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Fear of Fear Itself

Mar 28, 2023

• The banking sector is likely to remain the epicentre of investor fear
• Market focus has switched away from bank runs to exposure to commercial real estate
• Deutsche Bank is not Credit Suisse despite its share price following the same path
• Investors switch into money market funds from bank deposits is a problem for growth
• Investors should remain cautious and focus on quality income

The markets are in fear. They fear about where next the fault lines in the financial system lie. The receding confidence of investors and depositors, who are reacting with emotion rather than just hard analysis, is further complicating matters.

The banking sector is likely to remain the epicentre of investors’ fear. The share prices of banks remain under pressure, as evidenced by the 40% rout in the US banking stocks since their peak in October 2021. Yet, to date, the magnitude of the recent pullback in banking shares has been modest compared with what we experienced between December 2006 and February, 2009 when the MSCI US Banks sector plunged 83% from its peak. During 2006-09, the ills of the heightened exposures to mortgage lending laid bare the market’s vulnerabilities and caused a widespread fall in banking shares. However, the events driving the current crisis have been markedly different in nature. The current crisis started with investor concerns over misjudgements in treasury management at medium-size banks. At the margin, as investors fret increasingly about the prospects of a recession, there are murmurs about the exposure to real estate on the banks’ lending books.

The market has been rather ‘methodical’ in picking off banks almost one by one. The crisis that initially swept through a few medium-size US banks then took Credit Suisse completely off-guard and is now at the doorstep of Deutsche Bank. As they look more vulnerable, history, too, isn’t on the European banks’ side. From 2006 to date, while the US banks are down approximately 25%, European banks have plunged 70%.

Chart 1: European banks’ significant underperformance vis-à-vis US banks

MSCI US and European Banks indices rebased to 2006=100

Source: Bloomberg

Credit Suisse and Deutsche Bank, among the weakest of European banks since the global financial crisis, had been perennial poor performers. In the current times of investor angst, the market is in no mood to spare the weaker banks. Credit Suisse was a mess and had to be sorted out, but to be fair, Deutsche Bank looks different. Although its share price has performed poorly since 2006, recent actions by the new management have helped deliver a robust operational performance and a much stronger balance sheet. But, those initiative and the recent good corporate news aside, the bank’s share price has continued to slide in recent trading sessions. Over the three days to Thursday’s close, the bank’s share price had plummeted close to 30% to €8 before it recovered to close at €8.50 on Friday. The good news is that many analysts are keen to highlight the marked improvement in the company’s operational performance in recent quarters with substantial cost-cutting and a significant improvement in its capital ratios. The bank is not yet back to being robust, but neither does it look like it needs intensive nursing through a crisis.

Chart 2: Credit Suisse and Deutsche Bank the weak links in Europe

Credit Suisse and Deutsche Bank share prices rebased to 2006=100

Source: Bloomberg

Trouble pending in real estate loans
The recent challenges in the banking system have led investors to analyse the financial sector more forensically. Over the past week, analysts have highlighted banks’ exposure to the real estate sector. Again, it comes back to how banks, in their desperation to raise profits in a near-zero interest rate environment, stacked up with assets that offered attractive yields. In 2022, US banks went on a frenzied buying spree of floating-rate commercial real estate (CRE) loans. That year, the US banks’ loan exposure zoomed 4x the average of the previous years.

Smaller US banks are estimated to hold 80% of the CRE loans worth $2.3tn. Defaults are now starting to accelerate. In March alone, there have been $3bn of defaults, and $270bn of loans are coming due by the end of the year. The current value of loans and securities held by the US banks is $2.2tn lower than the book value of these loans and securities on their balance sheets.

There remain signs of stress among US banks. The Federal Reserve’s discount window, where banks go to the Fed to post collateral and get liquidity, had the biggest spike in one-week borrowing levels. It is just below the record at the peak of the global financial crisis of 2008 and during the pandemic in 2020, now reaching $152.8bn. Warning signs should be flashing red; the banks are signalling that they don’t have enough liquidity to cover short-term needs, which are currently highly volatile, as depositors are moving out of smaller, community and regional banks and moving into the big 4, the so-called systematically important banks.

Chart 3: Discount window borrowing well beyond 2008 peak (millions)

Source: Bloomberg

The challenges in the real estate sector are not just a US phenomenon. The ECB estimates that CRE loans already account for around 30% of the non-performing loans, and its data on 32 of the most CFE-exposed banks found that 26% of the total corporate exposures are commercial real estate. JP Morgan believes that the Nordic, Irish, Austrian, and HSBC are the most exposed, with more than 10% of their total loans broadly in commercial real estate. Domestic UK banks, by contrast, have relatively low exposures.

Investors are backing cash via money market funds
The challenges in the markets force investors to seek absolute safety by investing in money market funds, which typically invest in short-term treasuries. Global money market funds have seen enormous cash inflows recently. Global cash funds had inflows of $143 billion in the week to last Wednesday. Money markets funds’ assets have risen to a record $5.1 trillion, according to EPFR global data. These flows take cash away from other asset classes and also away from the private sector. If people withdraw their bank deposits and place those funds with the US treasury, they will reduce the effectiveness of that cash in funding the economy. A bank will leverage each dollar deposited and make several dollars of lending. A dollar placed with the US government, on the other hand, funds a deficit dollar for dollar.

Limited signs so far of a meaningful fall in inflation
The key to defusing the current crisis of confidence would be a meaningful, sustained fall in inflation. Unfortunately, a significant setback in inflation is nowhere to be seen. March’s global economic data still points to robust industrial confidence and hence good GDP growth. Good growth coupled with tight labour market conditions leads to the persistence of inflationary pressures. This week economists expect Euro area headline inflation to be around 0.5% month-on-month. Meanwhile, Germany’s public transport system is expected to grind to a halt as strikes paralyse the airports. German unions are seeking a 10-12% wage increases.

Central bankers, after their last week’s meetings, appear determined to continue to raise interest rates despite the concerns surrounding the banking system. We have not faced such a scenario in decades. Investors should remain cautious. At this juncture we believe short-dated bonds offer safety, and investors should consider global low-risk equities with yield support, and Asian equities for the ongoing rebound in growth in China.

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