House View: April 2023

April 3, 2023

Cash is king

The new calendar year has proven to be almost as volatile as the previous one, with investor sentiment reaching the highest level since late 2021, only to reach lows that had not been reached once in 2021. The first quarter started with upbeat expectations, both for inflation and company earnings, based on the notion that somehow, a happy ending may be reached, in which no recession emerges (“no-landing”) and inflation rates slow gently. The flaring up of financial crisis events in March has put a swift stop to such presumptions however: the rapid increase in central bank rates have started to reveal cracks in a banking sector that for too long had indulged in the warm bath of ultra-low interest rates. The sudden shock of depositors withdrawing large amounts from certain banks has alerted the authorities for sure. While it remains unclear how many other institutions are in critical condition, we are convinced that more “accidents” (as some may euphemistically refer to failures and subsequent bailouts by the authorities) are to come.


Source: Bloomberg

While for the time being things appear to be contained, we ponder the question of where the next issues will surface. The state of the US commercial real estate sector will certainly lead to losses, considering the structural change in demand for office space in the large cities and the steep rise in interest rates in the past 12 months adding to an already difficult load. But also in the private debt space, a much less regulated part of the debt market, the strain stemming from higher yields – aggravated by the application of financial leverage in many deals – could lead to some investors taking significant hits.

Banking sector troubles

What does this mean for the economy? With the demise of the 16th-largest US bank by assets, depositors as well as banks are on high alert, and with the publicity surrounding the topic, even the least interested person with significant bank savings has learnt that investing in Treasury bills yields much higher interest income than sticking with bank deposits. With currently about USD 18tn in bank deposits in the US, the threat of further withdrawals looms large, in our view. Thus, the US Treasury and the Fed have issued soothing statements to the depositors of the troubled banks, in effect guaranteeing all deposits at those institutions. We remain doubtful whether this is enough.

Statistics on the most recent „liquidity stress relief program“ by the Fed, called Bank Term Funding Program (BTFP), have shown that there is indeed already demand for additional central bank funding despite the very negative signals any participating bank is sending out that had many observers expect that the facility would not be drawn at all. Wrongly so, as it has already been drawn upon, as can be seen by the Federal Reserves weekly statistical release called H.4.1: in the first weeks of its existence, banks drew USD 62bn via this facility.

Loan growth in question

A looming risk of shareholder withdrawals is not the primary fear of systemically-important banks (SIB), but of the small- to medium-sized institutions, also known as „regional banks“. These make up two thirds all commercial real estate lending and about 30{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} of all commercial and industrial loans in the US, according to the Federal Reserve. Should only half of all the regional banks step on the brakes in lending out deposits for fears of a waning deposit base, the impact on the real economy will be strongly felt. We would therefore expect signals from the federal government that deposits in US banks are safe – if not this spring, then after another crisis event that could dwarf the fears in connection with Silicon Valley Bank (SVB), the Californian bank that got bailed-out in early March.


Source: FRED

The general issue of stress in the financial system stemming from the sharpest monetary tightening in decades cannot be easily discarded, in our view. The recent wobbles in the US banking sector have been reflected by the sudden demise of Switzerland’s Credit Suisse, a once proud institution with more than 160 years of tradition. At the Swiss government’s behest, rival UBS had to do a takeover of the troubled bank – deposit flight in the order of CHF 10bn a day triggered the worst fears in the Swiss capital Berne, which had to call upon emergency law to sidestep shareholder rights. The liquidity provisions of the Swiss National Bank amount to CHF 200bn, notably more than the total debt of the Swiss Confederation, its cantons, and communes together. The loss-absorption cushion offered to UBS amounts to about CHF 70bn, a whopping 13{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} of Credit Suisse’s balance sheet as of end-2022. Will this be enough? We would lean towards an affirmative answer, however the opaque nature of CS’ assets will keep us from knowing for certain for a while.

When in doubt, ease?

The economic and financial world have just witnessed once again that whenever the financial sector gets into trouble, the central banks will make sure there will be enough liquidity for credit markets not to completely dry up. While averting a global financial crisis is a legitimate aim by itself, to us the whole situation shows that the inflationary pressures that have built up will stick around for longer than the markets are foreseeing, simply because draining the liquidity floods added in the past two decades will be a lot more difficult than many would like to think – if it is not outright impossible.

The Fed balance sheet had started shrinking from a peak at almost USD 9tn in April 2022 to a good USD 8.3tn (a 7{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} drop), only to see the emergency funding measures in connection with the banking crisis driving the balance sheet up by more than 60{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} of the previous decline. The ECB up until now has been more successful in shrinking its balance sheet.


Source: Bloomberg

However, the Fed’s European counterpart is not out the woods as we can well imagine issues in the euro-area banking sector and there is also, lest we forget, the potential of another eurozone crisis. With credit spreads of both Italian and Spanish 10-year government bonds over their German counterparts standing at about the midpoint of the span of the past 8 years, things appear ok for the time being. Unfortunately, the situation can change very quickly, as was demonstrated by the share prices of US regional banks in March.


