Financial Update from Brewin Dolphin - 10 March 2023
The Weekly Round-up
Friday 10 March 2023
In his latest weekly round-up, Guy Foster, our Chief Strategist, discusses the liquidity crisis at US lender Silicon Valley Bank, and signs of a resurgence in the UK economy.
Trouble in the Valley
Markets suffered a mild panic on Thursday as two lenders suffered financial stress. The most significant was Silicon Valley Bank (SVB). Like all banks, SVB makes money by borrowing over short periods and lending over longer ones in order to achieve an interest rate margin. Its short-term borrowing is deposits from Silicon Valley-based technology companies that are funded by venture capitalists. These doubled during 2021. In order to generate a return on these, SVB invested in the highest-quality loan assets, such as US agency mortgage-backed securities (MBS).
Whilst MBS sound concerning given their role in the financial crisis, these securities do not represent a solvency risk. However, they did fall in value as interest rates rose. Furthermore, banks have been forced to raise the rates they pay on deposits in order to avoid customers moving their deposits.
The specific challenge that SVB faced was that it was forced to sell high-quality loan assets in order to be liquid enough to meet deposits. In doing so, it crystalised a loss which it then needed to repair through a sale of shares.
I was fortunate enough to be able to speak to the CEO of a large US bank with knowledge of the matter, who believes the situation is very contained. SVB has a particularly volatile deposit base and its depositors (as businesses) do not benefit from federal deposit insurance. Therefore, if their bank looks weak, the rational thing is for them to panic early. Venture capitalists encouraged this behaviour by suggesting depositors start looking for safer homes for their cash.
Although the challenges do seem quite contained, banks (which are quite a heavily owned sector as investors hunt for beneficiaries of a rising interest rate environment) sold off in sympathy. As interest rates have risen, banks have become more limited in their ability to capture all of their excess returns as margin. Higher rates have seen depositors shopping for better rates or for alternative homes for their cash.
The higher rates go, the more thought depositors will put into the value they are receiving from banks. Expectations about the future path of interest rates went on a wild ride this week!
In the US, markets listened intently to Federal Reserve chairman Jay Powell as he gave testimony to congress. This was the first commentary from the chairman for a month, during which time economic data had turned decisively stronger (as we have discussed in previous weeks). His comments reflected this and opened the door to faster rate hikes at the next meeting in under a fortnight.
A question for Powell is the extent to which interest rate increases have affected the economy. We know that housing market activity has declined sharply since interest rates have risen. Anyone moving house now will likely have to give up an attractively cheap mortgage and replace it with a new one at a much higher cost. New housing construction has slowed down as a result.
This week saw several new pieces of data on the labour market. Job openings increased yet again, suggesting the labour market is tight. And the highlight of the week was the monthly non-farm payroll survey, which saw another strong month of jobs growth.
With Powell’s remarks still ringing in investors’ ears, was this enough to cement expectations for a half percentage point increase in interest rates? A few mitigating factors said no.
Despite the rise in employment, the unemployment rate actually increased. That reflects the fact that more people have been drawn into the labour force, perhaps by the promise of higher wages, or because their savings are dwindling or because inflation is eating away at their standard of living.
Although more people are working, there was a further decline in the average hours worked. And although job openings and construction employment both rose, job openings in the construction industry saw their biggest-ever monthly decline on record.
So it remains a real dilemma for the Federal Reserve as to how to proceed. There are some tentative signs that the economy may weaken in the future, but they remain inconclusive. Under these circumstances it would seem prudent to maintain a relatively hawkish stance. The risk that inflation should seem untamed remains the highest of all. But the Federal Reserve will be particularly nervous given the part that monetary policy has played in putting a regional bank (SVB) under financial pressure.
The UK resurgence
The global economy has lived with the threat of a recession looming in the middle distance for a year or so. Sometimes it seems to be approaching; other times it seems to be getting further away.
The UK was the economy that seemed most likely to enter a recession. In fact, this was the near unanimous opinion of economists surveyed by Bloomberg (as we have observed before). Lately, however, that threat of recession is looming considerably less largely.
In January, purchasing managers’ indices (PMIs) had suggested that the economy was stagnating, before a surge of growth in February. So this morning’s gross domestic product (GDP) report, which showed that even in January services were growing, surprised the pessimists (which was just about everyone).
The breakdown of growth during the first month of the new year showed a reasonable expansion of services. Part of it was predictable: activity was unusually depressed during December by strikes and bad weather. Brighter factors, though, also had an impact – for example, the World Cup was a small boost to pubs, but the UK’s own football schedule was suspended.
Due to these things and the scattering of additional bank holidays, services sector activity has been pretty choppy lately. But as mentioned, the pick-up in the PMIs was the first factor suggesting that expectations for the UK economy may have been too pessimistic.
This week, the British Retail Consortium’s shop sales survey suggested that retail sales, which accelerated during January, were probably stronger still during February. Over time, there has been a strong correlation between UK house prices and retail sales. Prices have risen on the Rightmove website, and this week Halifax’s house price numbers also seemed to suggest prices were firming.
The outlook for house prices remains challenging. Mortgage costs have soared as interest rates have risen, although costs have fallen a bit recently as the market puts ‘Trussonomics’ behind it. The RICS house price survey is just one indicator that suggested prices would fall sharply this year. The latest iteration of that index saw a positive revision, so while it still looks grim, the implied house price falls are smaller than they were previously. There was an increase in new buyer enquiries nationwide and this was particularly evident in London. That, again, supports other evidence that the capital is regaining its appeal (Rightmove saw prices rise 2% in a month more recently).
Housing remains under-supplied in the UK, which may prevent the worst predictions of sentiment indicators from feeding through to lower house prices. The January GDP numbers saw construction as the biggest detractor, but the PMIs suggest it has expanded since then with civil engineering and commercial activity driving positive momentum. The one sector still in contraction is house building, which suggests very little is being done to redress the under-supply of homes.
So the conclusion seems to be that it has been a bullish week for GDP on the demand side but, as far as housing is concerned, supply remains constrained. Anything to address this in next week’s budget would be a positive surprise. Historically, the government has found it easier to stimulate the demand for housing than the supply of it.
In the US, next week’s focus will be on the February inflation print. The US reports inflation data later than many European economies, whose results have generally indicated a reacceleration of inflation. To me, this suggests that a half a percent increase in interest rates this month seems more likely than not.
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