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Having not written one of these update notes for longer than I should have done, the events in the banking world and the fallout from them have led to a flurry of writing. I hope there is no need for another one in the short term!
I’ve commented on the actual events of the collapse of US regional banks and Credit Suisse and you will notice I have stopped short of calling it a “banking crisis” or “global financial crisis”. Now it’s time to have a look at the actions and comments of the major central banks, who are the key policy makers, along with the regulators and governments in this case.
Taking it in turn
Major central banks announced policy changes during the last two weeks. The European Central Bank (ECB) was first in the schedule on 16 March. They plumped for the expected 0.5% increase in interest rates, the banking sector travails were in their early stages at that point. Worst fears were not shared by the ECB; they saw the risks of elevated, embedded inflation too great to not deal with as suggested by the comment “inflation is projected to remain too high for too long”. Hence the increase in rates, rather than a smaller or no increase to alleviate stress in the financial system.
But the following week the problems in the banking system had escalated and the US Federal Reserve Bank (Fed) raised interest rates by 0.25%, less than had been expected prior to the turmoil. The Bank of England (BoE) followed suit the next day.
The Fed was juggling beating inflation, avoiding recession and making sure the financial system remained secure. That is quite a challenge and unsurprisingly they moderated their stance on inflation, along with comments that further tightening may be necessary, although the language was softer than previously. They noted that the banking system was sound but that the risk to economic growth from tighter credit conditions, in other words, higher interest rates, was real. This looked like a pragmatic approach by the Fed, one that would calm nerves and show that they are attentive to all the risks around at present.
The BoE followed a similar path in the face of stronger than expected UK inflation data and subsequent strong retail sales.
The juggling act the central banks have is getting tougher, but it seems clear that the order of priority is 1) maintain banking and financial market stability 2) moderate inflation 3) avoid recession. A sensible approach.
OK, so no banking crisis then, but what about inflation and recession?
Banking is an industry in which confidence is very important and as a result Deutsche Bank came under the spotlight. Deutsche Bank does not look like Credit Suisse or Silicon Valley Bank in our view. It has come a long way since it was seen as one of the weaker banks in Europe; it is profitable and benefitting from rising interest rates. Sensible analysis rather than fear mean that confidence has returned, for now.
However, confidence can be a fragile factor and it is not possible to say, as I write this, that there will not be further instability in the banking sector.
Inflation: it is not beaten. The data in the UK is clear and other indicators, such as employment numbers in the US show that economy to be strong. It is not possible to say with any certainty that the increases in interest rates we have seen have won the war on inflation. However, it is almost certain the trend will be on the way down. Furthermore, the issues in the banking sectors will help moderate inflation.
To explain that point; the response of commercial banks to recent events will be to tighten their lending conditions as they will not want to fall foul of the problems we have just seen, also, they will not want to risk borrowers not repaying. Simply, that means less liquidity in the economy, less spending, therefore fewer inflationary pressures. But, and it is a big but, that also means less growth and therefore a more likely recession.
I can paint just about any picture for the global economic outlook that I think has credibility, other than a period of strong economic growth. Slowing growth, is almost inevitable, recession (of one degree or another) is likely in most developed country economies. The outlook is not favourable, in my view.
OK, so that’s the economic bit, what about financial markets?
Good question, I wish I knew! If you have read any of these notes over the recent past you may have noted that the one adjective I have used more than most to express my view is “cautious” (yes, I did check my grammar). That remains the case.
Let’s start with the less optimistic views; economies slow, inflation remains a problem, interest rates stay elevated, economies slow and company profits suffer. That suggests an unexciting, difficult period for bond and stock markets overall.
If it is recession looming, everything I have described immediately above happens quicker and probably sooner. That is not all bad news. Recessions have the effect of “cleansing the system”, although it is not all pleasant, the economy and businesses can recovery and regenerate. Financial markets are likely to reflect that, for bad and for good.
However, when I speak to our investment teams I am struck by the long term opportunities they are seeing. The team that manages our bond funds are struggling to get excited, but when they tell me about the returns that are available from good quality bonds issued by companies and money market investments, I see those as something to base a diversified investment portfolio on. If I speak to the various teams that manage our equity funds, each of them will give me great examples of companies they think will provide attractive returns over the long term.
The last word
We invest for the long term and are focused on providing good investor outcomes. But we try to take advantage of short term opportunities that the volatility in financial markets provides.
March has been quite a month and I hope the need for another rush of buses isn’t required.