A fortnightly look at global financial markets

• Uncertainty abounds, investors should remain diversified
• Three scenarios for capital markets as the Fed ponders what to do
• UK budget – the welcome sound of grown-ups speaking

?

Market sentiment:?Uncertain. The risk of a major bank collapsing as a result of the failure of three U.S banks over the last 10 days (Silvergate, SVB and Signature), appears limited. Common Equity Tier 1 ratios are generally robust (meaning the banks have the capacity to absorb large losses), and the quality of assets held is much higher than it was in the run-up to the global financial crisis. And yet…Credit Suisse shares are falling again, despite its 14.1% CET 1 ratio*, and global investors are nervous that further surprises await them.?

?

The effect is likely to be reduced risk appetite in the weeks ahead. Good for bonds, commodities and safe haven currencies such as the Swiss franc and the Japanese yen, but not so good for higher-risk parts of the stock market, such as growth companies and emerging markets. Financials look a little risky in the near term, with good names liable to be sold off with the weaker ones if we do see contagion in the bank sector.

?

However, chasing near-term winners is dangerous. Financial history suggests investors should remain invested in a diverse portfolio of assets (ie, bonds, equity, real estate etc), to maximise returns relative to the volatility (risk) of the portfolio. And should short term tactical bets prove necessary, an active fund manager is better placed to make them than a non-professional.

?

Three scenarios as to how the Fed, and financial markets, might respond to the SVB failure.?There are perhaps three schools of thought regarding how the Fed might respond to the Silicon Valley Bank (SVB) failure. We will know more next week, when it next meets to set interest rates. But for now, it is interesting to think through the scenarios, and how they may impact on financial markets.?

?

1. Job done.?The Fed, having ridden into town with the Federal Deposit Insurance Corporation (FDIC), has put in place measures to prevent further bank runs. The FDIC has promised all individual bank deposits are insured, while the Fed will swap Treasuries at par value (though their market value may be below par), so banks can have ready cash.?

?

The Fed can say ‘our job is done’ regarding the banks, and vow to resume its war on inflation with a 25bp rate hike next week. There is no doubt that the war needs to be fought: yesterday’s climb in core CPI inflation, to 0.5% month-on-month, confirms a picture of stubborn inflation in services, driven by wage growth.?

?

If this scenario plays out, we can expect short-dated Treasury yields to rise, long-dated perhaps less so. The 2yr/10yr inverted yield spread to return to the 1% level of a week ago. Stock markets will go back to waiting for a new global economic cycle to kick in late 2023/ early 2024, perhaps starting to price this in from the summer.?Let’s give this 50% probability.

?

1. Preventive medicine – and no major upset.?The Fed decides that its rate hiking days are over, fearing macroeconomic instability if it persists with rate hikes. What other troubles may be exposed by higher interest rates? Something else lurking in the U.S regional, or European, bank sector? Or perhaps in the ‘shadow banks’ of money market funds, private equity, hedge funds??

?

In this scenario the Fed consciously trades macroeconomic stability for higher inflation. It will hope to be able to return to its war on inflation at a later point, before inflation becomes an embedded problem. The U.S, and indeed the global economy, returns to pre-global financial crisis rates of inflation and interest rates as the Fed and other central banks eventually their 2% inflation targets.?

?

But there is no major upset to the global economy, the Fed’s precaution proved unnecessary (or perhaps helped prevent an upset).

?

In this scenario, we can expect a steepening Treasury yield curve. Long-dated yields will rise on the threat of inflation being seen as an acceptable price to pay for macroeconomic stability. Short-dated yields may not move at all, held down by Fed assurance that the terminal interest rate of the current cycle has been reached. Stock markets will benefit from the prospect of a looser monetary policy than expected, and from the receding risk of an earnings recession. But tech and other long-duration, ‘jam tomorrow’, sectors may underperform as the long-term cost of borrowing increases.?Perhaps 30% probability?

?

1. Preventative medicine- but an upset occurs.?Scenario 2), but this time there is a major upset to the global economy. Banks restrict their lending, as they fear counter-party risk and their own ability to raise emergency cash. Recession follows.

?

In this scenario, which currently seems the least likely, government bonds rally as recession equals unemployment, and the likely end of core inflation. Treasuries, bunds and other ‘core’ government bond markets also benefit from their safe haven status. Stock markets fall, though the high yielding defensive sectors, such as utilities, pharma, consumer staples, perform relatively well.?A 20% probability.

?

?

U.K budget – the welcome sound of grown-ups speaking.?Chancellor of the Exchequer Jeremy Hunt is surely right in viewing bottlenecks in the labour market as barrier to growth. He has today announced measures aimed at bringing disabled people back into the workforce, and to encourage young mothers to return to their careers he has announced a reform of childcare subsidies.?

?

For the over 50s there are significant reforms to pension rules, to encourage workers with large pension pots to remain at work. The annual tax allowance for tax-deductible contributions will rise from ￡40,000 to ￡60,000, and the lifetime allowance of ￡1.07 is being replaced with…no limit at all! Hunt couched this reform as a benefit to the NHS, by referring to the need to keep highly experienced doctors at work. That was to disarm the opposition Labour Party. In fact, the reform will benefit all workers.?

?

Despite near record low unemployment of 3.7%, the economy is barely growing thanks in part to the disappearance of around 300,000 workers from the labour market since the pandemic began. There are 1.1 million job vacancies. The policy reforms announced today will help alleviate the bottlenecks. They are a surer way of improving economic growth than the expensive across-the-board tax cuts announced in last September’s ill-fated budget, by then Chancellor Kwasi Kwarteng.