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Banking Turmoil: Outlook and Investment Implications

On March 22, the U.S. Federal Reserve (Fed) hiked interest rates by 25 basis points to curb inflation despite turmoil in the banking industry, noting that…



On March 22, the U.S. Federal Reserve (Fed) hiked interest rates by 25 basis points to curb inflation despite turmoil in the banking industry, noting that “the U.S. banking system is sound and resilient,” but “recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation. The extent of these effects is uncertain.”

While the full impact of the turmoil in the banking industry and the Fed’s response is still unknowable, we are gaining perspective on its economic impact, and thus its investment implications. Captured below are perspectives from each of our investment teams.

Macro Environment

Since the beginning of March, U.S. policymakers have taken aggressive steps to alleviate liquidity stress in the U.S. banking system. For as long as the yield curve remains inverted, concerns about some banks—particularly smaller, regional ones—may persist.

As these smaller financial institutions play a critical role in the U.S. economy, continued liquidity challenges in the banking sector may dampen banks’ appetite and ability to lend, thereby curtailing some economic activity. Smaller banks—those with assets of less than $250 billion—account for 60% of residential and 80% of commercial real estate lending. All in all, smaller U.S. banks extend about 50% of all commercial and industrial (C&I) loans and 45% of consumer lending.

The Fed provides weekly data on various types of bank lending with a 10-day lag. We note that lending by small banks has decelerated already—presumably in response to the stress in the banking system. Whatever the reason, softer bank lending effectively amplifies the already dampening effect of higher rates on economic activity. In this sense, banking system stress may obliviate the need for additional rate increases.

While we remain of the view that the Fed will prefer to raise rates and then pause for a considerable period of time, liquidity challenges in the banking sector may effectively lower the federal funds rate setting necessary to cool domestic demand enough to cool consumer price inflation to 2% to 3% by 2024 year-end.

U.S. Value Equity

It’s shocking to think that the KBW Bank Stock Index (BKX) has fallen by nearly 30% in the month of March. However, when bank failures occur, it’s not uncommon for investors to sell shares and ask questions later. Even prior to the Silicon Valley Bank (SVB) Financial debacle, we had been actively reducing our exposure to the banking subsector and are net underweight relative to our respective indices. Why? As fundamental investors, it’s important to remember the factors we believe drive bank stocks over the longer term: net interest margins, loan growth, and credit quality.

Net interest margins: We believe we are closer to the end of this rate-hiking cycle than the beginning. It’s generally believed, however, that the stress of the last several weeks will help further the disinflation narrative, and some investors are now predicting rate cuts for the back half of 2023. We, however, continue to believe inflation, while moderating, will take time to return back to the Fed’s 2% target. If the Fed is forced to hold rates higher for longer than the market is pricing, pressure on net interest margins will likely continue as banks have to keep paying up to retain deposits. As such, we believe the expansion in net interest margins that regional banks have enjoyed over the last several years is likely not to continue. 

Loan growth: We estimate that between the start of the pandemic and when the Fed began raising interest rates last year, deposits at U.S. banks rose by more than $5 trillion. However, due to weak loan demand, less than $1 trillion was lent out. We have yet to see how much of those deposits have now left smaller regional banks to either higher-yielding alternatives (such as money markets) or the safety of systemically important financial institutions (SIFIs). Regardless, it’s hard to imagine an environment in which loan growth can catch up with deposits in the near term, especially if we are entering a potential recession in which banks will tighten their lending standards.      

Credit quality: Historically, bank failures have occurred due to credit issues as opposed to a mismatch of duration between assets (long-term government debt) and liabilities (deposits). We find it intriguing that some (admittedly poorly managed) banks have failed due to their inability to hedge their interest-rate exposure properly in a rising-rate environment. It makes one ask if credit will be the next shoe to drop. It’s quite plausible to expect that banks will react to this turmoil by tightening their own lending standards. This, in turn, could cut off access to credit for individuals and businesses seeking to borrow, increasing the chance of a recession and likely credit issues. We are already starting to see the cracks of such, whether in venture-backed technology, the California wine industry, or the commercial real estate sector, where smaller banks have grown their exposure compared to their larger peers in recent years.

Longer term, we believe regional banks that have been prudently managing their balance sheets with diversified deposit bases will likely benefit. 