Source: Bloomberg

Rate expectations diverging

Fed Funds Rate expectations as reflected in futures prices have undergone an enormous change within a matter of mere weeks: Had the market expected leading interest rates in December 2023 to stand around 5.5{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} by the end of February, expectations dropped by more than 200 basis points into mid-March and quickly reached 3.9{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539}, almost 7 (!) quarterly point cuts relative to three weeks ago and has since settled around 4.5{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539}. According to the FOMC members’ own expectations, listed in the “summary of economic projections” (SEP), also called “dots”, the Fed Funds Rate is still to be raised by one quarter point until December: quite a meaningful divergence between the market and the FOMC.

Two factors we would consider responsible for this big a gap: for one, the recent tremors in the US banking sector, with regional banks market capitalization dropping a whopping third since early March, signifying the mismatch between asset and liability duration that has brought several banks in the US to their knees. The confidence loss in the banking sector will tighten financial conditions further, which by itself should take some pressure off the FOMC to keep raising rates. For the other, central banks’ signaling – as in today’s case with the FOMC emphasizing further rate hikes due to continuing inflationary pressures – lies at the heart of today’s monetary policy, and here the FOMC members felt compelled to stamp out any speculation that the Fed were to return to the ultra-loose monetary policy path of yesteryear before inflation has returned to the long-term target.


Source: Bloomberg

Bad time for a government debt crisis

Three years after the onset of the greatest global health crisis in a century, government finances are displaying different forms of disarray, namely high deficits during a time of low unemployment and steadfastness in economic growth that continues to puzzle many observers. John Maynard Keynes would feverishly call for building up a financial cushion, to save for bad times when more government support is needed for the economy to avoid a deep recession. However, we fail to see any meaningful efforts to reduce the deficits. After an extraordinary situation called for extraordinary measures by the state to save its citizens from hardship, the voters appear unwilling to be weaned off government support, shielding them from unexpected trouble such as the steep energy price hikes in the past fall.


Source: Bloomberg

Public sector employees are on strike in several European countries, calling for higher wages in the face of rising inflation causing hardship for the economically weakest parts of society. As justified as these demands may be, government finances are already taking a hit from higher interest rates that will become increasingly painful as old government bonds expire and need to be refinanced at steeply higher rates. Take for instance the US which is running a government deficit of north of 5{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} at a time when nominal growth remains in the high single-digit percentage points.

Judging from the past 30 odd-years, falling nominal growth rates generally coincided with increasing budget deficits. The past incidents when the budget deficit dropped below 6{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} of gdp from above, nominal growth was close to or even in negative territory (2008, 2020). In other words, the “automatic stabilizers” of unemployment insurance and social security payments (including supplemental nutrition assistance program SNAP) will drive up the deficit in the next recession meaningfully.

Considering the current state of the banking sector as well as the effects of the past 13 months of monetary tightening, negative gdp growth could be just around the corner, depending on the household’s willingness to consume the excess savings stemming from the Covid-related government stimuli. We would like to pose the question of what will happen to company earnings in such a scenario – the market consensus of earnings growth in 2023 of 10{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} appears far off to us.


Source: Bloomberg

Resistance to reforms in Europe

In Europe, the budget situation is not wholly different, with some efforts undertaken to reduce the ballooned deficits from the pandemic now triggering citizens’ ire. In France, the demonstrations and skirmishes between police and protesters that were triggered by a pension reform calling for a higher retirement age are continuing. While it may be understandable that workers are battling the change of retirement rules to leave them worse off, a higher life expectancy calls for a higher retirement age. The redistribution system between the generations needs reforming, with a growing part of the government budget used to sustain pensioners. France is a particular example, where President Mitterrand cut the pension age from 65 to 60 in 1981, when the average French inhabitant’s life expectancy stood at 74.1 years. In 2010, when President Sarkozy raised the retirement age from 60 to 62, life expectancy stood at 81.4 years, while today it is 83.1 years. Hence, while the average Frenchman could expect to enjoy only 9 years of retirement in 1980, this figure rose to 16 years after the Mitterrand reforms, to almost 20 years in 2010 and, according to the Macron government plans, to 19 years after enacting the current reform.

Bleak government debt outlook

With a view to the demographic changes taking place globally, the long-term outlook for government finances is bleak. Depending on the degree of stickiness of inflation in the years ahead (of which we are convinced), nominal gdp growth rates could surprise to the upside, taking the pressure off gauges such as debt-to-gdp ratios. However, according to the US bipartisan Congressional Budget Office’s (CBO) latest estimates, nominal growth would need to reach 6.9{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} in 2033 for example, only for government debt as a percentage of gdp to remain stable. We would like to stress that the CBO uses long-term expectations of 10-year Treasury yields of 3.8{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} and of the Federal Funds Rate of between 2.4 and 2.7{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} in 2025-2033. Should these estimates prove over-optimistic, the net interest outlays would be even larger, further pumping the deficit.


