“Recent indicators point to modest growth in spending and production. Job gains have picked up in recent months and are running at a robust pace; the unemployment rate has remained low. Inflation remains elevated.

The U.S. banking system is sound and resilient. Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation. The extent of these effects is uncertain. The Committee remains highly attentive to inflation risks.”

 – Excerpts from the Federal Reserve FOMC Statement 22^nd March 2023

LAST QUARTER REVIEW

In March, the Federal Reserve (Fed) raised the federal funds rate by 0.25% to the 4.75% – 5.00% range despite concerns about the US and global banking system, following the collapse and rescue of Silicon Valley Bank (SVB) and Signature Bank in New York the previous week. The American central bank pledged to continue doing whatever necessary to return to its target 2% inflation, including the likelihood of further rate hikes and continuing sale of Treasury, agency and Mortgage-Backed Securities (MBSS).

Inflation in the US slowed to 6.0% in February, making this the eighth consecutive monthly decline since the peak rate of 9.1% in June 2022, and the lowest since September 2021. Additionally, the predicted inflation rate for 2023 is now expected to be between 3.5% – 4.0% for 2023, between 2.0% – 2.5% in 2024 and just 2.1% in 2025.

US Treasury (UST) bond yields at the long end were volatile during the quarter with the interest rate on the benchmark 10-year Note ranging from 3.37% to 4.08% as investors’ risk appetite swayed back and fore in line with inflationary or recessionary fears. Following the collapse of the two American banks and the rescue of Credit Suisse by UBS in Switzerland, investors risk appetite declined markedly with a rush into US Treasuries which resulted in yields at the longer end declining to 3.57% at quarter end.

In contrast, the value of the US dollar was relatively stable throughout the quarter ending at 102.5 on the DXY index (a basket of other currencies) having been at around the same level commencing 2023. On Wall Street, the benchmark S&P 500 gained 7.03%, the Dow Jones rose 0.38% and the Nasdaq 100 21.71% (but remains down 11% over twelve months).

In the UK, the Bank of England (BOE) raised interest rates (for the ninth consecutive time) by 0.25% to 4.25%, having already raised the rate by 0.50% earlier in the quarter. Inflation to the surprise of the BOE and most analysts rose to 10.4% in February, the highest rate since 1981, but is expected to decline sharply during 2023.

Arguably the UK economy is already in recession as the third quarter of 2022 showed a contraction of 0.1% while the fourth quarter saw an increase of 01.%, which suggests a negative likely GDP print during calendar 2023 following a 4% expansion in 2022. During the quarter, the yield on the UK’s 10-year Gilt fell to 3.49% from 3.7%, while sterling remained little changed at $1.23, and equity markets grew modestly.

The European Central Bank (ECB) increased interest rates by another 0.5% in March to 3.5% after having previously raised rates to 3% earlier in the quarter. The ECB is forecasting inflation (currently is at 8.5%) at 5.3% in 2023, 2.9% in 2024 and 2.1% in 2025.

The biggest news in Europe was that UBS will buy rival Swiss bank Credit Suisse for 3 billion Swiss francs ($3.23 billion) in stock and agreed to assume up to 5 billion francs ($5.4 billion) in losses. The merger was engineered by the Swiss authorities to avoid more market-shaking turmoil in global banking, but unfortunately some of Credit Suisse’s bondholders are set to be wiped out with an estimated 16 billion Swiss francs ($17 billion) becoming worthless.

Interest rates were unchanged in China as the People’s Bank of China (PBOC) kept steady its key rates for the seventh consecutive month at the March fixing with the one-year loan prime rate (LPR) at 3.65%; while the five-year rate, a reference for mortgages, was maintained at 4.3%. In an effort to release long term funds for banks, and support economic recovery, the central bank cut the reserve requirement ratio for financial institutions by 0.25%.

At its March meeting, the Bank of Japan (BOJ) kept its key short-term interest rate unchanged at -0.1% and that for 10-year bond yields around 0%, while annual inflation fell to 3.3% in February from January’s 41-year high of 4.3%. During Governor Haruhiko Kuroda’s final session before retirement, the BoJ reiterated it would take extra easing measures if needed while expecting short-and long-term policy interest rates to stay at their present or lower levels.

Global oil prices fell during the quarter with West Texas Intermediate (WTI) and Brent Crude futures at $76 and $79 per barrel respectively as fears of recession accelerated following the banking developments. It was a similar story with European energy markets as Dutch front-month futures, Europe’s gas benchmark, traded around €44 per megawatt hour, the lowest since August 2021, while  gas storages are 56% full, well above the average for this time of the year following a milder than expected winter on the continent.