Given the magnitude and speed of recent events, it will take time to truly understand the far-reaching implications. It’s likely the banking industry will now face much tougher regulation, a higher risk of increased capital requirements, higher fees to cover the likelihood of FDIC insurance increases, and a renewed debate about which institutions are too big to fail.

For these reasons, along with the factors referenced above, we remain cautious about increasing our weighting to banks in the current environment. However, the recent volatility does offer the opportunity to upgrade the quality of our holdings. Given the sell-off, valuations for some banks are beginning to look attractively priced, even when we stress their tangible book value for unrealized losses in their held-to-maturity portfolios.  

Longer term, we believe there will continue to be a place for regional banks within the banking system, and that those that have been prudently managing their balance sheets with diversified deposit bases will likely benefit. 

As we shift through the rubble looking for high-quality franchises that have been indiscriminately punished, we will continue to prudently manage the portfolios and alert you to our thinking about portfolio positioning. 

U.S. Growth and Core Equity

While the issues that resulted in SVB Financial’s failure were largely driven by the unique nature of the company’s asset and deposit base, the economic and stock market implications are potentially much broader. All banks have a fundamental mismatch between the duration of their assets and liabilities, and their revenues and costs can respond differently to changes in interest rates. This mismatch can come with significant consequences when confidence in the banking system falters, as we are seeing today. As individuals and businesses pull deposits from banks they view to be less safe and put those deposits into larger banks, you could see additional bank failures and/or sustained higher market share at larger banks at the expense of smaller regional players.

We are actively assessing our U.S. growth and core portfolio companies against a widened range of potential outcomes as this situation unfolds.

At a higher level, the funding costs for banks are likely to increase given pressure on deposit flows and the higher cost of those deposits. Higher funding costs and a preference to build excess capital on their balance sheets could lead banks to tighten lending standards. This in turn would reduce the availability and increase the cost of financing for businesses broadly and for the consumer. It is too early to know, but the lagged impact of the Fed’s tightening cycle and potentially more restrictive bank lending standards may lead to slower economic growth ahead.

Following an era of inexpensive capital for the last 10-plus years, an environment of higher interest rates and higher inflation could result in a more challenging operating environment for businesses and a more discerning market environment. Companies with strong balance sheets, durable business models, sustainable cash flow, and the ability to self-fund growth are uniquely positioned in this type of environment and over the long term. While we remain focused on investing in mispriced, durable business franchises, we are actively assessing our portfolio companies against a widened range of potential outcomes as this situation unfolds.

Global Equity

UBS’s acquisition of Credit Suisse last weekend marked what was essentially the fourth major bank failure in recent weeks. The combined failure of these four banks prompted an in-depth analysis of the global banking landscape.

We believe Credit Suisse is a fundamentally impaired business after years of instability and losses. Moreover, comments from a key shareholder (Saudi National Bank) and heightened volatility in the global banking sector impaired confidence in the bank. The UBS deal is a best-case outcome to prevent contagion and systemic risk to the financial system because Credit Suisse is a global systemically important bank (GSIB).

The biggest surprise was the full writedown of Credit Suisse’s additional tier-one (AT1) bonds, but not its common equity, which would usually receive priority over equity in a bank failure. The fact that this did not occur in the Credit Suisse/UBS deal led AT1s to trade down until other regulators outside of the Swiss clarified their own stance where AT1s fall in the capital stack, partly alleviating market concerns. Although funding costs may rise, we do not believe this will cause concerns about capital more broadly at this point.

Across developed and emerging markets, we tend to invest in higher-quality banks, which generally have held up well through the current situation.

Additionally, some indicators that we watch for signs of financial market stress—such as spreads in wholesale U.S. dollar funding markets and credit index default swap (CDX) levels—started to subside this week from elevated levels the prior week.

Broadly speaking, we believe developed market ex-U.S. banks’ balance sheets are generally sound. The market structure is more consolidated than it is in the United States, with the largest five or six banks having the majority of market share. Developed market banks are also heavily regulated and stress-tested, and key liquidity and capital ratios are at healthy levels. That said, as interest rates rise and the economic environment deteriorates, banks in developed markets will likely see loan growth slow, the benefits of higher interest rates ease, competition for deposits increase funding costs, and asset quality deteriorate. Although balance sheets are generally solid, the environment will likely result in lower growth and returns.

