Economic Update – April 2023

Key points:
– What impact has the banking crisis had on interest rates and markets?
– Who/what caused some of the failures in the US regional banks?
– Economy showing resilience – key employment data still strong in US and Australia
– Inflation still above objectives but growing evidence that the high point is in the past

The Big Picture

There is a lot going on in the world of finance and to make some sense of it, we will do our best to walk you through it in a calm and rational manner. Cutting to our conclusion, we do not think we are in a crisis – like in 2008 – or anything like it. Yes – some did/will get hurt but the problem is well-contained – at least until the next ‘crisis’ emerges.

Going back to our previous Economic Update of March 1st, no one was talking about banking crises. Indeed, the month started calmly with our growth data release and the RBA decision to increase the cash rate seemingly just as we all expected.

Indeed, the first nine days of March were largely ‘business as usual’. Then, unbeknown to us at the time, a moderately-sized bank in California, called Silicon Valley Bank (SVB) had a $42bn run on its deposits in only one day – a record of sorts. Still unbeknown to us at the time, the next morning, SVB contacted the regulator that it had about $100 bn more of requests to withdraw deposits and it couldn’t make them good. The bank was shut down and events escalated quickly.

Before we get into the details, it is important to refresh our understanding of how banks work. Around the 1960s, life was a lot simpler in terms of financial products and technology. Depending on the jurisdiction, a bank would accept deposits and establish customer accounts then allow customers to transact on them to facilitate their lives and businesses. The bank would only hold about 10% of those deposits in cash (when cash really was cash – i.e. notes and coins) and lend out, or invest, the other 90% often in the form of loans to businesses, home loans and personal loans.

Cash could usually be withdrawn at call (i.e. immediately, when the bank was open – no 24 hour internet banking!) but the loans usually had fixed, much longer investment terms. If depositors suddenly demanded their money back, the first 10% of assets could be offset against the cash holding. 10% then was thought to be a reasonable buffer to withstand the whims and needs of depositors. If more funds were to be withdrawn, there was a problem as the longer-term loans could not usually be reversed at will.

Banks exist for many important reasons. We couldn’t have an efficient society without them. They make their profits on the difference between the interest paid out on deposits and that received on longer term loans. Banks compete with one another on both deposit rates and loan rates to make the system work efficiently.

As we all know, depositors don’t get much interest on simple deposits but they pay quite a bit on home loans and the like. The bank pockets the difference and this is called the ‘net interest rate margin’ (NIM). What happens to fresh deposits that have not yet been lent out in the traditional way? They would usually be parked in safe assets such as long-term government bonds and the like until prudent loans could be made to clients.

Under normal conditions, long-term bonds have a higher yield than short-term bonds and deposits. All is then good for the banks. However, from time to time, particularly when a central bank is trying to slow down its economy, a central bank might force up short-term rates such that there is a so-called ‘inverted yield curve’. That is, short-term yields are higher than long term ones. When this happens, part of the traditional banking model doesn’t work. Such inversions are usually short-lived and there are complex financial products that allow banks to deal with the inverted situations.

Because a bank exists on this model that does not keep 100% of deposits on call, if a situation arises where depositors lose confidence in the bank and are concerned for the safety of their money, they collectively and actively withdraw their capital. This results in a ‘run on the bank’. In the ’old days’ this might have amounted to a queue at a cashier’s counter to take out bundles of notes and coins. Runs do not require logic or fact. Older readers might recall John Laws, the one-time famed Sydney radio announcer, started a run on a bank from some slack comments he made on his show and he got into trouble for it.

Dialling forward many decades and deposits can be removed electronically and moved directly to another financial institution – within seconds or less. No queues; no notes; and no coins!

Let’s return to the SVB case in particular. It has been reported in mainstream media that SVB was ultra successful in attracting new customers. Indeed, they specialised in ‘tech start-ups’ and the like, and some of the venture capitalists who funded these start-ups located around Silicon Valley, even insisted that they use SVB as their bank. As a result, the SVB client base was not diversified in any reasonable sense and the clients were largely very well educated and very well connected (including via social media and other rapid contact methods). Some have suggested SVB was more of a hedge fund than a bank in this regard.

That SVB was particularly successful in attracting deposits was arguably its downfall. It attracted deposits so rapidly that it couldn’t match those assets quickly enough with sound loans so they parked these large amounts of excess assets in seemingly safe long-term US Treasuries – often thought of as the safest assets on the planet.

