The crucial questions – understanding the current market

Partnervest

In moments like these when events are rapidly unfolding and investors struggle to keep up with volatile markets, it is important to step back and ask three crucial questions:

1. Is a systemic financial crisis unfolding?
2. Will central banks stop hiking rates?
3. What actions can policymakers take to stabilise banks, financial markets and the economy?

Here are our current thoughts:

A decade of cheap funding and deposit stability had ended.

Over the past decade, zero interest rates made for stable bank deposits because nothing offered a more attractive return. Following 4.75 percentage points of US Federal Reserve (Fed) rate hikes that began 12 months ago, deposit holders have choices, such as money market funds that offer more compelling returns and are nearly as liquid.

Rising rates pose challenges to the asset side of banks’ balance sheets. That became plainly evident at Silicon Valley Bank (SVB), where losses on unhedged bond holdings blew a hole in the bank’s earnings, leading to its collapse. Other banks may have managed interest-rate risk better, but given the opacity of their holdings, their hedging strategies and their reporting, this lack of transparency is unsettling.

Recent central bank tightening could be a positive signal.

The European Central Bank (ECB) hiked rates 50 basis points (bps, one basis point equals 0.1%) last week, sending a message to markets that policymakers do not think the situation is as bad as many have thought. Similarly, the Fed raised rates 25 bps this week, and also stated that it sees the US banking system as “sound and resilient.” By their actions and their words, the ECB and the Fed are trying to bolster confidence that the financial system and economy are stable enough for them to remain focused on their priority of bringing inflation down to more acceptable levels.

Depositors must be reassured.

Banking crises are pernicious because once depositors question the strength of banks, rapid withdrawals quickly follow, putting at risk both weak and strong banks. In the United States, the Fed, Federal Deposit Insurance Corporation (FDIC) and Treasury have taken significant steps through expanded deposit insurance and liquidity provisions to reassure depositors. The Fed has also extended US dollar swap lines with other central banks to ensure that other countries have adequate access to dollar liquidity. Longer term, bank regulators must expand their efforts to properly supervise banks, including using new stress tests. They must also merge or consolidate failing banks where necessary. One area of particular importance is to review bank holdings of marketable securities that could be a source of future write-downs in the event of asset sales to meet liquidity needs.

To bolster depositor confidence, regulators must be empowered to force changes to bank risk management practices where necessary.

Central banks must not shy away from making clear statements about cyclical risk and how banks should view the quality of their loan portfolios.

Rapid and aggressive monetary policy almost always produces a recession. Central banks must apprise banks of economic risks and regulators must undertake scenario and stress-testing of loan books to assess proper provisioning policies and, where necessary, potential capitalisation needs. Those examinations must be made in advance of any cyclical deterioration in credit quality.

As beneficiaries of deposit protection, banks must be adequately supervised and regulated. Increasing transparency of banking is in everyone’s interest. Greater transparency helps to stabilize the economy and financial markets.

Banks have always been and will remain systemically risky because of the liquidity mismatch between banks’ assets and liabilities. The onset of aggressive monetary policy tightening has increased systemic risk on both sides of bank balance sheets. When depositors are fearful, runs can be indiscriminate. Steps taken since the failure of SVB to implicitly extend deposit insurance, to provide central bank liquidity and to absorb Credit Suisse into UBS have calmed market fears.

While the opaque nature of banking should always caution us against firm conclusions, the available information leads us to conclude that systemic risk is receding. That will allow central banks to remain focused on reducing inflation.

Partnervest – Building Diversified Portfolios

At Partnervest, we offer portfolios designed to provide diversification based on a careful analysis of the underlying exposures within. These portfolios are then adjusted to consider the relative attractiveness of different each asset class given the prevailing economic conditions, whilst maintaining targeted risk and return parameters. 

Our online platform is designed to make it easy for you to allocate your cash to a portfolio of carefully selected investment products designed to harness the benefits of diversification, and specified to target risk and volatility levels. In a world of rising uncertainty and fast-moving markets, having a partner that can help you invest your wealth quickly, easily, and intelligently can make all the difference.

To learn more about how Partnervest can help you build your financial future, contract Serg Premiere 1300 734 496 or email [email protected].

Authors: Stephen Dover, CFA Chief Investment Strategist Head of Franklin Templeton Institute

This article was originally published in on the Franklin Templeton Australia website – Partnervest is a division of Franklin Templeton Australia Limited (ABN 76 004 835 849, AFSL 240827

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