Credit Suisse problems add to market volatility and uncertainty

What happened?

Credit Suisse shares fell 30% intraday on March 15 to a record low dragging the whole European financials sector lower.¹ It has been involved in a series of scandals over recent decades, the latest of which were risky exposures to Archegos Capital Management and Greensill Capital.²

However, what triggered the latest incident was a comment by the Saudi National Bank, their biggest shareholder, that they will not raise their investment in Credit Suisse citing regulatory limits.³ (They want to avoid the regulatory burdens that come when a shareholding reaches 10%.) This followed the delayed release of the bank’s annual report on March 14, which showed an increase in customer outflows to 110 billion Swiss francs (CHF). PricewaterhouseCoopers, their auditor, has also included an “adverse opinion” on the effectiveness of the bank's internal controls over its reporting. In the current environment of heightened sensitivity to loss of deposits after the collapse of Silicon Valley Bank (SVB), it drove a significant negative response from investors.

Market reaction

Credit Suisse is a systemically important financial institution globally with CHF 531 billion of total assets — approximately twice the size of SVB in terms of total assets — and CHF 1,294 billion of assets under management as of the end of 2022.⁴

We think the size of Credit Suisse’s assets indicates larger counterparty exposures — an uncomfortably close equivalent to Lehman Brothers, which had about $600 billion USD of total assets in 2008. The incident raises echoes of the 2008-2009 Global Financial Crisis and has triggered a flight to safety within equity markets and across all asset classes.

Falling equity markets were accompanied by lower sovereign yields and higher gold prices, while volatility indicators spiked. Rate futures indicated lower probability of rate increases for the next meetings of the U.S. Federal Reserve (Fed) and the Bank of England. Expectations for the most likely outcome of tomorrow’s European Central Bank meeting moved to a 25 basis points hike from 50 points previously.⁵

Our outlook

We still think the financials sector will find it hard to outperform in the face of increasing macro headwinds, regardless of a resolution of the Credit Suisse incident. Deposit rates will have to increase to stem outflows and that should put pressure on margins.

Although the events of the past week seem isolated and specific to certain business models, we think the more widespread issue of a higher interest rate environment revealing further weaknesses remains. There have been only eight bank failures in the last five years (out of 563 total since 2000), partly due to interest rates staying historically low since the Global Financial Crisis.⁶

In our view, however, there’s a high probability of regulators and central banks acting in concert to backstop the financial system, which should prevent a repeat of the Global Financial Crisis. For example, the Swiss National Bank indicated late on March 15 that, if necessary, it will provide liquidity to Credit Suisse. Nevertheless, we expect investor sentiment to remain fragile in the short term, and events like this can nip a nascent market recovery in the bud. More broadly, we expect the financials sector and risk assets to stay weak until there’s a strong commitment from governments and central banks to prevent these issues from spiralling further.

Our investment strategy

We anticipate volatility in the near term, helped by uncertainty around Fed policy, and fears of whether banking issues are more systemic. Our macro framework shifted to contraction at the end of February as market sentiment deteriorated. In the near term, we favour a more defensive posture in portfolios — fixed income over stocks, higher quality credit over risk credit, as well as defensive sectors and factors. We would anticipate, however, an improving global risk appetite once the Fed hits the pause button. 

What we’re watching

The risk is that the banking sector issues are more widespread than just Silvergate, Silicon Valley Bank, Signature Bank, and Credit Suisse. We’ll be following the banking sector closely to see how it’s faring in the face of significant headwinds, especially credit default swaps, for potential contagion to other large financial institutions.

Another risk is if inflation moderation isn’t satisfactory for the Fed to hit the “pause button” soon, and that rate hikes continue for some time. A prolonged or renewed tightening cycle could increase pressure on the banking sector, increasing recession risks, and delaying the time before a sustainable economic recovery could start. 

With contributions from Paul Jackson