GDP Data shown are to the 31st December 2022; Interest Rate, Equity & Bond Index Data are to the 31^st March 2023; Equity Indices used: US – S&P 500, UK – FTSE 100, Eurozone – Euro Stoxx 50, China – Shanghai Shenzhen CSI 300, Japan – Nikkei 225, Germany – Xetra Dax; Sovereign Bond Indices used: S&P US T-Bond, S&P UK Gilt Bond, S&P Eurozone Sovereign Bond (Eur), S&P China Bond, S&P Japan Government Bond, S&P Germany Sovereign Bond.

CURRENT CONSIDERATIONS

Prior to the collapse of Silicon Valley Bank (SVB) in the US on Friday March 10th, both the US and the overall global economy looked remarkably robust. This was despite the past twelve months seeing a concerted campaign by the Fed and other central banks to bring runaway inflation under control through a series of punitive interest rate increases over the last year.

The shock collapse of SVB with assets worth more than $171 billion followed by the American authorities moving to secure the assets of Signature Bank in New York potentially changed all that. A week later we witnessed the move by the Swiss authorities to rescue Credit Suisse, while a conglomerate of the ten largest banks in America cobbled together $30 billion to reassure depositors and investors in First Republic, another California Bank.

Investors are now nervous that the monetary actions of the Fed and other central banks may have broken the financial system, but thankfully the swift actions of the authorities calmed the markets for now. In Washington DC a joint statement released by the Department of the Treasury, Fed and Federal Deposit Insurance Corporation (FDIC) announced that all depositors in both SVB and Signature Bank were going to be fully protected including all those with amounts in excess of $250,000, the normal limit of protection.

Furthermore, the statement declared this would be achieved without any losses being borne by the US taxpayer. However, shareholders and certain unsecured debtholders would not be protected, while any losses to the Deposit Insurance Fund to support uninsured depositors would be recovered by a special assessment on banks.

The joint statement issued on the 12^th March concluded, “The U.S. banking system remains resilient and on a solid foundation, in large part due to reforms that were made after the financial crisis that ensured better safeguards for the banking industry. Those reforms combined with today’s actions demonstrate our commitment to take the necessary steps to ensure that depositors’ savings remain safe.”

The American Federal authorities helped further calm markets by announcing the introduction of a second initiative of setting up a “bank term funding programme” (BTFP) to restore confidence. The BTFP will permit banks to pledge Treasuries, mortgage-backed securities (MBSS) and other qualifying assets as collateral in return for loans that are equal in value to the face value of the pledged securities.

The borrowing rate on the cash pledged as collateral by these banks using the BTFP will be fixed at the “one-year overnight index swap”, plus 0.1%.” An article analysing this initiative in The Economist suggested the terms offered by the BTFP are overly generous and that a rate that closely tracks that of the Fed funds is not much of a penalty for accessing the facility.

The Economist article inferred that the generous BTFP initiative is effectively an expansion of the state backstopping the banking industry by the back door. The Economist reminded its readers that the Fed already has a lending facility, called the discount window, where banks can borrow against collateral at fair value, while this new facility not only protects against liquidity issues, but it also insulates them from interest-rate risk.

In Switzerland, the drama unfolded over the weekend preceding Monday the 20^th March as the deal to have UBS effectively take over Credit Suisse appeared necessary to be secured before markets opened and investors had started panic selling the shares of the latter. It is reassuring that so far the authorities both in America and Europe are taking the necessary pre-emptive and / or speedy responses for each individual banking crisis as it emerges.

Nevertheless investors are likely to remain nervous especially with the Fed facing the conundrum of whether (in gambling parlance) to stick or twist with interest rates. If they continue raising rates, they risk the potential collapse of the entire global banking system, while if they cease raising them or begin cutting too soon, they risk allowing inflation to regain a hold, which long term is no less dangerous economically.

We now know that SVB was more like a hedge fund than a conventional bank following the disclosure that as it expanded quickly in the last few years, it was unable to create enough loans to match its deposits. It used the substantial excess deposits to purchase US Treasuries, a large percentage of which were at the longer end of the interest rate curve at a time when rates were historically low and looked set to remain that way indefinitely, and accordingly the duration risk of these investments was unhedged.

When inflation became a problem and the Fed began raising interest rates last year, SVB’s unhedged interest rate risk increased, as the “mark to market” (MTM) value of the assets on its balance sheet began plummeting. The question that markets will be nervously asking is how many more banks in America and Europe are in a similar position to SVB with assets held on a MTM basis making them potentially insolvent?

