Reflections of the CIO… March 2023

March 2023 was a month during which the sheer speed and scale of market movements and regulatory intervention surpassed anything we had seen before, including the great financial crash of 2008. The reason was the emergence of separate crises in the global banking sector where, within two short weeks, the 16^th largest US bank (Silicon Valley Bank, or SVB) and a globally systemically important financial institution (Credit Suisse) had both collapsed.

These separate collapses came about for essentially the same reasons – the twin loss of confidence from both the banks’ depositors and shareholders, leading to collapsing share prices and deposit flight or, in other words, a good old fashioned ‘bank run’. The speed of the collapse had two concurrent and impressively large side effects.

The first impressive side effect was the speed of intervention from the relevant local authorities, where both the Swiss and US central banks, regulators and governments stepped in early and aggressively. Senior managers of the failed banks were fired, depositors were guaranteed and the banks themselves sold in rapid auctions. In addition, billions of dollars were injected into the wider banking sector in an effort to stave off a broader panic. As we write, these efforts appear to have worked very well and markets have moved on, almost as if nothing had happened. This was partly due to the fact that both SVB and CS had specific long standing issues, which were not reflected in the wider banking community, but it was also due undoubtedly to the scale of the liquidity injections. For example, the US Federal Reserve’s balance sheet grew by over $400bn in March as it stepped in with emergency loans.

The other remarkable side effect was the size of price movements in the global bond markets and certain other assets, such as gold. As the initial shock of the SVB failure spread, highly leveraged bond positions were liquidated by hedge funds in an effort to de-risk. The swings in prices over the two weeks of the panic in some US government bonds were 5 standard deviation events (or, in plain English, movements that would have been expected to have a 1 in 3,500,000 chance of happening).

By the end of March, calm had returned to markets and, perhaps bizarrely given the news flow, stocks, bonds and client portfolios have ended the quarter with broadly positive returns. We truly do live in interesting and sometimes baffling times, but this particular three-month period does require some explaining.

Our simplest explanation for what is going on goes back to Covid times, when the amount of money provided by governments and central banks to society at large ended up driving rapid inflation as economies opened up again. This inflationary pressure was turbo charged by supply bottlenecks and a war related spike in energy prices. Central banks scrambled to deal with the problem by aggressively raising interest rates in an effort to cool end demand and slow economies. This typical response was always going to take some time to impact, and, for roughly the last six months, markets have been living in a state of expectation, waiting for either something to break in the financial system, or economies to enter recession, or both.

Until March, neither expectation had been properly realised. Asset prices were meandering within trading ranges awaiting the emergence of enough real-world data or events to find a theme to coalesce around.

March then duly provided the first real shock of this tightening cycle with the banking failures of CS and SVB. Something had clearly broken in the system and yet, given the clean-up efforts after the last big banking crisis, we don’t think that the idiosyncratic problems of CS and SVB really are indicative of the sector as a whole. The lessons of early and large-scale intervention from the authorities have also been learnt and, to that extent, we can see how the rapid shift from panic to calm during the month has an odd logic to it. We don’t think a banking crisis is likely, here in the UK or elsewhere (which as not the same as saying that individual institutions won’t fail, as they undoubtedly will continue to do so).

What we do see now are several big differences of opinion in market pricing that will need to be resolved. Bond markets now price in interest rate cuts in the summer months, yet central banks are clear that this will not be the case, as the inflation battle is not yet won. Analysts currently forecast limited impact to corporate profits from here, despite economists projecting imminent recession. These differences will need to be ironed out over the next few quarters and, as we can see from the outsized price movements in the last few weeks, there clearly were an awful lot of oversized positions still being run by the trading community (as distinct from the investing community, where we operate).

The March clean-out of these positions hopefully will introduce an element of calm for the next few months, but that isn’t the same as saying we think things will be quiet. It would be highly unlikely we navigate through an interest rate cycle so quickly without some more impact in the real economy, which we haven’t yet experienced. Markets anticipate this to some extent but, then again, they also feel to us to be a little too optimistic at the margin. We remain under risk in portfolios, alert to opportunities but in no hurry to pretend we have enough evidence yet to call an end to volatility. We would expect that process to take another quarter or two and will keep you updated.