Similar to developed market banks, emerging markets (EM) banks generally have sound balance sheets, but we look at them on a case-by-case basis because their market structures and risks tend to be idiosyncratic.

Across developed and emerging markets, we tend to invest in higher-quality banks—those with strong competitive advantage, high return on equity (ROE), and healthy capital ratios—which have proven their ability to deliver through credit cycles. Generally, these banks have held up well through the current situation. Contagion is, of course, a concern, and the situation is highly fluid, so we are constantly reevaluating the situation to ensure we are comfortable with our investments across financials as the situation evolves.

Emerging Markets Debt

EM fixed income is not directly exposed to problems in the U.S. financial sector, but high-yield EM debt has been significantly impacted by increased risk aversion. Forced selling from exchange-traded and other passive funds amid very poor liquidity conditions exacerbated the sell-off.

That said, we believe EM fundamentals remain resilient and that current prices provide a very attractive investment opportunity.

We have been gradually increasing exposure to high-yield EM credit and local currency debt.

EM banking systems look better positioned in terms of capital than they were during the Global Financial Crisis, thanks to the implementation of robust macroprudential regulation in recent years. While there are a few countries where the banking system displays certain vulnerabilities, very few of them have broad challenges that would create near-term solvency and financial-stability concerns.

We believe recent developments in the global banking sector will impact EM banks mostly through second-order effects, as direct links to affected institutions are limited. Most EM bank debt issuers are leading local institutions and benefit from granular and well-diversified deposit bases, which support robust liquidity profiles.  

Overall, EM credit spreads, yields, and currency valuations are at historically attractive levels.  Moreover, concerns about the U.S. financial sector should bring forward the end of the monetary tightening cycle, in our opinion.

All things considered, our positive medium-term view for EMD remains intact, and we have been gradually increasing exposure to high-yield EM credit and local currency debt.

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The post Banking Turmoil: Outlook and Investment Implications appeared first on William Blair.

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How much more financial pressure can Australian mortgagees take?

Talk to anyone on the street these days and the conversation will inevitably turn to how inflation is increasing their cost of living in some form or another….



Talk to anyone on the street these days and the conversation will inevitably turn to how inflation is increasing their cost of living in some form or another. Inflation has risen steadily since the beginning of 2022 despite the determined efforts of Reserve Bank of Australia (RBA) to bring it back towards its target range of 2-3 per cent.

In less than 1 year and 11 interest rate rises later, official interest rates have risen from 0.10 per cent to 3.85 per cent but inflation remains stubbornly high at 7 per cent. Interest rates have never risen this fast before nor from such a historically low level either.

As previously outlined in an earlier blog entry on Commonwealth Bank (ASX:CBA), the big four banks of Australia have just under 80 per cent of the residential property mortgage loan market. In “normal” economic times of rising interest rates, banks should be natural beneficiaries of these conditions. However, these are not normal times.

The business model of banks has generally stayed the same for centuries, i.e. borrow money from one source at a low interest rate and lend it to a customer at a higher rate. Today, the Australian banks generally get their funding from wholesale and retail sources. However, the banks were offered a one-off funding source from the RBA called the Term Funding Facility (TFF) during the COVID-19 period to support the economy. This started in April 2020, priced at an unprecedented low fixed rate of 0.10 per cent for 3 years with the last drawdown accepted in June 2021 for a total of $188 billion. Fast forward to today and the first drawdowns from this temporary facility have already started to roll-off which means that these fund sources need to be replaced with one of considerably more expensive sources, namely wholesale funding or retail deposits. As a result of this change in funding, bank CEOs have unanimously declared that net interest margins, and hence its effect on bank earnings, have peaked for this cycle despite speculation that interest rates may still rise later in the year.

Prior to the start of the roll-off of TFF drawdowns, the entire Australian banking industry engaged in cutthroat competition for new and refinancing mortgage loans in a bid to maintain or grow market share. In the aftermath of the bank reporting season, two of the big four banks have stated they are no longer pursuing market share at any price, with CBA and National Australia Bank (ASX:NAB) announcing they will scrap their refinancing cashback offers after 1 June and 30 June respectively.