Let’s now introduce the US Federal Reserve (The Fed). Whether rightly or wrongly, the Fed has been on a mission since March 2022 to raise the Fed Funds rate (short-term interest rate) to bring down price inflation which has undoubtedly been above its policy objective of 2% – 3%.
For many years before, the Fed rate was low and often close to zero. The rapid rise in its rate from just above zero to nearly 5% in less than a year caused the yield curve to ‘invert’. That is, the yield on short bonds became substantially higher than those of long-term bonds. That was a deliberate action to (hopefully) control inflation.

Let’s get back to SVB. It had a rapid run on its deposits for whatever reason. It was rapid because the depositors were sophisticated and well-connected. We saw analysis from reputable experts on CNBC saying that the deposits withdrawn did not go to cash or anything like it. The deposits largely went to the bigger well-known banks or the money market to earn higher returns on savings. This was not a run on ‘the banks’ as a whole, but simply reflected clients making a choice of which bank or institution to deal with.

We have noted evidence to suggest that SVB was not squeaky clean in a number of regards but it also got caught out on the presumption that US Treasuries are all but riskless. If a Treasury is held to maturity (like holding a 10-year bond for 10 years), the holder will reasonably expect to get all of their money back and all of the yield payments along the way. Corporate bonds might well have quite different probabilities of default. However, if a Treasury is not held to maturity, its (mark-to-market) price fluctuates on a daily basis responding intraday to changes in interest rate expectations.

SVB, when faced with a run on its deposits, would have needed to sell its long-term Treasuries at an unexpected loss (on a mark-to-market basis) because the price of a Treasury is inversely related to its yield and yields were being forced sharply upward. As the Fed forced up yields, they forced down the value of SVB’s (and others) Treasuries and the gap was enormous because of the aggression of the Fed policy. Selling a Treasury early can always result in a profit or a loss on capital.

To start a run, it wasn’t necessary for SVB to actually crystalise a loss through selling the long- dated bonds it owned at a loss. Any qualified financial analysts could view the SVB portfolio and realise the increased risk that SVB was facing.

Some have suggested that SVB should have been subjected to the same stress tests that bigger banks faced after the GFC – and that would have prevented the problem. Seemingly expert analysts on CNBC suggested that SVB would have passed such stress tests because the existing stress test was about how a bank could deal with falling rates. There was no stress test for rising rates. Whose fault is that?

So where does this leave us? Several smaller banks have been subjected to runs. That is no different in substance in Australia from people and businesses moving deposits from small banks to the big four or five. We may not like it, but that is business.

Contrast that to 2008 or so when there were complex financial products that no one seemingly fully understood and who owed how much to whom. In the panic most financial institutions then stopped lending to each other – called a credit freeze. Central banks freed up liquidity from the end of 2008 and commercial banks then got back on track. This time around, government agencies merely ‘insured’ the deposits over the traditional $250,000 limit. Problem solved!

This run on SVB and a few regional banks was not nice but it will not knock the global economy off track – or at least that is what we think.

Having hopefully dealt with the ‘banking crisis’ let us focus on analysing market behaviour and possible projections – including any ongoing implications from the ‘crisis’.

At the start of March, Australian GDP growth came in at a respectable, but not stellar, 0.5% for the quarter or 2.7% for the year. The RBA hiked its rate by 25 bps to 3.6% and foreshadowed more hikes to come. This action was largely anticipated.

China surprised a little with some strong economic data and policy objectives.

The US then reported its very strong labour market data which followed an even stronger prior month.

Even the UK dodged the recession bullet with positive growth in Q4, 2022 rather than the expected pull-back and the start of a recession.

Before the SVB collapse, Fed chair, Jerome Powell, was talking about maybe returning to a 50-bps hike at the March 22nd meeting following the smaller 25- bps hike in February. The market started pricing in an e o y 2023 Fed rate even higher than the Fed’s projection of 5.1%. Back in January, the market thought 4.4% was the level. Expectations were swirling; then the story about SVB broke!

Market expectations for the e-o-y Fed rate were rising to the point in time of the SVB collapse but then fell from a high of 5.84% to 3.44% in a week. Panic was permeating the markets. In normal times a small fraction of that change would have been considered big.

