On 29 March, Global Strategic Advisor Joe Prendergast sat down with Senior Research Analyst and Financials Specialist Sebastian Orsi, Head of Fixed Income Strategy Elizabeth Geoghegan and Chief Investment Officer Bernard Swords to discuss the recent turmoil in banks. We present highlights and talking points from our speakers below.
The Background
Sebastian: At the start of the year, a financial crisis didn't top investor concerns but the catalysts for this were hiding in plain sight. In the US, it was basic interest rate risk and liquidity mismatches in a regional bank with a very narrow business model that failed. In Europe, it was a series of costly ethical scandals over many years, as well as a lack of a credible strategic plan that really exhausted the clients’ and investors’ patience. Both situations developed into classic bank runs, which is when too many depositors ask for their money back all at once. And given that the banks directly involved were relatively large, it caused concerns that the problems would cascade through the banking system, possibly creating another financial crisis. In our view, that is not likely. Policymakers have certainly responded quicker than the global financial crisis in 2008. After that time, significant changes in regulation of bank capital and liquidity were introduced, with far more circuit breakers in place.
What's the outlook for bank stocks? Will they become attractive?
Sebastian: We have had lower than average exposure to banks in client portfolios. Higher interest rates are generally positive for banks and have boosted earnings forecasts, but those higher interest rates come with risks and costs, such as having to pay for deposits and bad debts. We felt these risks weren't reflected in some markets, particularly when we're in the later stages of an economic cycle. We're unlikely to add to our current bank holdings in the near term.
The Impact on the Bond Market
How has fixed income been reacting to these latest developments?
Elizabeth: What we have seen is a reversal of recent trends. In February, you saw a lot of positive economic data coming out and market participants started pricing in the possibility that interest rates would go higher and stay high for a longer period. We saw interest rates rise, which weighed on the performance of bonds, causing negative price performance across all bond markets. Interestingly however, the positive economic data was viewed as supportive for the outlook of corporates. Hence, whilst higher rates were negative for the performance of bonds, corporate bonds were less impacted than government bonds given the positive tailwind from better economic growth expectations.
In March, events in the US and European banking sectors lead to a downgrading of investor economic expectations. This led to a flight to safety by investors, as they moved to purchase ‘safe haven’ assets such as government bonds. This increase in demand led to higher bond prices, and hence lower interest rates. Interestingly however, although lower interest rates are positive for all bond markets, corporate bonds benefitted less than government bonds from this tailwind in March as the prospect of weaker economic growth presented a drag on the outlook for corporate profitability.
Where are the peaks for rates currently priced in for the US and Europe?
Elizabeth: The US Federal Reserve currently has a policy rate of 5%. During the period of strong data, it was anticipated that could move to as high as 5.5% and that the ECB, currently at 3%, could go above 4%. Following a re-rating of expectations, U.S. key rates are now not expected to exceed 5%. For the ECB, a max of 1-2 hikes of 0.25% is expected. Interestingly, markets now appear to be pricing in cuts from both central banks by the end of the year. However, given the volatility of markets in recent weeks, I would caution extrapolating too readily from these expectations.
On the recent widening of corporate spreads, is this now an opportunity in corporates or a cause for concern?
Elizabeth: I think the best way to answer this is by asking what is the purpose of corporate spreads? Corporate spreads are essentially the yield premium required by investors to invest in corporate bonds over government bonds which are considered inherently lower in risk. Corporate spreads are there as means to compensate investors for taking additional risk, specifically credit or credit default risk. As a result, following recent events, it is only reasonable that we have seen a move higher in corporate spreads, to reflect higher perceived risks. So, in a sense this is a natural development, but as investors our concern is always where to from here?
We always try to frame an outlook through the lens of expected returns. When we look at corporate bonds today the spread premium has increased and could increase further which is a headwind for returns. However, importantly, this is also against a backdrop of yields which are a lot higher than they were a year ago. This means that there is now a higher buffer on offer to investors to protect against such risks.
It’s important to note that this is a higher buffer against losses, not a total or equal offset. However, this is where the selection of high-quality investment grade corporates in Europe can provide an additional layer of quality within a well-diversified investment portfolio. In addition to this, targeting shorter maturity bonds, which are less impacted from higher rates and offer attractive yields relative to longer maturity bonds, is another way in which one can position for optimal expected returns within a diversified portfolio. But that is an additional conversation!
What's the alternative for an investor seeking to get a return on excess cash?
Elizabeth: A good alternative may be to invest in short-term core European government bonds, which would have strong credit ratings and they're relatively liquid as well in terms of trading. German 1- and 2-year bonds are in the range of 2% - 2.5%, sometimes 3%, depending on where you're looking on the curve specifically.
The Economic Outlook over the Long and Short Term
Have the events changed anything in our thinking on global markets and the current outlook and what we're doing with asset allocation?
Bernard: The important question for us was, is this a systemic problem? If it is not a systemic problem, then it doesn't materially change the way that we look at things. This mini bank crisis is the kind of event that happens when you've had the degree of monetary tightening that we've had. We've had setbacks in some markets, but all our model portfolios are still delivering positive returns right across the risk spectrum.
What is the impact on monetary policy?
Bernard: All central banks have been consistent in saying they have two toolboxes, one dealing with macro stability: inflation, growth, employment etc., and one dealing with the financial stability, liquidity, the banking system, etc. They are different toolboxes and don't expect them to use one to augment the other. Central banks are telling us we're still looking at inflation, these events don’t take them off that course.
How are our regional and sectoral preferences lining up now in this late cycle time?
Bernard: During the market rally in January, our defensive sectoral stance was not helping at all. It was a negative in relative terms, but that has gone into reverse now in March. We have a defensive stance with health care and consumer staples being the ones that we would favour. We have been out of deep cyclicals: energy, materials, even financials, and we think that's the way it'll carry on this year with ups and downs from month to month.
Thank you to all who attended the webinar. If you have any questions on the topics discussed, please contact your relationship manager at Goodbody.