Turning our attention back to the average Australian, the big bank mortgage customers have been remarkably resilient. The Australian dream of owning the house you live in is still alive for now, with owners willing to endure significant lifestyle changes in a bid to keep up with mortgage payments. The big banks have reflected this phenomenon with a reduction in individual loan provisions and only a modest increase in collective loan provisions.

Time will tell how much more financial pressure Australian mortgagees can take, especially with the RBA still undecided on the future trajectory of interest rates. What has been agreed on by the big banks, is that things are not going to get easier. At least not in the short-term.

The Montgomery Funds own shares in the Commonwealth Bank of Australia and National Australia Bank. This article was prepared 29 May 2023 with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade these companies you should seek financial advice.

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U.S. Breakeven Inflation Comments

I just refreshed my favourite U.S. breakeven inflation chart (above), and I was surprised by how placid pricing has been. This article gives a few observations regarding the implications of TIPS pricing.Background note: the breakeven inflation rate is …



I just refreshed my favourite U.S. breakeven inflation chart (above), and I was surprised by how placid pricing has been. This article gives a few observations regarding the implications of TIPS pricing.

Background note: the breakeven inflation rate is the inflation rate that results in an inflation-linked bond — TIPS in the U.S. market — having the same total return as a conventional bond. If we assume that there are no risk premia, then it can be interpreted as “what the market is pricing in for inflation.” I have a free online primer here, as well as a book on the subject.

(As an aside, I often run into people who argue that “breakeven inflation has nothing to do with inflation/inflation forecasts.” I discuss this topic in greater depth in my book, but the premise that inflation breakevens have nothing to do with inflation only makes sense from a very short term trading perspective — long-term valuation is based on the breakeven rate versus realised inflation.)

The top panel shows the 10-year breakeven inflation rate. Although it scooted upwards after the pandemic, it is below where is was pre-Financial Crisis, and roughly in line with the immediate post-crisis period. (Breakevens fell at the end of the 2010s due to persistent misses of the inflation target to the downside.) Despite all the barrels of virtual ink being dumped on the topic of inflation, there is pretty much no inflation risk premium in pricing.

The bottom panel shows forward breakeven inflation: the 5-year rate starting 5 years in the future. (The 10-year breakeven inflation rate is (roughly) the average of the 5-year spot rate — not shown — and that forward rate.) It is actually lower than its “usual” level pre-2014, and did not really budge after recovering from its post-recession dip. (My uninformed guess is that the forward rate was depressed because inflation bulls bid up the front breakevens — because they were the most affected by an inflation shock — while inflation bears would have focussed more on long-dated breakevens, with the forward being mechanically depressed as a result.)

Since I am not offering investment advice, all I can observe is the following.

  • Since it looks like one would need a magnifying glass to find an inflation risk premium, TIPS do seem like a “non-expensive” inflation hedge. (I use “non-expensive” since they do not look cheap.) Might be less painful than short duration positions (if one were inclined to do that).

  • Breakeven volatility is way more boring than I would have expected based on the recent movements in inflation. The undershoot during the recession was not too surprising given negative oil prices and expectations of another lost decade, but the response to the inflation spike was restrained.

  • The “message for the economy” is that market pricing suggests that either inflation reverts on its own, or the Fed is expected to break something bigger than a few hapless regional banks if inflation does not in fact revert.

Otherwise, I am preparing for a video panel on MMT at the Canadian Economics Association 2023 Conference on Tuesday. (One needs to pay the conference fee to see the panel.) I have also been puttering around with my inflation book. I have a couple draft sections that I might put up in the coming days/weeks.

Email subscription: Go to 

(c) Brian Romanchuk 2023

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“What’s More Tragic Is Capitalism”: BLM Faces Bankruptcy As Founder Cullors Is Cut By Warner Bros

"What’s More Tragic Is Capitalism": BLM Faces Bankruptcy As Founder Cullors Is Cut By Warner Bros

Authored by Jonathan Turley,

Two years…



"What's More Tragic Is Capitalism": BLM Faces Bankruptcy As Founder Cullors Is Cut By Warner Bros

Authored by Jonathan Turley,

Two years ago, I wrote columns about companies pouring money into Black Lives Matter to establish their bona fides as “antiracist” corporations. The money continued to flow despite serious questions raised about BLM’s management and accounting. Democratic prosecutors like New York Attorney General Letitia James showed little interest in these allegations even as James sought to disband the National Rifle Association (NRA) over similar allegations. At the same time, Black Lives Matter co-founder Patrisse Cullors cashed in with companies like Warner Bros. eager to give her massive contracts to signal their own reformed status. It now appears that BLM is facing bankruptcy after burning through tens of millions and Warner Bros. cut ties with Cullors after the contract produced no — zero — new programming.

