If ever there was something to fear north of the wall, it is hyperinflation.
This has destroyed many economies including Greece, Zimbabwe and Argentina — sending its people on a worldwide diaspora in search of better economic prospects elsewhere. Central banks are therefore our night’s watch against the wildfire of inflation running rampant. But what happens when the main tool of containing inflation has negative repercussions of its own?
Notwithstanding recent inflation prints continuing to come above most central bank targets, we have started to see cracks in various banks across the globe which would certainly provide central banks cause to pause for thought. We have however continued seeing rate hikes from the US Federal Reserve, Bank of England and the European Central Bank.
Meanwhile, in the US, we have seen at least three big bank closures in the past couple of weeks, with Silicon Valley Bank (SVB) being the largest bank failure since the 2008 global financial crisis. These have come under pressure in a high-rate environment, increased demand for liquidity, deterioration of asset values and loss of confidence from the market. While we have seen comparisons to the 2008 global financial crisis, we maintain that there are stark differences.
On similarities, there is a general loss of confidence in the banking sector which has led to a run on the banks as depositors withdraw funds from these banks, which is a self-fulfilling prophesy as it leads to the bank’s actual collapse.
Banks can often raise capital by either getting additional funding from investors, selling of their assets or exercising loan facilities from central banks or other commercial banks. The problem in a high-rate environment is that investors tend to have a high-risk premium attached to capital provision, asset values like bonds tend to be depressed, central banks tend to be reducing money supply and other commercial banks tend to be preserving their own liquidity.
It is however difficult for central banks to turn back from their normalisation path, particularly as the core objective of containing inflation has not yet been achieved. Inflation is a destroyer of value, leaving individuals poorer in real terms and often disproportionately affecting the poor. It therefore becomes a destruction of passion in fire, or one of hate in ice as Robert Frost puts it.
On the differences, there is nothing fundamentally wrong with the assets held by most of these commercial banks, unlike in 2008. The main issue is that they are being offloaded in a market downturn due to liquidity constraints. Furthermore, the contagion in the US is limited to the smaller regional banks. These have a concentrated pool of clients with similar characteristics, not benefiting from diversification like the larger banks do and not having as large a balance sheet.
For instance, SVB’s main clients were tech and health-care start-ups, largely unprofitable long-duration companies feeling the pressure of rising rates and in desperate need of liquidity — in turn putting SVB under pressure. Silvergate and Signature had concentration in crypto assets. The larger, more diversified banks, despite the short-term negative sentiment on the banking sector, actually have a lot to benefit from a fundamental perspective. They have been buying up assets from the smaller banks at deep discounts, gaining clients from the regional specialised banking sector, growing their market share and revenue as a result.
In Europe, the acquisition of Credit Suisse by UBS is not a bank closure. Credit Suisse will continue trading until the transaction is finalised. The transaction is meant to halt any potential systemic risk in the Swiss banking sector, as there have been confidence issues on Credit Suisse in the past.
The activity in the banking sector can be characterised as more of a consolidation of the struggling banks into the bigger, well- capitalised banks which are not only well positioned to absorb the negative effects of the high-rate environment, but also monetise the opportunities that come with it while maintaining market confidence. However, we must concede the unknown risks of aggressive regulatory and policy changes — which often expose weaknesses in the system that were not apparent.
Locally, we have been able to withstand a lot of these pressures, past and present, including the 2008 global financial crisis. Banks have recently released their earnings, with high single-digit to low double-digit earnings growth across the big banks.
On the offshore side, we have recently included JPMorgan into our global equity portfolios. It has a high quality management team, healthy balance sheet, sufficient liquidity, diversified revenue stream, is well positioned in the market to take advantage of the current environment and is trading at attractive valuations with decent upside potential.
It may certainly feel that there is more conflict within the banks, first between the central banks and the commercial banks, second within the larger commercial banks and the smaller ones, however a common thread is the desire for financial stability within the banking system. While there may be pain along the way in achieving this, the benefits will be reaped by both producers and consumers of financial services. In the meantime, we will continue to navigate the markets in search of opportunities for our clients’ investment portfolios.
• Smith is chief investment officer at Absa Global Investment Solutions, Stockbrokers & Portfolio Management.
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