CIO MONTHLY Financial stability constrains the US Federal Reserve

• Private sector balance sheets show no imbalances in either the US or Europe.

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• The vulnerability of the financial system as it faces rapidly rising capital costs has been bluntly exposed in recent weeks.

• Tensions in the banking sector have tightened monetary conditions, but neither the US Federal Reserve nor the European Central Bank can measure the extent of this tightening.

• Central banks cannot ignore the financial stability dimension in their efforts to balance inflation and growth concerns.

• Private sector credit growth is starting to slow meaningfully as banks are forced to tighten lending standards.

• The global economy has been hit by four massive supply shocks this decade.

• Normalising monetary policy after a decade of artificially suppressed yields and volatility is no easy task.

• The disinflationary process in the US remains on track but volatility remains high in a context of structurally elevated supply fragility.

• As the tightening starts to bite more seriously, a more cautious positioning is warranted.

Only when the tide goes out do you discover who has been swimming naked

For more than a year, we have ruled out a US recession for a number of reasons, not least the health of the US private sector, with no imbalances or excesses to unwind. While companies and households have been busy repairing their balance sheets over the past decade, they have emerged even stronger from the Covid-19 pandemic thanks to generous government transfers.

In March 2022, the US Federal Reserve (Fed) embarked on a renewed rate-hiking cycle facing a US headline inflation reading of 7.9% in year-on-year terms. Fast-forward to today, we have witnessed a total of nine rate hikes ranging from 25 to 75 basis points, resulting in a cumulative tightening of 4.75% over the course of a year. At the same time, US headline inflation has decelerated to 5.0% as per the latest release for March 2023. Up until last month, the resilience of the US economy against the backdrop of one of the most violent resets of the cost of capital in post-World-War-II history was nothing short of remarkable. Though last October’s near collapse of UK pension funds, which ultimately led to an emergency intervention by the Bank of England, was a foretaste, it took a whole year since March 2022 for the first serious, potentially systemic, cracks to appear.

The recent crisis triggered by a run on Silicon Valley Bank deposits initially appeared to be idiosyncratic, i.e. limited to a small number of US regional banks with a rather specific business model and depositor base. However, as soon as the focus shifted to the extent to which former President Trump repealed the Dodd-Frank Act in 2018, market participants realised that the problem was more complex than a few banks failing to adhere to the basic principles of asset-liability management.

At the heart of the Trump administration’s changes is an increase in the threshold above which a bank is considered systemically important – from USD 50 billion to USD 250 billion – and therefore subject to enhanced regulatory oversight. Smaller US banks were thus able to fly under the radar and were not subjected to adequate liquidity stress tests. In retrospect, this significantly impaired the financial stability and is even more of a risk today, as enabled by digital banking features, bank runs can happen at record speed.

Fortunately, regulators on both sides of the Atlantic recognised the potentially systemic implications of the situation early on and intervened decisively. While the crisis appears to have been contained for now, we recognise that the probability of a recession in the US has increased significantly, as credit conditions are inevitably bound to tighten further. The latest survey report of the National Federation of Industrial Businesses shows that the availability of credit for small businesses is deteriorating sharply in the US as shown in chart 1. We are entering a phase where the normalisation of the cost of capital in the system is starting to bite more seriously. Business models that were built during the ‘cheap money’ era on the premise of having access to perpetual funding at very low or even zero interest rates are now being ruthlessly exposed.

Nevertheless, the US regional banking sector has come under intense scrutiny in the wake of recent events. On the liability side of their balance sheets, smaller US banks have recently suffered disproportionate deposit outflows, reducing access to cheap funding, as depositors have found higher short-term yields elsewhere (e.g. in money market funds and Treasury bills) or have simply decided to move their funds to larger, more regulated banks. This clearly represents a structural impediment to the profitability of the US regional banking sector, as they will either have to offer more competitive, i.e. higher, deposit yields or raise more expensive funding elsewhere. In addition, they will almost certainly face increased regulation now that their maturity mismatch vulnerabilities have been exposed.

Why does it matter? The US regional banking sector plays an important role from a private sector lending perspective. Indeed, most of the recent credit growth has been driven by smaller US banks, as is evident from growth clearly shooting above the pre-pandemic trend shown in chart 2.

Indexed (31.12.2014 = 100)

Net share indicating easier lending availability (in %)

NFIB small business optimism index – availability of loans

Note: Diffusion index – lower values indicate worsening credit conditions. Seasonally adjusted data.

Source: National Federation of Industrial Businesses (NFIB), Bloomberg Finance L.P., Julius Baer. Data as at 31.03.2023.

Private sector credit growth is slowing drastically

As the banking turmoil unfolded, the Fed moved quickly to deploy the full power of its balance sheet to counter a systemic risk and prevent a liquidity crisis. In particular, the newly established Bank Term Funding Programme (BTFP) allows affected banks to borrow cash for up to one year against high-quality collateral that has suffered significant mark-to-market losses. Notably, collateral is generously valued at par when using this facility. Owing to the full range of liquidity facilities available at the Fed, its balance sheet expanded significantly from mid-March, from USD 8.34 trillion to USD 8.73 trillion, before finally shrinking again to USD 8.63 trillion at the latest reading, suggesting that liquidity stress has been sufficiently brought under control.

