Not since the great financial crisis (GFC) of 2007-2008 has so much focus globally been on the stability of banks and their ability to repay depositors and investors. Our chief investment officer, Iain Barnes, answers some of the questions investors may have about the current situation and what it could mean for investment portfolios.
Why is there concern about the banking sector now?
The genesis of the current fears in the banking sector stem primarily from two separate events, with underlying connections. First, in the US, San Francisco based Silicon Valley Bank (followed by various other regional lenders) faced a rush from depositors to withdraw funds over fears it may not be able to discharge money to those who wanted it. This only amplified the negative impact, and the glum narrative, with the outcome of SVB becoming the second-largest bank collapse in US history.
Then in Switzerland, the formerly venerated Credit Suisse (established 1856), which suffered a string of financial and political scandals in recent years, saw its share price unravel further when it announced “material weaknesses” in its financial reporting last week. This spooked investors more, to the point that even a $54 billion loan from the Swiss central bank failed to stem the decline. Days later, the bank was subsequently rescued by rival UBS with implicit government support.
Connecting the two institutions was a somewhat cavalier approach to risk management and a resulting lack of trust. Intervention has successfully bolstered confidence in the wider sector, although US Treasury Secretary Janet Yellen failed to convince markets on Wednesday that the risk of flighty deposits in the US has been totally resolved.
How does the current situation compare to the crisis in 2007-08?
Our view has been that this is not the start of a systemic problem within the financial sector akin to the Global Financial Crisis. Banks are better regulated and generally less leveraged than 15 years ago.
However, we are aware that rate hike cycles expose fragility, which is a key reason why our expectation has been for slower corporate earnings growth than consensus. The propensity for bank lending has almost certainly been hit now, adding a further brake on economic growth beyond the existing tightening of financial conditions thanks more directly to rising interest rates.
What can central banks do to allay fears?
Effective central bank communication will be more important than ever. Given that the impact of higher rates can be felt with variable time delays, central banks such as the US Federal Reserve and Bank of England, who both met this week, simply don’t know how much of a slowdown is already taking shape.
The path towards a so-called ‘soft-landing’, whereby high inflation rates fade without causing unnecessary economic pain, feels narrower now. Clear communication from policymakers will therefore be crucial, especially if inflation data keeps coming in higher than the market expects (as we saw in the UK this week).
To this end, the Fed announced yesterday it would raise rates by 0.25%. While it is no doubt watching the situation closely, it doesn’t appear to be overly concerned about runaway contagion in the financial sector, stating that the “US banking system is sound and resilient”.
Meanwhile, the Bank of England raised interest rates by 0.25% as well, elevating Bank Rate to 4.25%. It also expressed confidence in UK banks overall and “judged that the UK banking system maintained robust capital and strong liquidity positions, and was well placed to continue supporting the economy in a wide range of economic scenarios, including in a period of higher interest rates. The FPC's (the Bank’s Financial Policy Committee) assessment was that the UK banking system remained resilient."
What about the impact on global investment assets?
Despite the worrying headlines, and big hits to the share prices of many banks, market levels as a whole have not been hit too hard. Since this current banking crisis started many global indices have recovered much of their losses, with the US S&P 500 actually rising over the period.
A more marked impact has been felt in bond markets, with levels of volatility rising quickly. On balance, traders anticipate that these dislocations will influence central banks and mean their pace of interest rate changes will slow sooner than otherwise or even stop altogether.
What should investors do?
We always encourage investors not to over-react to shocks to the system, and to be aware that markets typically rise over time. A recent example of the benefit of holding firm was during the major slump caused by the pandemic in March 2020. Those who didn’t panic and stayed invested didn’t suffer the harsh short-term losses, with markets eventually recovering fully.
Whether you invest in banks or not, we always recommend a broadly diversified portfolio, by regions, sector and type of asset. What the banking crisis has highlighted again is the danger of holding single stocks, even if the prospect of a large company going to the wall remain fairly slim.
How has Netwealth responded?
Against this changing market backdrop, we have made some alterations to overall portfolio positioning.
Our portfolios’ duration (the sensitivity to interest rate moves) has been helpful this year, reasserting the relevance of bonds to multi-asset strategies after a difficult 2022. In particular, we felt that the yields on short term US bonds were attractively priced compared to other rates and this was particularly effective during points of stress in the past week.
However, we think the speed of response from authorities will enable central banks to focus on inflation-fighting duties again, so we have sold these bonds across all but the most conservative portfolio risk levels. We have also continued to reduce the exposure to investment grade (high quality) corporate bonds on portfolios, as we don’t think the incremental yield available here will compensate for the risk of weaker performance if concerns over economic growth linger.
In a similar vein, we are retaining the slightly lower than usual allocations across equities, preferring to hold larger allocations to higher yielding (but lower rated) bonds.
More widely, and not necessarily as a result of these events, we have also made some changes to the weights at the regional equity level, alongside some general rebalancing. The attractive valuations within the UK, European and emerging markets have led us to expect improved returns in the coming years relative to Japan and the US, so we have adjusted our positions accordingly. Our focus within the equity allocations is maintaining diversified coverage of global markets, with an emphasis on holdings that will respond to different economic drivers.
We are closely monitoring the outlook for commodities. Our allocation to gold has performed well in the past couple of years, but we are holding off adding to broader commodities for now. Long-term, the characteristics could be helpful for overall portfolio performance, but we believe that a difficult economic backdrop and poor price momentum mean that it is still too early to reinvest.
As always, the team remain focused on building portfolios that represent the best mix of tradeable investments in a considered, cost-efficient way, and for all our clients’ levels of risk appetite.
If you have any questions about how our investment approach can help you, please get in touch.
Please note, the value of your investments can go down as well as up.