US bank troubles reverberate in Europe
The failure of two US banks during the last few days is reverberating in Europe, generating a broad risk-off move in financial markets.
On Friday, US authorities closed Silicon Valley Bank and then, on Sunday, did the same with Signature Bank. To limit contagion risk, the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve, with the support of the US Treasury, also took two significant decisions. They guaranteed all of the deposits of the two banks, including those that were uninsured, i.e. above the USD 250,000 cap of FDIC insurance. The objective was to reassure US bank depositors regarding the safety of the banking system and to avoid bank runs.
The Fed also launched a new scheme, the Bank Term Funding Program, with the goal of providing loans of up to one year, using an institution’s “safe assets” as collateral, at par. The programme offers an additional source of liquidity against high-quality securities, seeking to eliminate a bank’s need to sell those securities in times of stress.
Despite these bold moves, uncertainties remain regarding US regional banks and, more broadly, the entire US banking sector. Investor focus will be on how bank depositors behave in this volatile environment in the coming weeks.
European banking sector under pressure
But the US is not alone in facing trouble in its banking sector. Since the beginning of this week, the European banking sector has also been under pressure because of the tensions in the US as well as problems at Credit Suisse. Late Wednesday, however, the Swiss central bank said it would provide liquidity to Credit Suisse, if needed.
The European banking sector declined by 8.4% on Wednesday. The drivers of this correction were worries about potential contagion effects; investors discounting banks based on a more challenging economic outlook for the banking sector; and profit-taking, after the European banking sector rebounded by more than 40% since the end of September through 10 March.
Broad risk-off sentiment
The tensions in the US and European banking sectors are generating a broad risk-off movement in financial markets. European equity markets declined by 2.9%, while US equity markets outperformed somewhat, retreating by 0.7%. Overnight, Japanese and Chinese markets retreated by 0.8% and 1.9%. Within fixed income markets, government bonds rallied, with US ten-year Treasury yields reaching 3.5% and ten-year Bunds 2.13%. In commodities markets, oil prices tumbled, with WTI crude now trading around USD 67/bbl. Finally, the US dollar is acting as a safe haven, in particular against the euro, with the US dollar appreciating by more than 1.5%. These significant movements are motivated by risk aversion and are exacerbated by the increasing risk of recession, as financial conditions tighten. This morning, a rebound of European equity markets seems to be in the cards, after Credit Suisse said it will borrow up to 50 billion Swiss francs from the Swiss National Bank.
Central banks in the spotlight
Central banks will be in the spotlight in the coming days. The European Central Bank’s monetary policy meeting is scheduled for later today and the Fed meets next week. Before the crisis started, the ECB was considering a 50-basis point hike, while Fed Chair Jerome Powell was suggesting a possible reacceleration in the pace of tightening, given that inflation remains high.
Today, the outlook is much more uncertain. Even though inflation remains a key topic for central banks, the increase in volatility in financial markets is generating a significant tightening of financial conditions. Markets are now pricing-in that the Fed will reduce its Fed fund rates by 100 basis points by the end of 2023.Our investment strategy within this context
As explained in our latest market comments, tightening central banks always have an economic and financial impact. We continue to expect that economic growth will decelerate further in coming quarters, putting corporate earnings under pressure. In that context, market volatility could remain above its long-term average in coming months. Consequently, we continue to take a cautious stance in our portfolio positioning. We are underweight equities, and, in terms of regions, we are underweight developed markets compared with emerging markets. Regarding equity sectors, we have a neutral stance towards the financials sector and a slight defensive bias with an overweight in health care. We have an overall neutral stance toward fixed income, with a preference for high-quality segments that can provide portfolio diversification.
What investors should do
For investors invested in financial markets, we recommend waiting out the current market situation and not making any significant moves. Furthermore, a well-diversified portfolio will protect against over-exposure to specific risks. For investors willing to invest into financial markets, the market’s ongoing volatility will likely progressively expose opportunities.