Some states belatedly investigated BLM as founders like Cullors seemed to scatter to the winds.

Gone are tens of millions of dollars, including millions spent on luxury mansions and windfalls for close associates of BLM leaders.

The usual suspects gathered around the activists like former Clinton campaign general counsel Marc Elias, who later removed himself from his “key role” as the scandals grew.

When questions were raised about the lack of accounting and questionable spending, BLM attacked critics as “white supremacists.”

Warner Bros. was one of the companies eager to grab its own piece of Cullors to signal its own anti-racist virtues.  It gave Cullors a lucrative contract to guide the company in the creation of both scripted and non-scripted content, focusing on reparations and other forms of social justice. It launched a publicity campaign for everyone to know that it established a “wide-ranging content partnership” with Cullors who would now help guide the massive corporation’s new programming. Calling Cullors “one of the most influential thought leaders in American public life,” Warner Bros. announced that she was going to create a wide array of new programming, including “but not limited to live-action scripted drama and comedy series; longform/event series; unscripted docuseries; animated programming for co-viewing among kids, young adults and families; and original digital content.”

Some are now wondering if Warner Bros. ever intended for this contract to produce anything other than a public relations pitch or whether Cullors took the money and ran without producing even a trailer for an actual product. Indeed, both explanations may be true.

Paying money to Cullors was likely viewed as a type of insurance to protect the company from accusations of racial insensitive. After all, the company was giving creative powers to a person who had no prior experience or demonstrated talent in the area. Yet, Cullors would be developing programming for one of the largest media and entertainment companies in the world.

One can hardly blame Cullors despite criticizism by some on the left for going on a buying spree of luxury properties.

After all, Cullors was previously open about her lack of interest in working with “capitalist” elements. Nevertheless, BLM was run like a Trotskyite study group as the media and corporations poured in support and revenue.

It was glaringly ironic to see companies like Warner Bros. falling over each other to grab their own front person as the group continued boycotts of white-owned businesses. Indeed, if you did not want to be on the wrong end of one of those boycotts, you needed to get Cullors on your payroll.

Much has now changed as companies like Bud Light have been rocked by boycotts over what some view as heavy handed virtue signaling campaigns.

It was quite a change for Cullors and her BLM co-founder, who previously proclaimed “[we] are trained Marxists. We are super versed on, sort of, ideological theories.” She denounced capitalism as worse than COVID-19. Yet, companies like Lululemon rushed to find their own “social justice warrior” while selling leggings for $120 apiece.

When some began to raise questions about Cullors buying luxury homes, Facebook and Twitter censored them.

With increasing concerns over the loss of millions, Cullors eventually stepped down as executive director of the Black Lives Matter Global Network Foundation, as others resigned.  At the same time, the New York Post was revealing that BLM Global Network transferred $6.3 million to Cullors’ spouse, Janaya Khan, and other Canadian activists to purchase a mansion in Toronto in 2021.

According to The Washington Examiner, BLM PAC and a Los Angeles-based jail reform group paid Cullors $20,000 a month. It also spent nearly $26,000 on meetings at a luxury Malibu beach resort in 2019. Reform LA Jails, chaired by Cullors, received $1.4 million, of which $205,000 went to the consulting firm owned by Cullors and her spouse, according to New York magazine.

Once again, while figures like James have spent huge amounts of money and effort to disband the NRA over such accounting and spending controversies, there has been only limited efforts directed against BLM in New York and most states.

Cullors once declared that “while the COVID-19 illness is tragic, what’s more tragic is capitalism.” These companies seem to be trying to prove her point. Yet, at least for Cullors, Warner Bros. fulfilled its slogan that this is all “The stuff that dreams are made of.”

Tyler Durden Sun, 05/28/2023 - 16:00

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