14 March 2023 Equities | FX | Monetary Policy & Inflation | US

The US Banking Crisis – Contagion or Containment?

Summary

Contagion risks from the US banking crisis appear manageable.
Following the initial reaction, opportunities should arise for investors in select US financial stocks.
50bp at the March FOMC is no longer possible; 25bp is likely.

Market Implications

While systemic risks are low, cross-correlations among asset classes will rise, making diversification even more important.
USD is likely to find support as the Fed remains steadfast.

Contagion or Containment?

Despite the heightened uncertainty and volatility, I think the SVB/Signature crisis will eventually be contained and contagion risks in the US banking sector are manageable.

Market participants will prove reasonably discerning in their assessment of the US banking sector, once the initial knee-jerk reaction is done. There will be much better value in select US financial stocks once the ongoing selloff abates.

Will the Crisis Impact Fed Hiking Plans?

I do not believe the Fed will be dissuaded from hiking rates next week. 50bps is certainly off the table, so 25 bps is likely.

As it stands, not hiking next week sends the wrong message. They are still trying to salvage their credibility, and price/wage pressures remain an issue. Tuesday’s CPI data will significantly influence what the FOMC does next week.

Not hiking next week due to the SVB saga would seem a weak excuse to pause. It would then likely mean having to restart.

How Will Investors Respond?

If today’s selloff is any indication, investors are spooked. But I see this as a knee-jerk selloff in global equities that will likely not last.

The negative wealth effect from an equity market decline is a Q2 event at the earliest but much more likely a Q3/Q4 event. Triggers are as follows:

The turnaround in earnings expectations with Q1 and Q2 numbers expected to be disappointing.
Ongoing allocation switches by asset owners.

There will be a pullback in US bank lending activity, and the credit crunch impact will likely abet the US corporate earning downturn by Q2/Q3.

Diversification Is Now More Important Than Ever

While systemic risks are low, cross-correlations among asset classes will rise. Think equities, credit/HY, and risky assets in general. Consequently, diversification becomes even more important.

This diversification may play out across geographies and via more Relative Value plays rather than directional plays in portfolios. During selloffs, asset prices tend to overshoot, presenting more opportunities for both tactical and strategic market participants.

Even as Fed rate hike expectations may be tempered for now, the FOMC remaining steadfast in the coming weeks/months is likely to keep the greenback supported. Also, expect USD to benefit from safe haven flows as SWBs/CBs favour USTs especially at the current attractive yields on offer.

Asset Allocation

Recall that most pension funds/E&Fs got into the VC/PE space in recent years to diversify. The already negative expectations for mark-downs in these portfolio positions are likely to be exacerbated if the VC/PE firms and startups affected by the SVB collapse face liquidity issues and cannot access their funds.

This may trigger a re-allocation away from “Diversifying Strategies” in asset owner portfolios. The beneficiaries are likely to be safer haven USTs, Value Equities and Cash.

In Sum…

The Silvergate/SVB/Signature failures have come fast and furious, undermining confidence in the US financial sector. Even so, the exposures of these failed banks are impacting the relatively marginal crypto and VC/PE spaces, not most banks that lend to corporations and individuals. The market reaction has vastly reduced the UST curve inversions, alleviating pressure on banks in general.

If the Fed persists with a 25bps rate hike next week, it will be very likely that the accompanying statement and subsequent Fed speak will be dovish, recognizing the need for a pause given recent events.

The terminal rate is likely to have a 5% handle or 6% at most handle in the coming months/year.