Daily institutional strategy review

Silicon Valley Bank, a midsize bank in the US with a heavy presence in Silicon Valley, has announced that it needs to sell a large portfolio of US Treasuries at a significant loss to cover deposit outflows. The pressure on the technology sector has resulted in reduced deposit balances among the bank's clients, while higher US bond yields have contributed to mark-to-market losses on its asset portfolios. The US Treasury, Federal Deposit Insurance Corporation, and the Federal Reserve have guaranteed all deposits at the bank and ensure access to all funds this week. In an attempt to prevent wider contagion, the Fed has announced a new Bank Term Funding Program (BTFP), offering banks loans of up to one year against Treasuries and other collateral. While the Silicon Valley Bank situation is unique, the fundamental challenge it faces is also a risk for other banks. Most banks invest customer deposits into mortgages, government securities, and loans held on the balance sheet, and if banks are forced to sell assets prior to maturity, there is a risk of losses. The Fed's Bank Term Funding Program will provide banks with the funding needed to meet deposit outflows without needing to sell securities immediately. European banks also own securities portfolios with unrealized losses as a result of the increase in bond yields, but exposure to mark-to-market losses appears to be lower. In Asia, initial speculative pressure has focused on Japanese lender exposure to US debt, with concerns overdone, in our view, with Japanese lenders backed by much higher retail cash deposits, loan-to-deposit ratios of near 60%, and no obvious catalyst to drive a liquidity event. The offshore holdings for PE/VC investment products are an area to watch, although systemic risks appear to be negligible.

What would happen to inflation if the Fed stops raising interest rates? It would be difficult for the Fed to raise rates after supporting the financial system with extraordinary measures, especially since higher rates contributed to the problems. Pausing rate hikes for a short period would not have a significant impact on inflation. The Fed could choose to pause at their next meeting to contain financial stability risks while using the dot plot to show their commitment to tackling inflation. In the long term, the economic impact of tighter bank funding conditions will play a crucial role. If the US economy goes into recession, the Fed may need to cut rates, but inflation will likely be less of a concern if consumer demand weakens. If growth remains strong, the Fed will need to continue raising rates to control inflation while monitoring and addressing financial stability issues.

Regarding investment implications, it is recommended to diversify beyond the US equity markets. The outlook for US equities for the rest of 2023 is uncertain due to high valuations, falling earnings estimates, an increasing likelihood of recession, and the risk of further unforeseen consequences of Fed tightening. Opportunities may be found in equity markets exposed to China's reopening, including emerging market equities, Chinese equities, and German equities. The MSCI Emerging Markets index is trading at a 43% discount to developed markets, indicating a potentially positive return over the medium term. US financials are least preferred due to many issues, including weak capital market activity and regulatory scrutiny. Instead, global energy, consumer staples, and industrials are favored. Investors are advised to manage liquidity as rate expectations evolve by holding no more than 3-5 years worth of expected net portfolio withdrawals in a Liquidity strategy, locking in interest rates in high-quality cash and fixed income instruments that align with the expected time horizon.

Investors should look for high-quality income opportunities in the fixed income market, with a preference for high and investment-grade bonds. There are also opportunities in emerging market bonds, but investors need to be selective and active in their approach. The Big 6 US banks are considered globally systemically important and are expected to maintain strong credit profiles, while European banks have solid fundamentals but may be impacted by central banks' tighter monetary policies. Private debt can be a good source of funding for companies as banks pull back, and private lenders have raised record funds and are in a strong position to deploy capital. The US dollar has weakened in response to lower Fed rate expectations, and investors can use periods of dollar strength to reduce allocations to the currency. Investors worried about the risk of a financial crisis can consider diversifying into safe havens like the Swiss franc and gold or the euro, and for those who believe in China's domestically driven consumption recovery, the Australian dollar is recommended.