Active Thinking

At GAM Investments’ latest Active Thinking forum, David Dowsett discusses the implications of the Credit Suisse takeover for markets, the impact on the interest rate curve and why emerging markets still look positive.

20 March 2023

From a European financials perspective, I do not think what has happened to Credit Suisse should derail the investment case for European financials. It is a painful and historic situation, given the importance of Credit Suisse as an institution in the financial system and to Switzerland. However, it is largely being seen as a one-off.

There is still ongoing uncertainty in the US banking sector which warrants caution. I think that we are probably only in the early stages of the uncertainty around US regional banks, which are more lightly regulated and probably still have more mark to market challenges ahead of them. As a result, single name risk in that sector from a headline perspective is still apparent and is something we should be prepared for.

Aside from the situation within the banking sector and the spill over effect to equity markets, we have seen a huge repricing of interest rate expectations.

On the banking sector as a whole globally, it is important to stress that this is not a bad asset problem. The Global Financial Crisis was such a problem, where banks had significant assets on their balance sheets that were not worth anything or worth very little; this is not the case this time. We have a mark to market situation and level of uncertainty associated with government bonds and the bubble that burst last year that has to work its way through the system. I do not believe that there is a silver bullet to resolve this issue and it has to resolve itself over a period of time. It is worth bearing in mind that government bonds will mature at par. From this perspective, there is less price risk than there has been in previous episodes of banking uncertainty.

We also have uncertainty about deposit outflows, particularly in the US, where smaller banks are still vulnerable, in our view. There is action authorities can take that are much wider ranging guarantees of deposits in the US. It is, though, very difficult to do and there are concerns over the legal implications and the legislative process associated with that. However, there is a growing sense that wider action for banks in the US to deal with that issue is going to be necessary. The moves last week of major banks to reinvest deposits, back into First Republic for instance, are very much a sticking plaster move that will not decisively resolve the situation.

I would emphasise that I do not believe overall that this is a credit event for the banking sector in the US, the same as it is not in Europe. Rather, it is a product of the tightening of interest rates that we have seen over the past 12 months and in that respect, is typical of what might be expected at this point in the cycle; liquidity conditions are tightening and businesses that have not been run effectively during the period of low interest rates are now not viable. What we are seeing is what tends to happen before a recession. This is not the precursor to a global banking crisis, but is making the recession that has been on the horizon more inevitable, which is what we are seeing priced in the interest rate curve with the move in the 2-year.

There is an argument that the remarkable rally seen in the short end of curves is probably overdone for the short term. The eurodollar curve, very short-dated interest rates, is actually pricing in close to 100 bps of cuts for the rest of the year in the US, which we think is too much. Again this comes back to our belief that a tough economic situation lays ahead, but not a major banking crisis. In this case, the Federal Reserve may not raise rates much further but, in our view, it is not going to cut them as dramatically as priced into the interest rate curve while inflation remains sticky.

By contrast, emerging markets (EM) still look quite positive. I think liquidity conditions overall are going to loosen somewhat in a global liquidity context because of the interest rate rally. Emerging markets, from a banking perspective, do not have any of the concerns that we see in the developed world at this point in time, and our analysis suggests that they will not encounter such concerns either. Additionally, in that area of the world, the growth impulse is stronger due to the Chinese reopening. While EM currencies may not perform well in the short term when there is a lot of uncertainty about global risk appetite, I believe the general picture of a recovery in non-US, and particularly EM, assets in 2023 still holds throughout the current situation.

I would not underestimate the sticker shock of a USD 16 billion write-down, and anticipated default, on assets that were trading at around 85 cents a week ago. I would also not underestimate the contagion effects in the short term to an asset class that is USD 275 billion in size, ie the total AT1 market. These are meaningful but do not translate into a credit/banking crisis in my view. They do however, translate into further headwinds for developed world growth.