Source: Congressional Budget Office

US debt ceiling concerns

The midterm elections in the US this past November have brought a majority to the Republican Party in the House of Representatives. Listening to some hardline members of its Freedom Caucus, one might think that its aim is a US government shutdown with the horrible prospect of the largest government debtor in the world defaulting on its debt. We consider this a low-probability prospect as many current proponents of a hard line against the Biden administration likely could become afraid of their own courage, meaning they will likely be offering a hand for a compromise at the eleventh hour. The turmoil of even an only temporary disruption of the US Treasury activities in our view could wreak havoc globally. In addition, the greenback’s long-term standing as global reserve currency would get further eroded.

We have long favored precious metals as portfolio insurance during times of financial market stress as well as a hedge against inflation. The erosion of the US dollar’s position as sole global reserve currency will continue in parallel with the rise of non-Western countries that object to a unipolar world order. Gold in our view is among the prime beneficiaries of such a development, because jealousy and distrust among major non-Western countries will keep any alternative currency (e.g. the Chinese Yuan or the Indian Rupee) from becoming the currency-of-choice for those economies that prefer to keep some distance to the West. With the recent advent of banking crisis fears, another important reason why people hold gold is gaining new popularity: the fiat currencies are built on trust in the financial system. Whenever doubts about the system stability itself are rising, “safe” alternatives are being considered – gold has been among the safest stores of value over the very long run.


Source: Bloomberg

The prospects of central banks soon reaching the (preliminary) end to rate hikes, though not confirmed by FOMC members but expected by the market in late spring, could further drive up the price of gold, as it has in the past 20-odd years: within less than three months after last hike, any temporary low was in and the minimum gain for gold in the following 18-24 months was +50{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} in each of the three cases: 2000, 2007, and 2018.

Since the history of digital assets with its less than 15 years of existence cannot offer the same amount of empirical evidence, we nevertheless see a very similar line of thought behind the recently risen demand for cryptocurrencies. The publication of the Bitcoin white paper in November 2008 coincided with the raging of the Global Financial Crisis. This is not just pure coincidence, but rather the opposite, as the Bitcoin network was devised as an alternative to today’s centralized financial system.

Equities’ absolute vs. relative valuation

After a bad 2022, what are the prospects that 2023 will be any better in terms of equity market performance? Valuations by themselves have come down, but not to levels that by themselves would call for buying stocks. Looking at long-term absolute valuation measures, stocks are very far from being cheap, especially considering very optimistic earnings estimates for this year. When one compares equity earnings yields (the inverse P/E) to bond yields, that is to compare the equity valuation relative to bonds, the situation looks even worse. Based on data by Nobel prize winner Robert Shiller, the (smoothed) excess earnings yield over bonds implies historically low excess returns of equities over bonds in the order of 2{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539}, roughly half the long-term average.

The relative valuation of equities vis-à-vis bonds could improve via several different avenues. First, the earnings yield could rise, either by rising earnings (very unlikely in the current situation, as we said) or by falling share prices. Second, the bond yield could fall again, increasing the yield difference between the two asset classes. Judging from our inflation outlook, falling bond yields appear unlikely, to formulate it mildly. We would even go as far as to say that for the inflationary pressures to be driven out of the global financial system, much higher interest rate levels are needed. Therefore, any shorter-term decline in yields will only further stoke longer-term inflation. The genie of inflation has been let out of the bottle and to push it back in, we dread that strongly positive real yields will be necessary, as happened in the early 1980s under the reign of Paul Volcker as FOMC Chairman.


Source: Bloomberg


  • The strongest monetary tightening in decades has led to the first cracks in the financial system, with parts of the banking sector showing signs of distress.
  • Regulators and monetary authorities have identified the issue of deposit flight and have introduced measures to stem a further loss a confidence – at the price of reversing the balance sheet shrinking process.
  • The net effect of the authorities’ response is stoking inflation in the longer run, as the extra liquidity provision runs counter to the rate hikes that the major central banks have announced in March.
  • We can make out other parts of financial markets that could come under severe pressure, namely the private markets, a much less regulated part in the financial world, as well as US commercial real estate that could cast its shadows over investor sentiment.
  • The market expects the Fed to soon turn its hiking stance into cutting rates again. This has given a boost to precious metals as well as digital assets that should further profit from continuingly elevated levels of inflation.
  • The fact that government budget deficits in the order of 5{65b79214172807242d5f8cbb54acc75262ef12d1d68a01b20791f3528a757539} are common during a time of booming labor markets (with the lowest unemployment rate since the Eurozone’s coming of existence) lets us wonder how investors will treat government debt when the next recession strikes.
  • Signals of a coming recession are growing, with global purchasing manager indices trying to stabilize, but with the headwinds from tighter financial conditions and important central banks vowing to stay the restrictive course of lead interest rates, we fear some form of recession may not be avoidable.
  • The debt ceiling talks in the US have the potential to cause much mayhem on global markets. If the worst-case scenario, a government shutdown, were to materialize, heavy losses for the US dollar and other asset classes would likely be the result, depending on the duration of a Treasury default. We expect some form of accord in the eleventh hour.

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