Cracks have begun to emerge in the banking sector in recent weeks. As the tide of cheap money that has flooded financial markets for more than a decade ebbs, members of our investment teams are on the lookout for other signs of distress.
Read this article to understand:
- Why a systemic banking crisis appears unlikely
- Why worse rated segments of bond markets could be vulnerable
- Potential knock-on effects of problems in commercial real estate
“You don’t find out who’s been swimming naked until the tide goes out,” legendary US investor Warren Buffett famously quipped at Berkshire Hathaway’s 1994 annual meeting. The remark came as he explained to shareholders of the US firm how reinsurers tended to do “dumb” things that don’t become evident for years.
Over the past 18 months or so, major central banks have hiked interest rates at the fastest pace in four decades and begun to shrink outsized balance sheets as they try to tackle soaring inflation. As the tide of global liquidity that has flooded the financial system for a decade or more rapidly recedes, the fragility of some business models is being exposed.
Recent weeks have seen the demise of three medium-sized US banks, First Republic Bank, Silicon Valley Bank (SVB) and Signature Bank, and a collapse in confidence in European giant Credit Suisse, which prompted a hastily arranged Swiss government-facilitated takeover by domestic rival UBS.
The failure of SVB, the US’s 16th biggest bank and largest lender to fail since the global financial crisis, prompted fears among some that the world could be heading towards a repeat of the devastating events of 2008/09. However, the nature of these failures was very different to those that led to the financial crisis, and banks today are far better capitalised than they were 15 years ago. The response from regulators and monetary authorities to help with resolving these banks seems to have calmed the situation, but one lesson from recent events is that in a world of digital banking, deposits can run much more easily than in the past.
Banks: No quick fix, but systemic crisis unlikely
Bank securities have staged a partial recovery, although they remain well below levels reached ahead of the recent issues. Figure 1 shows debt issued by European banks is on average yielding 175 basis points more than comparable government debt, down from a peak of 224 basis points reached in late March but still 39 basis points more than prior to the episode.
Figure 1: European bank bond spreads (basis points)
Source: Aviva Investors, Bloomberg. Data as of April 14, 2023
With most major banks’ balance sheets in a far healthier position than in 2008, a repeat of the financial crisis seems unlikely. Nonetheless, Oliver Judd, co-head of global credit research at Aviva Investors, says while European lenders and the big six US banks should be secure, worries over a potential crisis of confidence may continue to plague regional US banks.
“Congress’s 2018 banking deregulation bill, signed by Donald Trump, was designed to boost competitiveness. But loosening regulations on mid-sized and smaller banks always looked risky. The chickens may be coming home to roost,” he says.
Figure 2: European bank shares outperform US peers
Source: Aviva Investors, Eikon Datastream. Data as of April 14, 2023
While banking shares have likewise staged a partial recovery, they too remain well below levels reached ahead of the events in March. As Figure 2 illustrates, US bank shares have suffered relative to their European counterparts. Despite rebounding six per cent, the S&P 500 banks index is off 20 per cent since the start of February. By contrast, European bank shares have lost less than six per cent, although they are 12 per cent beneath their mid-February high.
It would be foolish to dismiss the risk of a worsening crisis engulfing the banking sector
Betty Sanchez Torres, global equity analyst responsible for covering financial companies at Aviva Investors, believes it would be foolish to dismiss the risk of a worsening crisis engulfing the banking sector. Nonetheless, she says there are grounds for believing US regulators will be able to prevent any problems facing other mid-sized lenders from infecting more systemically important banks.
As for the problems facing Credit Suisse, she adds they were largely self-inflicted and not indicative of a deeper malaise within European banking. Nonetheless, with inflation proving hard to eradicate and central banks likely to keep rates higher than financial markets expect, banks will remain vulnerable to the threat of recession.
Most European lenders should however be able to maintain payments to shareholders unless recessions prove deeper than seems likely, with sizeable provisions – taken at the start of the pandemic – unused and still sitting on their balance sheets.
“European banks should be able to avoid having to raise equity, especially when you consider the extent to which capital positions have been strengthened since the financial crisis. But share prices are likely to be volatile,” she says.
New regime brings new challenges
Chris Higham, senior corporate bond portfolio manager at Aviva Investors, who sees interest rates staying higher for longer than financial markets expect, says his team has spent a considerable amount of time trying to analyse the likely effects of “regime change” as the era of cheap money expires.
The threat posed by rising interest rates extends well beyond the banking sector to a range of businesses that had borrowed excessively or relied too heavily on cheap and easy liquidity over the past decade or more. For instance, across the globe, the number of so-called zombie companies – defined by bond investors as issuers generating lower profits than the interest payable on their debt for at least three years – has been rising. Many of these firms, which were already struggling to generate sufficient cashflows to cover interest costs when rates were lower, will struggle to survive.
Smaller US companies tend to be much more reliant on regional lenders for credit
“Smaller US companies tend to be much more reliant on regional lenders for credit. We are looking for lower-rated companies with worse balance sheets to underperform and expect high-yield debt to underperform investment grade,” Higham says.
Echoing Higham’s remarks, Sunita Kara, global co-head of high yield at Aviva Investors, says lower-rated high-yield issuers in the B and CCC rating categories, with high leverage and lean operating cashflow, are likely to be challenged “sooner or later”.