Small bank loans to private sector Pre-pandemic trend

Note: Small banks are defined as all domestically chartered banks outside of the top 25 ranked by size. The pre-pandemic trend is based on the five-year period starting 31.12.2014. Data is seasonally adjusted. Source: US Federal Reserve, Bloomberg Finance L.P., Julius Baer. Data as at 29.03.2023.

At the onset of the banking crisis, smaller US banks accounted for 24% of consumer loans, 34% of commercial and industrial loans, 38% of residential real estate loans, and a whopping 70% of commercial real estate loans as shown in chart 3. Against the backdrop of the latest turmoil, lending standards will inevitably tighten further. Indeed, when looking at the latest available data, US private sector credit growth started to decelerate across categories. In the last two weeks of March, US commercial bank lending fell by the largest amount on record, by just over USD 100 billion, mainly due to a decline in lending by small banks.

Note: Large banks are defined as the top 25 domestically chartered commercial banks ranked by size. Small banks are defined as all domestically chartered banks outside of the top 25. Data seasonally adjusted.

Source: US Federal Reserve, Bloomberg Finance L.P., Julius Baer; RE real estate: C&I = commercial & industrial. Data as at 15.03.2023.

While higher funding costs will put pressure on the net interest margins of affected institutions, concerns have recently arisen about the transmission of a credit slowdown to the broader economy and the possibility of a credit crunch. While commercial bank lending will remain under pressure given the current financing difficulties, only about 20% of lending in the US is done through the commercial banking system. President of the Federal Reserve Bank of St Louis James Bullard pointed to this fact, which led him to conclude that a credit crunch tipping the US economy into a recession is far from a foregone conclusion.

It is important to note that since the Great Financial Crisis, the ‘heavy lifting’, in particular in corporate lending, has in fact been done by non-banks in the shadow-banking system, a much less regulated part of the financial system. By definition, the shadowbanking system is very opaque, with limited public disclosure. However, given the predominant reliance of most shadow-banking vehicles on short-term funding while simultaneously buying longer-term assets, it is fair to assume that certain segments are meaningfully exposed to interest-rate risks, paving the way for idiosyncratic hiccups further down the road if such risks were not properly hedged. Even if these do not materialise, a slowdown in lending across all channels means that economic activity will face significant headwinds in the second quarter of 2023.

Cautious positioning is warranted as the tightening cycle nears completion

Looking at the bigger picture, investors should be reminded that the global economy has been hit by four massive supply shocks in this decade:

1) pandemic-related supply chain disruptions that distorted both global demand and supply patterns

2) a sustained shock to the labour market, i.e. a permanent reduction in the labour force due to population ageing and the mass retirement of the baby-boom generation

3) Russia’s invasion of Ukraine, emblematic of renewed geopolitical tensions against the backdrop of a multipolar world, reinforcing ambitions to relocate strategic industries to ensure security of supply

4) globally orchestrated efforts to decarbonise the economy, which will prove inflationary in the short term but disinflationary in the long term

While supply chain disruptions have proven to be temporary and are now fully resolved, the latter three shocks are permanent in nature. Faced with a structurally lower level of supply coupled with increased volatility around it, the major Western central banks will have no choice but to accept structurally higher inflation, averaging 3% instead of the traditional 2%. Moreover, whereas Western central banks used to have to balance inflation and economic activity, they now face a trilemma, with financial stability increasingly acting as a constraint on policy action the longer we stay in the tightening cycle. Neither the Fed nor the European Central Bank can afford a credit crunch in today’s highly indebted context.

More broadly, we are increasingly convinced that many of the trends that led us to declare the new era of state-sponsored capitalism in early 2020 are still well in play. Crucially, we maintain the view that the tail is wagging the dog, i.e. that given the exponential value of financial assets relative to global gross domestic product, changes in asset prices still have a disproportionate impact on the real economy. Severe disruptions to the financial system would fundamentally alter policy reaction functions. For the time being, central bankers would be well advised to take a step back in order to minimise the risk of suddenly having to fight last decade’s battle against deflation all over again in the event of further bank failures.

With this in mind, we are in the process of adjusting our portfolios to reflect a more cautious stance as we enter the second quarter of this year. In fixed income, we move up the quality ladder by selling off our high-yield exposure, which was mainly an artefact of the prolonged period of financial repression until the end of 2021 and the desperate search for yield that characterised it, and by reducing our exposure to our diversified basket of unconstrained bond strategies. With the cost of capital resetting in the system, attractive yields are now available without taking on as much credit risk. To this end, the proceeds are reallocated to investment-grade corporate bonds and US Treasuries.

In equities, we remove our strategic allocation to listed US and European real estate investment trusts, as they are structurally biased towards less attractive segments of the underlying property markets. We replace these holdings with allocations to domestic equities in the respective currency profiles. Furthermore, we sold out of a hedge fund position, reducing our overall exposure to alternative investments. We continue to use a barbell approach, mixing secular growth stories with quality defensive names, and this has helped our relative performance lately, as the market has also realised that anything with weak balance sheets and therefore stretched debt service burdens will come under increasing pressure the longer policy rates remain at current levels.

CIO Monthly | Financial stability constrains the US Federal Reserve

Current asset allocation (EUR mandate, dynamic weightings)

Founding Signatory of:

All sources: Julius Baer, as at 12.04.2023

REITs = real estate investment trusts

* 8% other developed market currencies, 2% emerging market currencies (EUR Balanced)

Note: From a UK perspective, this asset allocation refers to the Investment Approach, not the Relative Approach.