JP’s Journal: Déjà vu, maybe

It was my birthday last Monday, and I took the day off work, which I don’t usually do on my birthday but I’d planned for it and, I have to say, it made a pleasant change.

Given the fairly unavoidable news of the hurried sale of Credit Suisse to UBS over the weekend, however, it was hard to not to think about what was happening in the markets as I lunched with my wife and had dinner with the whole family in the evening.

Somewhere in the background at lunch, perhaps to remind me of my age, came the sound of a familiar 1970s song, Déjà vu, from the eponymous album by Crosby, Stills, Nash & Young. The song is pretty much imprinted into my memory from hearing it almost from birth. The singer (David Crosby, who died in January this year) explained the feeling of 'déjà vu' by asking how else he could explain knowing how to sing harmonies since the age of six or knowing how to sail a boat the first time he got on one. So, as the song goes, “If I had ever been here before, I would probably know just what to do”, before concluding “We have all been here before”.

There’s no denying that recent events – a couple of bank failures, others under significant pressure, and the whole financial system seemingly at risk of collapse – appear more than vaguely familiar. But have we really been here before, not just somewhere like it? In my view there are two clear differences.

First, this is not a financial crisis but a crisis of confidence. Notwithstanding the reportedly questionable risk management and controls at Silicon Valley Bank (SVB), and reported weaknesses in financial reporting at Credit Suisse, little has changed since the aftermath of the Great Financial Crisis, which included an overhaul of bank capitalisation. But banks also still rely on depositors depositing and borrowers borrowing, and those depositors not all withdrawing all their deposits and those borrowers not all defaulting on their payments at the same time. Nothing about this simple model has changed since 2010. Indeed, in that respect, not much has changed since the 18th century BC and the Bank of Babylon. This is not about borrowers’ inability to pay the interest on their loans (although this may become more challenging as rates rise). It is about confidence in the system to the extent that depositors are happy that, when they do eventually need cash, they can get it. The only aspect of recent events that could be referred to as being systemic is the size and importance of some of the banks under the spotlight, such as SVB (the biggest US bank run since that of Countrywide Financial in 2007; it may have been niche in its client base but was not a small bank) and Credit Suisse but also including the buyer of Credit Suisse, UBS. As I write, I am seeing news stories in relation to well-capitalised national champion Deutsche Bank, and the issuer is under pressure. Another potential bank run in the making. The biggest risk here is panic and that of contagion.

Second, interest rates are rising. Still rising. The broad expectation has been that inflation will fall, and it will, but it is being stubbornly persistent; in the UK, the most recent monthly Consumer Price Index inflation figure (February: 1.1%) was so shockingly high that it pushed the one-year figure unexpectedly higher (10.4% from 10.1% versus 9.9% expected). Were it not for the need to keep fighting the war against inflation, however, raising rates would be the last thing central banks would want to do in an environment in which the banking sector is under such stress as it is now. It had been thought that, as corporate and retail banks compete for new depositors (and to keep existing ones on board) and, consequently, balance their books on their lending business, they would raise their rates and thus do some of the work for central banks. But, over the last week or so, each of the European Central Bank (ECB), US Federal Reserve and Bank of England (BoE) has raised rates regardless.

So I am clear that we have not been here before. If we had been, perhaps we could relax in the knowledge that we would know what to do. Instead, we will need to rely on central bankers to navigate this untrodden path between high inflation and banking stress (not to mention the risk of recession).

It would be remiss of me not to mention, specifically, the events of last week in the context of bond markets. Even though everything that actually happened (the sale of Credit Suisse to UBS and the write down of Credit Suisse Additional Tier 1 (AT1) loss-absorbing bonds to zero) had happened by the time I opened my eyes to cards and balloons on Monday morning, the markets had still to react. Unsurprisingly, spreads of financial sector bonds (particularly subordinated) peaked sharply, taking spreads of the wider market to a level last seen at the beginning of the year, thus wiping out the strong gains made by credit in January in particular. Were it not for a rallying government bond market, year-to-date sterling investment credit returns would probably have gone from c5% at the end of January to negative. By Tuesday, the market had calmed significantly, and spreads retightened meaningfully. In the banks sector, senior bonds had almost fully recovered. As I write, year to date returns for the sterling credit market are c3%. But the market will take time to fully heal. And between now and then there may be further challenges and tests of confidence.

Investors in Credit Suisse AT1 bonds have lost almost all value. The arguments over whether the full write down of the bonds (a result of the Swiss Regulator claiming a ‘viability event’) was allowed, or whether the bonds did what they were intended to do or not, will continue for some time. The BoE and ECB made their views quite clear. I like to think of myself as a glass-partly-full type of person (even when it is only one-third or one-quarter-full). So, I can at least think that the AT1 bonds did their intended job – helping save the financial system from an even more disorderly failure.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.