US regulators moved swiftly to insure (guarantee) all necessary bank deposits so that depositors were insulated from the collapses. Moves were initiated for bigger banks to absorb some of the stricken smaller peers. Credit Suisse also got into financial trouble but for different reasons. The European Central Bank (ECB) reportedly ‘leant on’ the other big international Swiss bank, UBS, to buy Credit Suisse out and absorb much of its losses. Another problem solved!

Of course, the inflation story had not gone away. New data in the US and Australia pointed to slightly better inflation data – so what would the Fed do on March 22nd? Many suggested the Fed would not hike because of the SVB problems. In the end, the Fed hiked interest rates by 0.25% (25 bps) rather than the 0.50% or 50 bps, touted before the SVB collapse. However, Powell stunned some, including us, in his press conference.

Powell pointed out that there would be a tightening of credit resulting from the problems in the regional banks. He went on to say [paraphrased] that such tightening would act in the same direction as a rate hike and might amount to the equivalent of a 25 bps or maybe 50 bps or more hike. We cannot say with any precision!

So, what Powell has admitted to is a much bigger than anticipated effective policy tightening. That sounds like a recession is on its way to us (if it wasn’t before). The Fed’s 25 bps hike, plus another 25 or 50 (or more) bps from credit tightening spells trouble when we’ve already witnessed problems from the Fed’s prior hiking policy.

We have been arguing for some time that the US couldn’t avoid a recession (either later this year or next) but we think that has already been priced in by the market. That does not mean that share markets can’t go higher from here – with a little bit of volatility thrown in. In due course, we think the Fed will review its policy and go easier on interest rates.

We are (and have been) somewhat sceptical about the tight US interest rate policy for two reasons. First, the supply side problems in inflation (from the Ukraine invasion and the pandemic etc) do not respond to rate hikes. Secondly, because we all agree that interest rates – if they work at all – act with a ‘long and variable lag’. In other words, it might be too soon to know whether the first hikes that occurred in March 2022 in the US and May in Australia, have yet had any impact let alone the subsequent hikes!

But there is a possible lesson from Japanese actions (or lack thereof). Japan just released its inflation print of 3.1% (as expected) which was down from 4.2% the month before (a recent record). You might ask how high did they force rates up to get that effect. The answer is that their official cash interest rate is still 0.1% and the Bank of Japan hasn’t hiked since 2016. Go figure!

The market expects (has priced in) that the Fed will have to cut rates this year as ominous signs of a slowdown in economic growth start to build. However, the Fed is still clinging on to a policy of no cuts to the Federal Funds (Cash) interest rate in 2023!

To summarise – markets have recovered well following the dip after SVB failed. There hasn’t been a material impact on broker forecasts of company earnings as published by Refinitiv. But that could be because brokers do not yet know how to react to recent changes in macro effects.

There is no longer ‘no alternative’ to equities as both bond and cash yields have recovered so a portfolio containing both shares and bonds may have greater merit than in recent years.

The RBA looks like it might be ‘on hold’ after these events. Either way, Australia could dodge the bullet owing to having a smarter central bank and China’s nascent resurgence.

Asset Classes

Australian Equities

The ASX 200 didn’t have a good month – it was down 1.1% – but it has recovered from the mid-March low. Financials ( 5.1%) got hammered – probably because of the irrelevant knock-on fears from US regional bank woes. Property ( 6.9%) and Energy ( 4.8%) also saw losses.
We have the market as being slightly cheap and earnings forecasts are continuing to hold though we think the risk is, on balance, to the downside.

International Equities

US equities were up on the month (S&P 500 rising 3.5%) after a big wobble in mid-March. Other international markets had a mixed month. It is too soon to see any new trend emerge but we are of the opinion that markets will work their way through a difficult March and beyond.

Bonds and Interest Rates

The US Fed did equities no favours in its about-face on interest rate hikes. There is a general consensus that the sharp rise in the Fed funds rate caused (at least in part) longer term Treasury yields to rise sharply. Those rises in yields directly caused big falls in the value of portfolios of supposedly safe bonds. Had investors been able to hold on to maturity, investors would have been rewarded but, in this mark-to-market world, assets of many financial institutions caused a mis-alignment between assets and liabilities.

The Fed and the RBA each hiked their base rate by 25 bps. The ECB, not to be outdone, went +50 bps. The Bank of Japan (BoJ) didn’t blink as it hasn’t for around seven years. Its rate is still 0.1% and its inflation rate fell from 4.2% to 3.1%.

