Insight

The recent selloff in bank stocks

The recent selloff in bank stocks
Key Takeaways
1

The latest occurrences at two Californian banks look like isolated incidents so far, but we believe that investor concern is legitimate about pressure on deposits and unrealised losses in bond portfolios.

2

We see no indication that a financial crisis is brewing, as banks in general are well-capitalised, but higher rates can increase the risk of incidents.

3

Banks are facing macro headwinds from higher deposit rates lowering margins, inverted yield curves and an increasing risk of recession, which make us wary of the sector.

What happened?

Two different banks, a Californian financial services company and a Californian commercial banking company, have come under extreme pressure last week, with a Californian financial services company announcing it was shutting down and a Californian commercial banking company first announcing a large equity capital raise (which would be very dilutive of its outstanding stock) and then attempting to sell itself when it was unable to raise the capital.

How have markets reacted? What is our take on what is happening?

These two separate events in the US banking sector have combined to drive a 4.1% sell-off in the S&P 500 financials sector on 9th March 2023.1

In our view, it is telling that these two banks were involved in the areas that were hit first by rapidly rising interest rates that may expose unsustainable business models.

Hopefully they are not canaries in the coalmine, but we cannot rule out further incidents in the sector when interest rates remain high.

Nevertheless, these events show the risk of unintended consequences when central banks make such abrupt changes in policy. It may also make them more cautious about further tightening, especially if their mandates require them to maintain financial stability alongside reaching their inflation targets.

  • The Californian commercial banking company is the banking partner to half of US venture-backed technology and life sciences companies2 and has seen deposits fall due to higher-than-expected client cash burn. This forced it sell a large portion of its securities portfolio as a significant loss.
  • The Californian financial services company, a lender with exposure to the crypto market, filed for voluntary liquidation after being unable to find a resolution with the Federal Deposit Insurance Corporation (FDIC). 

What connects the two banks is the risk of a liquidity crisis turning into a solvency crisis, which has echoes of the Global Financial Crisis.

Nevertheless, we believe these incidents remain well-contained for now, considering that they are relatively small (combined total assets of $223 billion as of year-end 2022)3 and specialist lenders with concentrated exposures to a limited number of sectors.

However, investors seem to be concerned about the impact of large potential mark-to-market losses on banks’ capitalisation that the FDIC estimates at $620 billion, which can be manageable against $2.2 trillion worth of total equity for the sector at the end of 2022.4

We also believe there is a risk that banks in other regions may face similar issues, especially on their fixed income portfolios, although the ongoing decline in bond yields will help if it becomes a trend.

So far, given much tighter supervision, regulation and capitalisation of the money centre banks, financial breakdowns have been isolated and seem likely not to become systemic, though that risk has risen.

What is our outlook on the situation?

In our view, the sector will find it increasingly hard to outperform in the face of increasing macro headwinds.

Rising interest rates have been a tailwind for banks so far, as they were able to increase lending rates to customers, but that may be reaching limits of affordability.

At the same time, deposit rates have remained relatively low, resulting in an increase to their margins, though we believe that will change especially if deposits fall.

Consumers have been using up their pandemic-era excess savings to soften the impact of high inflation, and that has driven upside surprises in economic data.

However, that potentially means lower deposits, which may put pressure on banks to raise deposit rates as competition for customers increases, which can compress margins.

Also, the further the Federal Reserve pushes interest rates into restrictive territory, the higher the risk of recession, in our view, which can dampen lending growth. February’s US jobs report did not necessarily provide enough clarity on the next stage of policymaking.

While the headline jobs growth number was strong, prior months were revised lower, and wage growth was modest. 

On a positive note, interest rates fell across the US Treasury yield curve as the market is revising its expectation from a terminal Fed Funds rate of 5.5% to 5.25%.

Nonetheless, banks may face the perfect storm of decreasing volumes and margins at the same time, which keeps us wary of the sector.

What is our resulting investment strategy?

We anticipate volatility in the near term, helped by uncertainty around Fed policy and fears of whether banking issues are more systemic.

In the near term, investors are likely to benefit from defensive positioning.

However, we would anticipate an improving global risk appetite once the Fed hits the pause button, as markets positively re-price recession risks and ultimately look forward to and discount an economic recovery that could begin to unfold late this year.

What are we watching out for?  What are the risks to our view?

The risk is that the issues in the banking sector are more widespread than just a Californian financial services company and a Californian commercial banking company. We will be following the banking sector closely to see how it is faring in the face of significant headwinds.

Another risk is that the path of inflation moderation going forward may not be satisfactory enough for the Fed to hit the ‘pause button’ soon (especially if the Consumer Price Index print next week is higher than expected), and that rate hikes continue for some time. 

A prolonged tightening cycle would increase pressure on the banking sector and would increase recession risks and prolong the time before an economic recovery could start. 

Reference:

  • 1

    Source: Refinitiv as of 9th March 2023.

  • 2

    Source: Kinder, Tabby et al., 9 March 2023, Silicon Valley Bank shares tumble after launching stock sale, Financial Times, https://www.ft.com/content/69b70b4b-efeb-42c4-8882-c133f92d8356

  • 3

    Source: Refinitiv as of 10th March 2023.

  • 4

    Source: Federal Deposit Insurance Corporation

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