Following the collapse of the two American banks in early March, the yield on the benchmark 10-year note fell from almost 4% to less than 3.5% and remains thereabouts as risk averse investors continue to de-risk their portfolios. Additionally analysis by institutional fixed income managers Hoisington Investment Management (HIM) suggests that the rise in the velocity of money that occurred in 2022, due primarily to the actions of the private sector are not dissimilar to what occurred between 2003 and 20008 and again between 2016 to 2020.

HIM’s analysis suggests that just as in the two previous periods, it is most likely the short-term increase in velocity following the unprecedented fiscal and monetary stimulus injected into the American economy post-Covid are now being unwound with the help of the Fed’s interest rate hikes. All this suggests that as the inevitable recession arrives, inflation will finally recede and the decades old post 2000 deflationary cycle will be re-established leading to lower Treasury bond yields.

FORWARD OUTLOOK

Last quarter, we advised that equity market bottoms on Wall Street have usually occurred after the Fed has ceased raising interest rates and switched to reducing them instead! Accordingly, the pivotal time to go long on Wall Street is usually when the Fed has cut rates sufficiently enough to steepen the yield curve, allowing the bear market on Wall Street to finally end.

You may recall, we quoted the research of David Rosenberg of Rosenberg Research who had done exhaustive analysis of when the right and wrong times were to invest in Wall Street stocks during when the Fed was raising interest rates and the US Treasury market had signalled a forthcoming recession. David has been a regular on financial channels again in recent weeks warning investors not to be fooled by rosy short-term economic indicators as a recession is inevitable due to the Fed’s monetary action. 

David cited the analogy of how investors were wrong-footed by an IMF research paper in June 2008 suggesting that due to emerging market nations’ business cycles diverging from those of developed nations, the U.S. economy could fall into a recession without sparking a global crisis, which of course proved erroneous. He reminded investors that many analysts are making the same mistake today, and warned against investing in Wall Street stocks until the Fed begins cutting interest rates and the Treasury yield curve un-inverts!

However, in light of developments in the global banking sector, we could potentially see this pivotal moment sooner than we had otherwise expected, should the Fed be forced to reverse monetary policy in order to save the financial system. In the meantime, as previously advised, the outlook for commodities remains positive, with investments through funds investing in the FTSE 100 providing an excellent means of accessing this asset class and we shall continue to recommend diversifying portfolios by this means.

Although the price of oil and other fossil fuel energy commodities declined last quarter due to a combination of reasons including the anticipation of a global recession and a milder than usual winter both in Europe and North America, the arguments for longer term price appreciation remain compelling. These include the increasing realisation by investors that Exploration & Production (E&P) spending in oil and gas in 2022 was the highest in history, because as unpalatable as the fact may be, green and renewable energy is likely decades away from replacing fossil fuels both in terms of cost efficiency and practicality.

When it comes to energy demands, the United States, Europe, India, China, South Korea, and Japan accounts for 80% of the world oil demand. The harsh reality is that even if they double, triple, or quadruple their use of renewable energy it will have almost zero impact on oil demand, for the foreseeable future according to recent data provided by Dr Anas Alhajji of Energy Outlook Advisors.

Accordingly, maintaining a well-diversified and balanced portfolio remains key while we navigate the forthcoming recession. We will continue to look to decrease allocation to growth funds where appropriate (with the exception of energy and resource companies in the commodity sector) and reallocate to more defensive oriented funds aligned to value and income.

Additionally, to ensure optimal diversification as well as potential growth opportunities, exposure to funds invested in US Treasury and UK Gilts will be maintained and selectively increased at the expense of some of the monies currently in cash. Our recommendations to increase exposure to US and UK government bonds will increase proportionately as evidence grows that the Fed and BOE are defeating inflation.

We shall keep a close eye on developments and, in particular, any changes in investor sentiment with respect to both inflation and the global banking sector in order to determine when may be an opportune moment to look again to growth. As always, investment risk is at the forefront of our advice and, whilst it is often necessary to undertake adjustments in portfolio allocation in order to meet individual preferences, we are confident that our advised portfolios will remain well placed in meeting our clients’ needs.

Copyright © Ash-Ridge Asset Management 3rd April 2023.

Data Sources: Bloomberg; Brookings Institute; Economic Cycle Research Institute: Financial Sense; Financial Times; German Federal Statistical Office; Hoisington Investment Management; Macro Voices; National Bureau of Statistics China; Office for National Statistics; Real Vision; S&P Indices; The Cabinet Office Japan; The Economist; The Federal Reserve; The National Bureau of Economic Research; Trading Economics; UK Debt Management Office; US Debt Clock.org; Wall Street Journal; Zero Hedge.