How does the banking crisis impact the market outlook in 2023?

Although markets appear to have regained some composure, it has been an unsettling period for investors. The spectre of a systemic banking crisis has created significant volatility in equity and bond markets in the wake of the collapse of Silicon Valley Bank in the US and the fears over Credit Suisse in Europe.

Markets may have recovered some stability, but how does this affect the outlook for markets in 2023?

The current situation partly has its roots in the significant interest rate hikes seen in 2022. Silicon Valley Bank found itself forced to sell its holdings in long-dated bonds to meet cash withdrawals from its (predominantly technology-based) clients. In doing so, the bank realised a considerable loss. A vicious cycle developed whereby nervous deposit holders sought to withdraw their cash as fears over the bank’s health mounted, forcing it to realise more losses, weakening its financial position. Ultimately, the bank collapsed, the Federal Reserve and regulators stepped in to help depositors and inject money into the business to improve liquidity.

Credit Suisse didn’t have the same exposure to higher rates, but it became a focus for broader worries about the banking sector and saw significant depositor outflows. There were already concerns over the bank’s profitability and overall business model. These concerns appear to have been alleviated, for now, following the acquisition of the company by UBS.

Bond markets have moved to reflect expectations that the turmoil would force a significant change in interest rate policy from the Federal Reserve (Fed) and other central banks. This may be premature. The February CPI report and tight US labour market show inflationary pressures remain.

The Fed’s decision to raise interest rates by 0.25% on the 22 March balanced the need to tackle elevated inflation while also maintaining financial stability. This was lower than the 0.5% increase expected by markets at the start of the month, signalling that the Fed intends to tread carefully as it navigates volatility in the banking sector.

The decision was accompanied by a more conciliatory tone from the Fed Chair, Jerome Powell, and the move has been interpreted by financial markets that the Fed are likely to ease off on raising interest rates.

• The first, and most optimistic scenario, is that these events prove isolated. The problems are brought under control, confidence returns to markets and the economy remains resilient. In this situation, the Fed would continue with its original plan to keep rates tight throughout 2023
• A second scenario would see banks become more risk averse as financial conditions deteriorate. Small bank lending would fall, which would hurt economic activity and lead to a higher number of defaults. More problems could emerge in the financial sector. In this case, the Fed may be forced to ‘pivot’ and cut interest rates later in the year
• The final scenario is a deep banking crisis. Economic activity contracts sharply, leading to a prolonged recession. This would prompt the Fed to cut interest rates immediately and force it to inject more liquidity into the financial system to reduce the risk of contagion

The speedy and decisive response from policymakers supports a more optimistic outcome. The US Federal Deposit Insurance Corporation, an independent agency which focuses on maintaining financial stability, has moved in to protect deposits. Meanwhile the Fed enacted the Bank Term Funding Programme, which increases lending to banks. The Swiss central bank acted swiftly to get the UBS/Credit Suisse deal over the line. It’s been a robust response, which should help settle investors’ nerves.

However, there are arguments against this being an isolated event. There remain significant unrealised losses at smaller US commercial banks. It is not yet clear whether they have hedged these risks and whether they will be forced to divest assets (and crystallise losses). Equally, there may be other sources of stress in the system that have not yet been uncovered.

An extreme Global Financial Crisis-style meltdown also looks unlikely. While there are potentially risks in areas such as US commercial real estate and global housing markets, the global banking system remains well-capitalised. Tier 1 capital is significantly higher than during the last crisis, allowing banks to withstand negative shocks. Banks have also addressed risks in their short-term cash holdings. Central banks have new tools to provide liquidity and their quick response shows a ‘whatever it takes’ approach to averting a global crisis.

Against this backdrop, a midway scenario is our base case. We have already seen a fall in bank lending over recent months. As risk aversion and regulatory scrutiny of small banks increases, aggregate lending is likely to fall. This will hit economic activity, leading to more defaults and further tightening of lending conditions. This could threaten the stability of the financial system. If it reaches this point, central banks and financial regulators would step in.

There are a lot of moving parts when it comes to judging the investment implications. It will be important to monitor the situation as it evolves. We remain cautious and continue to prefer defensive sectors in the stock market. We have refrained from making knee-jerk decisions as we continue to assess the fallout from these events.