Shares have hit turbulence again with worries about inflation, interest rates, recession and now, problems in US banks. After rallying strongly at the start of the year the US share market has reversed much of its year-to-date gain leaving it down 20% from its January high last year and at risk of a retest of its October lows when it was down 25%. Non-US shares are holding up better with Eurozone shares down by 7% and Australian shares also down 9% from their record highs but are vulnerable to moves in US shares. This update looks at the key worries and what it means for investors.
Three regional US lenders have collapsed or closed in recent days. Silicon Valley Bank (SVB), which had a deposit base from tech (and some crypto) companies and customers, collapsed after running into trouble as deposits were withdrawn in the face of tough conditions in the tech and crypto sectors. Silvergate Capital and Signature Bank, crypto friendly banks, also closed after they were made vulnerable after the collapse of FTX crypto exchange. These closures have led to concerns they may reflect the start of broader problems in US banks. This is quite possible as Fed rate hiking cycles by tightening financial conditions invariably trigger financial stresses – think the tech wreck and Global Financial Crisis (GFC).
That banks exposed to tech and crypto either for deposits or lending are in trouble is not surprising as both sectors benefitted from the pandemic and easy money but have been hard hit by reopening and rate hikes. And it’s made worse where banks have concentrated investments in long term bonds which have fallen in value as SVB did – so if they have to sell them to meet withdrawals it’s at a loss. For example, there are reported to be $US620b of unrealised losses on securities at US banks – of course it’s only a problem if they have to sell them. But at this stage it’s too early to know if problems at these lenders reflect isolated problems in the tech and crypto sectors they’re exposed to, made worse by undiversified deposit bases and concentrated holdings of bonds that have fallen in value or are a sign of a broader problem in the US financial system.
Fortunately, there are some reasons to suggest that worst case scenarios involving a flow on more broadly in the US and beyond may be limited:
However, it will take a while to determine the full impact and for the dust to settle. Either way banks are likely to see a tougher environment ahead as growth slows and higher rates cause more financial stress for borrowers. It probably also means even tighter lending conditions for tech and crypto and for illiquid businesses like private equity and commercial property – and it’s a sign that Fed tightening has got traction!
Past financial crisis in the US have resulted in an end to Fed tightening cycles. At this point it’s not clear that we are seeing a full blown crisis unfold or not and high inflation is a bit of a barrier on what the Fed can do. As a result, so far, it’s just gone down the path of making it easier for banks to access cheap funding, so they don’t have to sell bonds at a loss. But how far the Fed and other central banks can support economies will at least partly be impacted by inflation.
Right now, it’s too high but it looks to have peaked. US and Canadian inflation peaked around mid last year, inflation in Europe later last year. Australian inflation likely peaked in December. Supply bottlenecks have improved, freight costs have fallen and slowing demand will reduce demand side inflation. As is often the case goods price inflation is leading with services price inflation more sticky reflecting still tight labour markets but these are showing signs of rolling over with job openings according to Indeed rolling over in the US, Europe, and Australia. Wages growth is a key driver of services inflation but in the US it looks to be slowing and in Australia there are no signs of a wage’s blowout. Easing inflation pressure is reflected in a declining trend in business surveys with respect to input and output prices and work backlogs and delivery times have fallen to normal levels. And if US bank sector problems depress economic activity, it will put more downwards pressure on inflation.
If we are right and inflation will fall going forward, albeit with bumps along the way, then central banks are at or near the top and will have more flexibility to respond to financial crisis like the issues now in the US. Indeed, the US banking problems with the risk of a flow on to other countries (where banks also have losses on their bond portfolios) may put pressure on other central banks to provide liquidity support.
This will likely be critical to how shares perform this year as the historical record shows that deep bear markets in US (and Australian) shares are invariably associated with US recessions. While the risk of recession has receded in Europe (with the collapse in gas prices) it remains high in the US with various leading indicators, including inverted yield curves (where short term interest rates are above long term yields) – warning of a high risk of US recession in the next 6-12 months. Problems in the financial system are adding to this risk which could easily push US shares down beyond the 25% top to bottom fall seen last year. However, if the Fed soon stops tightening, a US recession could still be averted or it could be mild which would limit further downside in US shares.
In Australia, the risk of recession is high but our base case is that it will be avoided thanks to strong business investment, Chinese reopening and providing the RBA soon stops hiking and US financial contagion is limited.
We see shares being stronger on a one-year view as inflation falls taking pressure of central banks hopefully enabling economies to avoid a deep recession. However, right now shares are at risk of more downside until some of the issues around the US financial system, inflation, recession and short term interest rates are resolved. There are several implications for investors:
1. Share market pullbacks are healthy and normal – their volatility is the price we pay for the higher returns they provide over the long term.
2. It’s very hard to time market moves so the key is to stick to an appropriate long term investment strategy.
3. Selling shares after a fall lock in a loss.
4. Share pullbacks provide opportunities for investors to invest cheaply.
5. Shares invariably bottom with maximum bearishness.
6. Australian shares still offer attractive income versus bank deposits.
7. To avoid getting thrown off a long term strategy it’s best to turn down the noise around all the negative news flow.
If you have any queries relating to the above articles or any other financial planning queries, please contact the office on 03 9375 4286.
Hughes O’Dea Corredig Private Wealth Pty. Ltd.
Trading as HOC Private Wealth
Level 2 / 333 Keilor Road ESSENDON VIC 3040Lisa.Papachristoforos@hoc.com.au
Categorised in: Articles