We hope you are keeping well and haven’t let the wetter conditions dampen spirits. Forecasts suggest more benign conditions are ahead; might the same be true for markets? We certainly see a similar stoic resilience of late, with investments holding up remarkably well in the face of a prospective banking crisis. Indeed, the swift collapse of Silicon Valley Bank followed by the shotgun wedding of UBS and Credit Suisse drew immediate parallels with the onset of the Great Financial Crisis, leaving many investors to fear the worst. The duration of the panic was thankfully curtailed however, at least initially, by US central bank policy designed to ease banking liquidity.

The specifics of the policy would allow banks to deposit qualifying assets, such as government bonds, at the US Federal Reserve in exchange for their maturity (or ‘par’) value. This was a particularly useful facility given many banks had bought significant volumes of government bonds with their deposits, only to see them fall in value as interest rates rose. The new policy, therefore, meant deposit withdrawals could be honoured without banks taking losses on their securities portfolio – an outcome which cut to the very heart of Silicon Valley Banks’ demise.

The sense of panic briefly returned, however, in the all-stock purchase of Credit Suisse by UBS. Averting a financial meltdown will have made no small contribution to the market’s resilience in March, however, the anticipated change in bank behaviour will have also played its part. Specifically, the likely move higher in deposit rates to help retain depositors, the increased compensation other bank creditors will demand given heightened solvency concerns, and the additional bank levies to pay for increased bank oversight, will all add up to a meaningful increase in bank costs.

Facing increased costs, banks may well tighten lending standards to both protect margins and reduce risks of default. Such choices, however, would likely lead to reduced lending and less economic activity. Though slower rates of economic growth aren’t typically viewed favourably, in this instance it may serve to bring down inflation faster than it otherwise would.

Sniffing out the combination of slower growth and lower levels of inflation, markets were quick to price in a lower peak in interest rates and lower levels of long-term bond yields. All else equal, lower levels of interest rates are good news for share prices as they increase the present value of future cash flows, and has, therefore, likely helped support equity markets of late.

The avoidance of a banking collapse and a more accommodative interest rate footing may continue to support markets as we head into the summer, however, risks abound. Whilst the threat of a systemic banking crisis looks to have faded for now, the health of bank balance sheets should not be taken for granted, and the prospect for ongoing deposit flight is stark.

Arguably of greater probability, however, would be the rapidly fading threat of banking failure, and the cover this would offer central banks to return to a more aggressive inflation fighting stance. A ‘higher for longer’ interest rate environment raises the prospect of more troubling economic outcomes later in the year, or early in 2024, and (in due course) might deliver another round of heavy market selling.

Kind regards,

iPensions Wealth Team

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