Commentary: The Psychology of Trust
They say trust takes years to build but only seconds to break. In a matter of days, trust in the global banking system came into question, culminating in some of the largest bank failures in history. Investors are now trusting central banks to cut interest rates to avert contagion, but is their trust well-founded?
Trust is the cornerstone of any relationship. This is not only true for personal relationships – it is the foundation on which banking was built. You trust your hard earned money with a bank, whose job it is to keep your money safe. Even though they lend this money out (for a profit), you trust that your money will be there for you when you need it. Trust is hard-earned – it takes years to build but only seconds to break. For the first time since the global financial crisis (GFC), we saw what happens when trust in banks is lost. The banks break.
Banks were viewed as one of the preferred sectors over the past couple of months. The belief was that banks would be safe going into a downturn, given the raft of regulation post the GFC. Valuations were still cheap, and net interest margins were expanding, despite an inverted yield curve. Banks could continue to lend long-term for a profit by not passing on the full extent of rate rises to their depositors. This, unfortunately, could not last and became their undoing, as depositors withdrew their money for the safety and higher yield of treasury bills or money market funds, or simply shifted deposits from less secure regional banks to more globally systemic (and more highly regulated) mega banks. Certain banks had difficulty managing these deposit outflows as they we forced to sell their most liquid assets (mostly US Treasuries) at a loss to their book value, which depleted their excess capital. Within days Silicon Valley Bank (SVB) and Signature Bank became the second and third largest bank failures in US history. A week later, Credit Suisse was forced by the Swiss regulator to be acquired by UBS to prevent another calamity. For perspective, Credit Suisse’s balance sheet is around twice the size of Lehman Brothers’ when it collapsed, at around 530 billion Swiss francs at the end of 2022. In less than a fortnight, the market went from debating the robust economy and interest rates needing to be higher for longer, to believing the start of the next global financial crisis was upon us, and that rate cuts were needed imminently.
Ghosts of 2008
It’s likely too early to determine whether or not this is a flash in the pan, or the start of something systemic. The S&P500 fell over 18% from the peak in 2007 to the collapse of Bear Sterns in March 2008, after which the market rallied 12% over the coming months as investors assumed the worst was over after they were acquired by J.P. Morgan. Six months later, Lehman Brothers and Washington Mutual collapsed and the market fell another 46% to the March 2009 low. We think that is why after the collapse of SVB this month, the market moved quickly to price in interest rate cuts. The 2-year US treasury yield collapsed, falling 130bps, which was the largest fall since the 1987 stock market crash, or to put it another way, the one-week move was a 7.3 standard deviation event. The markets were trusting the Fed would step in and cut rates to aid market stability, given the lingering memories of 2008.
However, one could argue that this is par for the course when trying to undo decades of excess on the back of ultra-loose monetary policy. The most aggressive rate hiking cycle in modern history was bound to cause stress, and those who benefited the most from excess liquidity are now the most vulnerable. This makes SVB and Signature Bank prime candidates, with the latter having almost 25% of its deposits from crypto clients and the former almost exclusively servicing tech venture capital (not to mention seemingly incompetent risk management to boot). The Fed stepped in with the Bank Term Funding Program (BTFP) to specifically provide liquidity to banks to meet redemptions in exchange for their US treasuries as collateral. This injection of liquidity helped stem the bleed and avoid (so far) broader contagion, however in our mind, it also provided cover for the Fed to continue focusing on inflation.
Volcker or Burns?
The market was surprised that the Fed hiked by 25bps this month during a perceived banking crisis. However, Powell has mentioned that rate hikes are used to fight inflation, and that the Fed has ‘other tools’ to help contain the damage if things start to break along the way. So far he is sticking to this playbook. There were nearly 300 US bank failures in the early 1980s, but this didn’t prevent Volcker from hiking aggressively, even in the face of rising unemployment. If Powell dithered at the first sign of trouble, he would have lost all of his inflation fighting credibility. Therefore it is perhaps premature to trust that the Fed will come to the rescue with rate cuts while inflation remains uncomfortably above target. If so, the economic cycle is likely to take longer to play out than markets expect and rates may have to rise again as these expected rate cuts come out of the curve.
Markets appear mispriced
Despite all of the above and after falling 4.5% intra-month, global equities ended up 2.8% by the end of March. We find it difficult to outline a bullish scenario for equities at these levels. Equities have been supported as falling bond yields support higher equity multiples. However, it seems unlikely central banks will cut rates aggressively without a recession, and equities have likely failed to price in the accompanying contraction in earnings if this were to eventuate. A typical ‘cyclical’ recession could see overall earnings decline by around 15-20% in the US, but a recession accompanied by a banking crisis, like the GFC, can see earnings fall much further. Current market expectations for earnings for 2023 in the US are flat. Equities therefore seem to be pricing in the best of both worlds – aggressive reduction in interest rates, but without any dent in earnings.
Alternatively, if the banking crisis is contained, rates will then return to being higher for longer, causing earnings to moderate and equity multiples to de-rate to align with the stubbornly high inflation regime. In the US, PE multiples are currently above 18x. Historically, when inflation is between 4-6%, the average PE ratio is below 15x, showing the potential for significant de-rating if we stay in a higher for longer regime.
Credit spreads blew out over the month but ended only modestly wider than they were at the start. Global high-yield valuations are neutral, which we believe is too complacent, given the risks. This implies default rates will be in line with a normal cycle, not a recession. Before the recent banking turmoil, loan officer surveys pointed to a significant tightening in lending standards, which is usually a precursor to higher credit spreads. The recent events will likely see banks step further away from lending, which will put strain on corporates to attain bank financing. With next to no new issuance in the high-yield market, lower quality corporates may struggle to raise capital, which could see spreads jump from their current sanguine pricing to a potential credit stress scenario.
Preparing for the downturn
The quick shift in sentiment this month highlights the danger of investing in markets where short-term movements are based on trust. Trust that inflation will fall back down to target, trust that central banks will prioritise growth and market stability over fighting inflation and trust that corporate earnings will remain resilient in the face of the most aggressive rate hike cycle since the 1970s. While trust may be the cornerstone of relationships, to us scepticism is the foundation of sound investing.
In portfolios, we added 0.25yrs of duration in US 5-year treasuries at the end of February and another 0.25yrs in US 2-year treasuries when we first caught wind of the imminent SVB collapse. This allowed us to capture the collapse in front end yields, protecting the portfolio. We took profit on the 2-year position as we believe yields may rise back up again if this current crisis subsides, with overall portfolio duration remaining at 2.25yrs. We reduced equities by a further 2.5% to target 15%, which is the lowest equity weight the fund has held, however, we bought 5% notional call options on the S&P 500 as cover for a continued short term bounce in equity markets. Given our view on credit spreads and the increased risk of recession, we hedged all our high-yield exposures and cut investment grade credit by 5%, taking our cash position to just over 35%.
We continue to believe that the Fed will likely keep rates higher for longer than the market is expecting, and that the resulting recession will be worse than markets are pricing. We therefore continue to de-risk the portfolio and build up dry powder. Currently we hold higher levels of investment grade credit and lower levels of duration to provide carry in the portfolio. If we shift our thinking to a more imminent recession we would rebalance these risks and increase duration and further reduce credit exposure.
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