Resilience in the face of adversity
The strong start to the year was tested in March with the failure of several regional banks in the US, followed closely by the bailout of Credit Suisse, the second largest Swiss bank. Unsurprisingly, these events led markets lower over the month as sentiment soured. However, it wasn’t long before they regained most of that lost ground during April, with shares once again showing resilience. Stress in the banking system appearing isolated and easing inflation calmed nerves sufficiently for the FTSE 100 to close just below its record high of just over 8000 and up 4.5% year to date.
After underperforming all assets last year, ‘growth’/tech stocks have rebounded strongly year to date driving most of the equity gains. ‘Growth’ stocks had reached valuations not seen for some time which enticed investors back in, lifting stocks and the tech-saturated US economy. Following the recent rise, it is hard to call ‘growth’ company valuations attractive when compared to history, bond yields or value stocks. The latter rebounded most in April, with many banks categorised as ‘value’ and recovering after an initial wobble.
Lower energy prices meant commodities were the worst performing sector over the quarter, but that continues to be good for European stocks which were most sensitive to the gas price shock. Gold has bucked the commodity trend as a ‘safe haven’ asset, rising in value on the back of a weaker dollar and expectation of lower rates in 2024. Elsewhere, real estate struggled thanks to higher borrowing costs, with commercial property feeling most of the pain. An overspill into residential prices in the US could be harmful, with it being over four times the size of the commercial sector. Major risks here should be contained with most homeowners in the US holding long-term fixed rate mortgages and therefore unaffected directly by higher lending costs.
Stronger economic data has helped resilience, but equally may contribute to stickier interest rates. Inflation is falling although the most recent US job creation report once again beat expectations in May (by over 30%) causing unemployment to unexpectedly fall further. At present, US bond markets are pricing (with almost certainty) that interest rates will be cut as early as the end of this year. We still think investors may be premature with this forecast and, in any case, expect central banks to act slowly on the way down, requiring concrete evidence lower prices can be sustained before dropping interest rates.
Don’t panic, any bank can fail
With enough loss of confidence this is true, but particularly so in a world of online bank-runs, rapidly rising interest rates and availability of higher returns with greater security outside of the banking system. That all being in the form of Government Bonds (UK gilts/US treasuries) and Money Market funds. The latter of these recently drawing inflows of £580bn in just ten weeks.
With the combination of uncertainty and availability of alternatives for savers, it is not hard to see how deposits can plummet overnight and continue to do so. Just last week, two more US banks – Pacific Western and Western Alliance – had their shares suspended. However, as we indicate, there is no need to panic as we do not see a re-run of 2008. Banks today are in much better health than during the credit crisis and, where cracks appear in the small and medium-sized banks, larger institutions are likely beneficiaries of a deposit boost, thus strengthening their positions. Banking consolidation, certainly in the US, is not new, given they have many more banks than in the more concentrated European system. In the 80s there were around 14,000 US banks and today, around 4,000.
Markets have calmed for now, but we anticipate a few more small/medium US names running into trouble, hopefully without too much fuss. We trust authorities will act if needed to avert an all-out loss of confidence as we journey along with a fragile financial system that still can’t cope with the monetary medicine required.
Ain’t no mountain high enough
It’s not just banks struggling to balance the books. The US government is again in need of an urgent agreement to raise the debt ceiling after spending more than they earn from tax receipts year on year. The next couple of weeks will be critical and may add some volatility to markets, in the form of upward pressure to treasury yields and weakness in the dollar. Ultimately, we expect a last minute agreement to be reached as the alternative, to default, would be a catastrophe for the US. That said, a more divided Congress raises the probability of a potentially ‘messy’ array of short-term measures if the ceiling isn’t raised in time, which won’t help short-term economic progress.
We think the big banks will be just fine, but regardless, there are good reasons for investors with large cash deposits to re-think where they store their wealth. Higher returns, greater security, even improved tax efficiency, are a win-win combination achievable from UK Gilts and money market funds and something you will likely hear more about from us this year. These benefits alone are reason for individuals and companies to re-locate cash savings, with the recent bank failures merely a reminder to review things today.
With the economy still expected to slow this year and equities having done so well year to date, we wonder if the latest rally has more legs left. On the whole, the service sector has been the saviour keeping the economy afloat, with goods and manufacturing having a harder time. Until an agreement is reached to extend the US debt ceiling, the next couple of weeks are likely to see a restricted range either way. US yields may creep up until then, with pressure remaining on the dollar and regional banking system.
It is true companies in the UK are not overvalued by historical standards and certainly not when compared to the US, potentially leaving room for price growth. Energy prices will also ease cost pressures for firms this year, but wage bills will bite and in the UK, what is left (in profits) will be 6% lighter than last year thanks to the rise in corporation tax from 19 to 25%. With productivity readings down and savings rates also falling, a slowdown in new jobs and rise in unemployment seem inevitable and is what central banks will require before lowering interest rates. Against this backdrop, assets that traditionally provide shelter from economic weakness look more attractive than they have for over a decade. Taking less risk with investments is an easier choice than it has been for many years.
Clients who pay close attention to our Bulletins will note our cautious undertone persists in pursuit of an honest appraisal of the indicators we watch. However, this is not to be mis-interpreted. Our outlook for low-risk investments (namely bonds) is more positive than it has been for a long-time, so the ‘risk averse’ are well positioned for the future. Investors prioritising the preservation of capital are now being rewarded for their patience and remain well positioned to take advantage of any economic shocks.
The details, views and opinions expressed above are KMD’s, can change at any time and are not intended to be advice or a solicitation to make an investment. Professional advice should be sought before acting on any information contained in this document. The value of investments can fall as well as rise and your capital is not guaranteed. Past performance is not a reliable indicator of future performance.