Quarterly Investment Review – Q1 2023
Like watching a mad donkey thrashing around in a field, bouncing off all the fences.
Bank of America on markets in 2023.
The first quarter was eventful. After the extremely difficult experience for both bonds and equities in 2022, markets started 2023 steadily. As a sign of interest rates normalising on 4th January for the first time since 2010 the Bloomberg index of negative yielding securities disappeared. They had peaked at $18.38 trillion in December 2020. During January and February the market fluctuated between concerns that the abrupt tightening of liquidity last year would lead to a recession, and the announcement of strong corporate results. However, in March a banking crisis erupted that has seen the demise of two American banks, Silicon Valley and Signature, and one Swiss bank, Credit Suisse. Banking crises are inherently disruptive, but this one puts the Federal Reserve and other Central Banks in a particularly difficult position. With inflation not yet under control, they need to keep interest rates high but this has put pressure on the weak points of the financial system, which need interest rate cuts. Further tightening could lead to more failures. The situation seems to require two opposing interest rate responses, a higher one for inflation and a lower one for stressed banks.
The bank collapses revived memories of 2008, but it is clear that this situation is different. The 2008 crisis affected the whole system, whereas today it is focused on individual banks with specific issues. This crisis is less a test of the banking system and more a test of how the authorities handle the bail out. Silicon Bank, which focused on loans to technology companies, had invested its deposits in long dated US government bonds. As interest rates rose last year their value fell, and the resulting losses unnerved customers and triggered a bank run. The extraordinary feature of the collapse was its speed, $42 billion of deposits were withdrawn on a Friday and over the weekend the Fed moved swiftly to guarantee all its deposits. It was unlikely that they would have allowed a bank to collapse for owning US Treasury bonds, but in a digital age nerves were frayed by the realisation that bank deposits are on a hair trigger. In a confidence crisis like this markets tend to look for the weakest link and test it, and Credit Suisse was such a target, as it has suffered a series of well publicised losses in recent years. It was forced to merge with UBS, in a somewhat controversial action by the Swiss regulator and government. This is not the same as the Lehmans collapse, individually these situations are not systemic, but together with events such as the LDI crisis in the UK last September and the Adani implosion in India, they drain confidence and raise concerns about what the next collapse will be. It suggests that parts of the plumbing are not quite right in the financial system. This is being exposed after fifteen years of ultra-low interest rates and the consequent misallocation of capital. To the extent that excesses are being squeezed out it is healthy, but it is uncomfortable to see the stresses revealed, and fears have risen that the economy may be heading into recession. Another marked difference to 2008, is that today inflation is much higher, at a time when global debt has vastly increased. This debt is predicted to rise further because of increasing defence budgets, and costs associated with relocating supply chains from Asia, and the green transition. On top of that there is now a war, which threatens supply shocks from Russia and China.
The course of inflation will be the critical determinant of markets for the next year. Inflation has changed from being generated by bottle necks caused by the pandemic to being driven by wage growth. If the economy is headed for recession then it is a highly unusual one given the strength of the labour market. But inflation has also been stimulated by a relative lack of capital expenditure.
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