The RBA is widely expected to be ‘on hold’ for a month but then go again.

The Bank of England (BoE) raised rates by 25 bps to 4.25% but their inflation rate rose to 10.4%.

Other Assets

The price of gold was well up on the month (8.2%) but that of oil was well down ( 5.5% for Brent). The prices of copper and iron ore each grew modestly.

The Australian dollar against the US dollar fell by 0.3%.

The VIX, an index that measures US equity market volatility, returned to a level below 20, a more normal level after a period of higher volatility recently. This gives an indication that investors seem to be getting more comfortable with the direction of the market.

Regional Review

Australia

Our unemployment rate dropped back to 3.5% from 3.7% and a bumper 64,600 new jobs were created in February. The number of full-time jobs increased by 74,000 while part-time jobs fell by 10,300. These are incredibly strong labour force figures and indicate a reasonably robust economy during the period.

While the RBA might have wished for weakness in this data as a sign that inflation might soon ease, it has only been 10 months since the tightening cycle started. If the RBA maintains a tight monetary stance, we fully expect the unemployment rate to shift higher quite quickly but at some unspecified future point in time. After a bout of higher unemployment, the rate usually returns to levels consistent with full employment rather slowly.

Our 2022, December quarter GDP growth came in at 0.5% for the quarter or 2.7% for the year. The more important figure from that statistical report was that the household savings ratio, it fell to 4.5% from 7.1%. This fall demonstrates that households are not adding to their savings – whether for retirement or consumer durables – as they do in general.

China

The Purchasing Managers Index (PMI) for manufacturing expectations came in at 52.6 at the start of March and 51.9 at the end, after having been as low as 47.0 at the beginning of the year. The re-opening of China’s economy after a three-year semi lock-down appears to be going well. The People’s Republic announced that it is targeting 5% or more growth in the coming period.

China seems to be committed to stimulus but with a focus oriented to a consumption led recovery as opposed to development as it has in the past. Evidence of its stimulatory approached was a cut to the Required Reserve Ratio (RRR) by 25 bps for banks, this enables them to lend a little easier.

Retail sales came in at 3.5% p.a. for January-February which was on expectations. Industrial output at 2.4% p.a. missed the expected 3.6% p.a. Fixed asset investment was 5.5% p.a.

US

The US recorded yet another bumper new jobs number of 311,000 – compared to a typical range of 200,000 to 250,000 in good times. The unemployment rate came in at 3.6% following the previous month’s 3.4%. Wage growth was moderate at 0.2% for the month.

CPI inflation came in at 0.4% for the month or 6.0% for the year. Core inflation – which strips out energy and food price inflation – came in at 0.5% for the month or 5.5% for the year.

Producer Price Index (PPI) inflation was actually negative at 0.1% for the month, 0.0% for the quarter and 4.6% for the year.

Personal Consumption Expenditure (PCE) inflation also showed nascent signs of recovery. The core version – which is the Fed-preferred measure of inflation – came in at 0.3% for the month against an expected 0.4% and 4.6% for the year. The headline rate was also 0.3% for the month but 5.0% for the year. While these data do not yet mark a victory for the Fed in its fight against inflation, it does seem to be getting close.

Since wages growth is now modest and PPI inflation shows input prices are not increasing, we expect consumer inflation (both CPI and PCE) to start falling to acceptable levels in the near future. Hence the Fed might soon pause and even consider cuts to its rate.

Both Powell and US Treasury Secretary Janet Yellen are reporting that banks have stabilised after the flurry of activity surrounding the SVB collapse. Fed data on its balance sheet reported at the end of March supported that view. There has been some outflow from banks of various sizes but they are largely offset by inflows to the money market. Some prefer to earn around 4% from the money market rather than close to zero in a bank deposit but the former is not insured as the latter is.

Europe

UK growth came in at 0.3% for Q4, 2022 when a negative result was widely expected. Its inflation rate jumped back up to 10.4% from 10.1% despite continued increases in the Bank of England interest rate from 4.0% to 4.25%.

The ECB vigorously addressed the inflation issue with a 50-bps hike to its interest rate even though banking problems had just come to light in the US and Switzerland.

Rest of the World

Japan’s rate of inflation fell from 4.2% to 3.1% while the Bank of Japan has kept its rate at 0.1% since 2016.