate-sensitive sectors may experience heightened volatility in coming months, against the backdrop of higher capital costs and a US recession.

Investors now demand a higher risk premium for holding European banks’ AT1 (Additional Tier 1) securities due to the increased extension risks following recent events. We recommend reducing concentrated positions in the financial sector, and maintain a defensive stance by moving up the capital structure of issuers with strong capital and liquidity buffers.

Growing concerns over the health of the US commercial real estate (CRE) market are driven by higher delinquency rates and CRE loan defaults, due to rising interest rates. Potentially aggressive underwriting assumptions in recent years, pressure on capital values amidst softening economic outlook and increasingly more stringent lending standards pose risks.

We would avoid painting the sector with a broad brush as risks can differ markedly across companies based on geographical and asset class exposure, management approach, track record and underwriting assumptions.

Another emerging risk is a potential political impasse regarding the US debt limit. Since the US Treasury has reached its statutory debt limit of US$31.381 trillion on 19 January, the government has begun the usage of extraordinary measures. Our base case is for brinkmanship, with Congress reaching a last-minute agreement to raise the debt ceiling.

However, protracted negotiations could raise the risk of a debt default that leaves the economy and markets in unchartered territory.

3. Portfolio diversification and resilience matters

While a post-mortem of 2022 portfolio performance implied that the 60-40 asset allocation was an anachronistic concept, this is due to the “macro-driven” nature of the market where inflation, interest rates and currencies created a crucible of correlated outcomes for bonds and equities.

In contrast, 2023 is shaping up to be a “micro-driven” market where diversification across sectors, economies and strategies can cushion the impact of idiosyncratic risks. In March, financial sector woes were offset by strong rebounds in technology stocks, buoyed by a host of recovery drivers of improved guidance and restructuring.

In addition, commodities and alternatives added diversification value in portfolios. In credit, Asian bonds remained resilient throughout the period of US/European banking turmoil. For instance, Asian investment grade bonds (Hong Kong, Singapore, Thailand and Indonesia) outperformed.

4. When liquidity ebbs, volatility and vulnerabilities rise

Consider this point on three levels: At the macro level, aggressive rate hikes in US and Europe have increased the cost of leverage after years of loose monetary policy. At the corporate level, US regional banking stress can be traced to an asset-liability mismatch, worsened by the withdrawal of deposits, and exposing the liquidity crunch that eventually broke the bank.

In our analysis of sectors and companies, we pay extra attention to leverage ratios, liquidity and sensitivity to interest rates to separate leaders from laggards.

At the portfolio level, investors should maintain sufficient cash and liquidity to handle periods of higher volatility and reduce excessive leverage. This is an important aspect of risk management at all levels in the current environment.

The flight-to-safety mode has benefitted gold, JPY and US Treasuries (UST). While we expect medium term USD weakness, the greenback has benefited from banking stresses while gold’s strong rally reflects its perceived resilience relative to the Japanese yen and Swiss franc.

5. Quality quotient

As markets stay volatile, value could emerge in quality companies with strong cash flows, balance sheets and resilient business models across consumer staples, healthcare, utilities, materials, industrials, telecoms, and technology. China is experiencing an upswing in its economic and market cycle.

In fixed income, we favour UST and developed markets (DM) investment grade (IG) bonds as potential recession hedges. While not completely insulated from global markets, we see positive risk-reward in Asia ex-Japan and China equities, as China’s upswing in its economic and market cycle benefits the region.

Chinese companies benefiting from policy tailwinds aimed at accelerating “Digital China”, boosting domestic consumption and renewable energy present structural investment themes for investors. Globally, rapid developments in generative artificial intelligence have boosted the multi-year prognosis for technology spending.

The writer is chief investment officer and head of portfolio management and research office, Bank of Singapore.