The fallout from the Q1 banking issues continued in April. Despite this the markets did not do much – equities up slightly, bonds flat to slightly positive in the month. What is notable is the sharp fall in European gas prices. It would be good to see these price falls feed into reduced energy bills for businesses and consumers.
Banking Problems Continue
First Republic is the latest US bank to fail. The Federal Deposit Insurance Corporation (FDIC) seized the bank and sold its deposits and assets to JP Morgan Chase. This follows on the heels of Silicon Valley Bank and Signature Bank failing in March. So, is this the beginning of a more significant US banking crisis or merely the delayed processing of the impact of significant bank deposit outflows in Q1 this year?
The rapid rise in interest rates over that past year has dealt a serious blow to banks that were betting on low interest rates remaining and the ability to retain deposits while not passing on the rate rises to their deposit holders. While the FDIC may have arrested the outflows for the short term by effectively underwriting all deposits, the whole event has awakened customers to the following facts:
- They can achieve better returns for cash than their bank is providing; and
- While people are slow to take on the hassle of moving bank account, that is only true to a point. So, how many people will look to move to bigger banks over the rest of the year ….. just in case?
If banks respond by increasing the rate they pay on deposits (as they surely must), that hits their profitability. And what about the loans they have made? The increase in interest rates has been very rapid and presumably it takes time for those higher interest rates to impact on the ability of businesses and people to pay. Will we now see a second wave of trouble for banks via an increasing number of non-performing loans?
Overall, it would be difficult to make an investment argument for investing in the smaller regional US banks now as they face some tough times ahead.
At the end of this blog I have included an illustration by VisualCapitalist of the assets and liabilities of the 4,000+ US banks. Interesting if you want to understand the structure of US bank balance sheets.
Interest Rates Rise Again
The FED and ECB both increased interested rates by 0.25% last week. At this point the US has raised interest rates by over 5% in the past year. Before last July Euro rates were minus 0.5%. They are now at 3.25%, an increase of 3.75% in 10 months.
Are rate rises done? In the case of the US we are likely close to the peak. In the case of the Euro area, we have more to go. Why? Because, as you can see below, core inflation is still a problem.
EU Core Inflation About to Roll-Over?
Core Euro inflation (yellow line) has been rising since January 2022 until the most recent reading (April 2023). Might we have passed the peak of core inflation? Hopefully, but it is likely that the ECB will still feel that they have more work to do.
World Economic Outlook Shows Economies Facing High Uncertainty
During April the IMF and World Bank held a meeting which brought together the central bankers and finance ministers from 20 of the world’s largest countries. The outlook from the meeting was downbeat.
The chart below shows the IMF’s latest (April 2023) forecasts for economic growth. The chart clearly shows we are already experiencing a significant slowdown in growth.
Chart: Shows Real GDP Growth. Source IMF April 2023 forecast
Pierre-Olivier Gourinchas, IMF’s chief economist, said: “If we were to find ourselves in a situation of a systemic financial crisis, it’s very clear that the objectives of financial stability take precedence over price stability in the near term.” In other words, inflation is the top priority for central bankers until it isn’t.
At the time of writing 424 of the S&P 500 companies have reporting earnings for Q1. Year on year earnings are down 2.8%. However, generally speaking earnings were better than expected. 77% of the companies produced a positive earnings surprise (relative to expectations). So, no strong evidence yet of earnings problems. In fact, in recent days we are hearing a rising cry about “greedflation” i.e., companies using the inflation problem to boost profits?
Joe Biden visited Ireland during April and it was great to see the spotlight on our wee country. We have a lot to be proud of. Since then, Biden has officially confirmed his intention to contest the 2024 US presidential election. There are concerns about his age (80) but are those less than concerns over Trump getting back in?
Meanwhile we can expect politicians to play brinkmanship with the US Debt ceiling. The US debt ceiling is a statutory limit on the amount of money the federal government can borrow to fund its operations. When the government reaches the debt ceiling, Congress must vote to increase the limit in order to prevent default on US government debt. Any downgrade or default on US debt would be very bad for markets. It is estimated the US government has enough money to last until June or July….. so you are going to hear a lot about the US debt ceiling over the next couple of months.
The outcome of the US election in 2024 will be perhaps more important than normal. If Trump loses, do we see an increase in bipartisanship as the country unites around national security, a common opponent in China and a set of policies (already in place) that puts investment in semiconductor chips and green technology at the centre of US industrial policy?
Our Investment Outlook
Last year the FED said that it was determined to squash inflation even if it meant breaking something. Well, arguably they have now broken something … the banks (regional banks).
- The impact of the banking fracture is to ultimately put further downward pressure on economic growth.
- That downward pressure, if it translates into a reduction in company earnings, may ultimately lead to an uptick in unemployment (the jobs market has remained incredibly resilient up to now).
- Central bankers likely need to be more data dependent going forward and see core inflation begin to fall if they are to avoid raising rates further. The risks of a policy mistake (by raising rates too far) have also increased, particularly in the EU.
- Ukraine and other geopolitical risks remain significant with bad outcomes not currently priced into markets. The core assumption of markets, at the moment, is that the Ukraine war will not end, or escalate significantly, any time soon.
- Overall, markets are likely to remain volatile until there is more certainty around (a) financial stability (b) core inflation falling back to the target of 2% and (c) the depth and length of economic slowdowns / recessions.
For short-term investors, this is not a market to be in but for our clients who are long-term investors, we continue to advise them to follow their plan and use market weakness to build on positions.
John Tuohy is Chief Executive of Acuvest, an Irish-owned, independent advisory firm specialising in wealth management, pensions, and investment advisory services for individuals, companies, pension schemes, charities, and institutions. John is a Chartered Financial Analyst (CFA) and a Fellow of the Chartered Association of Certified Accountants.
A Picture of the Assets and Liabilities of US Banks