Roz Amos, Chief Investment Strategist
There has been a lot of recent news coverage about issues within the banking system. We explain below what has been happening and why, although the situation warrants caution, we do not believe this is the start of a financial crisis.
Last year, it became clear that central banks needed to significantly tighten monetary policy in order to contain rampant inflationary pressures. Central banks have pulled two monetary levers – they have raised interest rates from historic lows and have cut liquidity in the financial market by beginning to unwind some of the money they have printed and injected into the system since the global financial crisis 15 years ago. Interest rates raise the cost of financing, but liquidity focuses on the availability of that financing in the first place, and this latter issue has been a key factor in some of the headlines from the world of finance over the last few weeks.
We downgraded our near-term views on economically sensitive asset classes in the second half of last year, and for the first time in many years we became more positive on bonds and cash investments. A key reason for this is that history tells us that when such monetary tightening takes place in the global economy, particularly with the speed and size of the changes witnessed over the last 12 months, it normally leads to shocks in the financial system as market participants requiring funding can suddenly run into difficulty.
A small example of this was the ‘Liability Driven Investment crisis’ that impacted the UK pension system in October last year, though thankfully that remained relatively well contained in the UK, thanks to some swift mitigating actions by the Bank of England and a change of fiscal approach by the UK Government. However, we have been expecting more shocks to emerge, and another example has materialised in the US regional banking system over the last couple of weeks, where three smaller banks were forced into rescue deals or collapse after running short of funds, as a result of the significant changes in price and availability of credit in the system that these banks had not apparently planned for.
Another more significant example has made headlines in Europe over the last week, culminating with Credit Suisse being acquired by UBS in a deal brokered by the Swiss National Bank. These instances have led to the market testing and questioning the strength of the broader banking system, and fears about where the next collapse could lie, with memories of the financial crisis in 2008 still fresh in many minds. Central banks are responding swiftly, making credit available to try and avoid further loss of confidence in the system. Nonetheless, share prices in banks have taken a hit in recent days, though at this point we think no other large, globally significant institution is struggling to the extent that Credit Suisse was. This has weighed on broader equity markets, whilst sovereign and high quality corporate bonds have outperformed as investors seek safe havens.
We do not believe this is the start of a new financial crisis. Banks are better capitalised than they have been in the past and large regulators and central banks are very mindful of the risks of the disorderly collapse of large institutions. Witness the actions of global central banks and regulators to support their banks, and the strong statements and efforts to protect depositors from loss. But these shocks will serve to further tighten the availability of credit in the near term, and may well lead to more negative headlines as other companies run into difficulty. This will likely weigh on the economic growth outlook and increases the chances of a deeper recession, which rather perversely implies that central banks may back off from further material interest rate rises.
We are not complacent- crises of confidence can turn into real crises very quickly in the banking system, as Credit Suisse’ fate demonstrates, and even strong central bank support was not enough for it to remain as a standalone entity. Rising interest rates and volatile bond markets remain a risk. At this point it seems that the risks are being contained but we will continue to monitor the situation and act where necessary.