We have the highest bond volatility in history, the war in Ukraine looks to have no end, and monetary authorities have moved the interest dial into a position which was finally able to “break something”. This is partly their strategy, partly a fall-out from a singular focus on fighting inflation without addressing what else might be at risk.
The jarring market events in March also mean that Fed Chair Powell may pivot after all, even after re-pivoting hawkish from his initial pivot. Confused? You should be! As we look forward to the end of this year, we don’t know whether the Fed will deliver another 75-100 bps hikes to fight inflation or cut by 75 bps to protect the fragile bank system and the taxed economic system behind it. How did we get here – could it really be a couple of bank runs that have completely reset forward expectations? On policy, maybe, but not on inflation.
Since Long Term Capital Management (LTCM) went bust in 1998, the world’s central bankers have used low interest rates and ever larger liquidity injections to induce more and more risk-taking without ever forcing too-leveraged banks and risk takers to take a loss, with the Lehman bankruptcy the exception that really proved the rule on the enormous ensuing bailout during the GFC.
Fast forward to today and we see the March intervention in the wake of the Silicon Valley Bank (SVB) collapse and then the Credit Suisse takeover by UBS arranged and subsidised heavily by the Swiss National Bank. There is even sudden talk of insuring all deposits to prevent bank runs. Are any and all financial institutions now moved into the “systemic” category?
What was SVB’s misstep that saw their stock marked from a price of over 100 to zero in two days? They had no clue what they were doing with their bond portfolio, which they kept growing as deposits came in the door and the Fed, their regulator, kept telling them: “Don’t worry! inflation is transitory, it will be back below 2% soon!”
It seems that transitory didn’t win, so Silicon Valley Bank became the poster child for a very old kind of panic, one in which depositors, lost faith in the bank and made for the exit all at once. SVB had a very unusual depositor base, but many regional and smaller banks have made similar missteps in investing bank funds in longer duration bonds, risking depositor stampedes to safer shores everywhere.
Regulators helped create the situation with the Held-to-Maturity (HTM) concept in accounting that allows banks to keep their bond holdings at the purchase price despite the mark-to-market value of bonds trading at perhaps a 20-30% discount. After the panic rescue of all of SVB’s depositors regardless of size and a new Fed facility – the BTFP (no, really) that allows any bank to borrow liquidity against its HTM portfolio at par and not mark-to-market, Voila, problem solved! Or is it?
No, because what if a bank’s funding costs on the liability side – the cost of its deposits - rise even if its depositors don’t pull all of their funds but look for places to park their funds at higher rates? Banks have ignored their customers for the longest time, focusing on serving big financial engineering needs of mega caps, private equity, venture capital funds and hedge funds. Now depositors have had enough. Too little transparency, no service and no interest rates. Major US money center banks paid zero interest on the current account as late as last week, where the Fed was expected to take short-term interest rates to well above 5%!
This banking crisis so far is not about the solvency of banks, but whether the banks can continue to operate profitably if funding costs rise and funds actually “go elsewhere”. How about a US 6-month treasury yielding 4.50%, for example? Big banks can only run with enough liabilities, deposits, to fund their assets. For whatever reason, but especially in a panic, if clients withdraw money, it forces banks to liquidate assets. That’s what this crisis is about.
But enough about bank runs, though the risks mentioned above will inevitably impact what this Q2 Outlook was meant to be about before the bank blowups of March: the Fragmentation Game. This is our term for the global need to secure access to energy, other vital resources, supply chains and computer power (mostly in the shape of semiconductors) but also how new alliances are being formed and shaped to rebalance the world away from western dominance.
We could have called it deglobalisation, but the world is still global in its trade, it’s just fragmenting more into blocs. Navigating these fragments will be key in investing not only this year but for the coming decades.
Being both strategic and tactical has never been more important, as a fragmenting and partially deglobalising world brings new production capacities where none existed before to secure supply chains, which will bring huge investments, as will the ongoing green transformation. Other fragments, on the other hand, may have excess capacity. Regardless, a Fragmentation Game overlay to investment decisions will be critical, as the far-flung, highly tuned and fully globalised networks break into new fragments and alignments.