Following the turbulent month of March, April has been relatively benign. From the lows in March, equity markets have recovered to recent highs and bond yields have risen. The mini banking crisis involving Silicon Valley Bank (SVB) and Credit Suisse, having been dealt with swiftly, appears to have been forgotten. Indeed, the market has reverted to concerns over the strength of the economy and the potential for tighter monetary policy.
Nevertheless, the episode is still likely to leave scars on the real economy. Banks may restrain lending and tighten standards. Which, with the backdrop of higher interest rates may be the final straw for the economy. First Republic, another regional US bank that was under considerable pressure in March, revealed this month that it experienced a withdrawal of 57% of deposits (when excluding the $30bn of deposits made by large US banks). Resultingly, the bank’s management is looking to restrain lending and encourage retail deposits. Since these results, it has become apparent that First Republic will either become a zombie bank, supported by the Federal Reserve and its larger peers, or will itself collapse.
Although First Republic is an extreme example, it is an experience that will have been repeated across many US small and mid-sized lenders. Importantly, these are the banks that have most contact with the real economy, lending to small and medium sized companies across the US, rather than focusing on corporate clients and larger metropolitan areas. Any bank experiencing deposit outflows and looking over with concern at the issues at First Republic will be keen to hold onto reserves and will already be taking action to restrain lending. This itself may have an impact on asset prices, such as commercial property and could further impact the solvency of the banking system in time.
Through the collapse of SVB and Credit Suisse, central banks were very willing to provide support and there is clear evidence to suggest that monetary policy has been loosened. However, with inflation still an issue, policy makers will be keen to step back from any perception that they are losing focus. Labour markets remain tight causing some second round effects from the price shocks in 2022. These cannot be allowed to persist for another year as it will risk inflation expectations becoming truly unanchored. This may be a greater challenge in the UK than it is elsewhere.
The rally in equity markets is incompatible with the deteriorating outlook. Valuations remain at or above long term averages and earnings expectations are beginning to be revised lower. A further slowdown in the economy or recession will undoubtedly lead to further downward pressure on earnings. Furthermore, this is with the backdrop of an attractive alternative, 4-5% returns on cash. This is something that the market has not reckoned with since the financial crisis in 2008. Within inflation falling, it may not be long until cash yields offer a real rate of return, and will likely draw investment from other asset classes.