“Companies with a lot of floating-rate loans in their capital structures are already being challenged. Those funded mainly via fixed-rate bonds that locked in low coupons pre-2020 are facing a doubling of cash interest costs,” she adds. “These challenges apply across sectors, and we expect the global high-yield default rate to moderately increase by about 150 basis points to 4.5 per cent in 12 months’ time. Some companies have an inappropriate amount of debt versus cash generation in a higher-rate world.”
Testing times for commercial real estate
Arguably no area is more vulnerable than commercial real estate, most notably offices, where the change in working patterns brought about by the pandemic has lasted longer than might have been expected. That has left landlords struggling to fill buildings, especially in less desirable locations, which is complicating their ability to meet rising debt interest costs.
Higham says although the portfolios he helps manage have some exposure to prime offices in central London, these investments have limited default risk and the portfolios are underweight the sector as a whole.
“With valuations already expensive, big structural changes in demand led to a rapid repricing of publicly traded bonds. But we are concerned about second-order effects when private markets start to reprice, as they inevitably will,” he says.
The real estate sector has a lot of debt to refinance against a backdrop of lower values, higher rates and more constraints from lenders
According to Gregor Bamert, head of real estate debt at Aviva Investors, the owners of commercial mortgage-backed securities and euro-denominated corporate bonds issued by property companies “have some testing times ahead”.
“The real estate sector has a lot of debt to refinance against a backdrop of lower values, higher rates and more constraints from lenders,” he says.
However, he argues the picture in the UK is “not entirely gloomy”, especially relative to the US, as there is a much bigger variety of lenders, more loans are structured with covenants to provide lenders with early warning signals, and commercial real estate loans form a much smaller proportion of banks’ balance sheets than in the US.
“It is also necessary to recognise the vast majority of UK real estate investment trusts have conservative debt levels and limited refinancing challenges,” Bamert adds.
Both Higham and Richard Saldanha, global equity fund manager at Aviva Investors, are considering potential knock-on effects of any potential problems in the real estate sector. Higham, for instance, is concerned about the trouble a downturn in commercial real estate could spell for banks and other financial companies.
It’s important to understand the exact nature of the commercial exposure before passing judgement
“Bonds by insurers were among the worst-performing in the dollar investment-grade market in March. Investors are aware many companies are heavily exposed to real estate assets and loans,” he says.
However, Saldanha says while everyone has been focusing on commercial real estate exposure as the next shoe to drop, this could throw up opportunities in other sectors. For example, while industrial companies that supply heating, ventilation and air-conditioning units have exposure to non-residential construction, in some cases this is more focused on institutional customers (such as schools and hospitals) that are likely to be fairly resilient even in a tougher economic environment.
“There is certainly potential for the baby being thrown out with the bathwater. It’s important to understand the exact nature of the commercial exposure before passing judgement,” he says.
Central banks’ inflation problem
Fears the banking sector’s problems could staunch the flow of credit as lenders tighten lending criteria has prompted financial markets to speculate central banks will scale back monetary tightening and, in the Federal Reserve’s case, cut rates sooner than previously anticipated.
The US federal funds rate, which currently stands at 5.0 to 5.25 per cent, is priced to end the year at at around 4.25 per cent (at one point, it had been forecast to end 2023 at 5.5 per cent). Looking further ahead, it is priced to end 2024 at 3.2 per cent, down from a high of four per cent.
It’s hard seeing central banks cutting rates as fast as markets seem to envisage
However, Michael Grady, head of investment strategy and chief economist at Aviva Investors, warns the likelihood is monetary policy will remain tighter for longer given how sticky core inflation is likely to be.
“Inflation is still uncomfortably high. It’s hard seeing central banks cutting rates as fast as markets seem to envisage,” he says.
Although the more favourable interest rate environment has propelled equity markets sharply higher since the selloff in March, Saldanha is cautious.
“If core inflation were falling fast, it would be a different matter. However, I am not sure how the Fed not raising rates as aggressively as expected, because of fears of a worsening banking crisis, can be viewed as positive for equities. Regional banks are in many ways the lifeblood for small and medium-sized companies in the US. It is almost inevitable tightening lending standards will have an impact,” he says.
Focus on the debt profile
Saldanha says while investors should always be mindful of balance sheet risk during economic cycles, that is especially true now. Aside from real estate, investors should be wary of highly indebted companies in other areas, such as the consumer discretionary sector, where cashflows are likely to be squeezed significantly.
He says the nature and profile of debt is also an important consideration. For instance, utility companies tend to finance their investments with longer maturity debt with fixed interest payments, meaning they are more sheltered from rapid rises in interest rates.
We are alert to the danger posed by the tide of cheap money going out
While the fact non-financial companies’ balance sheets are in good shape offers investors some comfort, the likelihood is that there will be a rising number of corporate failures as the era of cheap money ends. But picking out where potential vulnerabilities lie in a precise manner is far from straightforward.
“If you go back to the outlooks for the start of this year, nobody was forecasting or expecting a banking crisis. Rising interest rate margins meant most people were positive on the sector. Nonetheless, we are alert to the danger posed by the tide of cheap money going out,” says Higham.