JP’s Journal: Admit what you don’t know

The current banking crisis is a great illustration of how markets work and why economics is not a science – despite attempts to convince that it is.

Confession time: I don’t know how the current situation will play out and that should give clients confidence. It’s time to batten down hatches, ensure portfolios are diversified, and be grateful for an investment approach that biases investment grade holdings towards secured debt. It is not time for heroics.

Banking is about confidence and trust; lose them and you are in trouble. Strong capital and liquidity ratios sound good on paper and are part of establishing confidence, but deposit flight will win out. Credit Suisse is a clear example of this. Despite reasonable headline capital and liquidity figures, evaporating confidence in the Swiss lender fed into depositor flight, bond market panic, and culminated in a forced rescue by rival UBS. And despite equity holders not being completely wiped out (simply a 90% loss over the last 12 months), the bank’s most junior bonds have been written down to zero. And whilst this circumvention of the traditional creditor hierarchy was allowed in those bonds’ legal contracts, it has caught many investors off guard. Predicting where we go from here after this tumultuous weekend is very difficult, and with so many variables and such a wide range of outcomes that I don’t think it is added value. Note to economists: try modelling this. I am sure that some will come up with a robust econometric model – after the event. But confidence, for both business and consumer, is central to how economies work and it is a very fickle thing; once lost, is not easy to get back. What we will do is to continue to act prudently and take appropriate risk where we see value. Looking across our strategies I believe that our exposure to banks, including Credit Suisse, fits this description.

Although uncertain, there will be real economic consequences stemming from this banking crisis and it reinforces my view that corporate profits will soon be coming under pressure. As an aside, I like podcasts and it is one of the reasons that we created the ‘5 Points’ Monthly Podcast for RLAM fixed income strategies. At the moment I am listening to ‘Break up of Big Oil’, telling the story of John D Rockefeller and the dismantling of his Standard Oil Company empire – I was not aware that Exxon and Chevron were founded from this breakup.

So, what is the relevance of this today? Well, I have been struck at how large global multinationals have been able to defend margins in the face of significant cost pressures. The simple answer is that they have been able to pass some costs to their clients and consumers. Looking at US operating margins, we can see that there has been an upward trend since the late 1980s. There has been cyclical variation, from a low of 5% to a recent peak of 12%, but there has been a definite upward slope over the last 30 years. Is this because companies have consolidated and become too powerful – shades of Standard Oil? I think this is a strong possibility.

So where next for margins? The recent modest decline has seen US margins back to their 30-year upward sloping trend line. My take is they are going lower and that the current banking crisis makes this more likely. Lending conditions will become tighter, businesses will cut back on investment and consumer will become more nervous.

Government bonds, unsurprisingly, were the winners from the financial turmoil. Yields on 10-year US treasuries ended the week at 3.4%, 60bps below early March levels. Looking at what is priced into markets, we can see that investors are looking at 3.75% – 4% for the year end Federal Funds rate; two weeks ago, this was well above 5%. In Europe, the trajectory is the same despite last week’s rate hike. The message from the European Central Bank (ECB) is that it stands ready to respond if necessary to the banking crisis. On the issue of whether there was now a trade-off between financial stability and price stability, the ECB message was ‘there is no trade-off’. Markets, however, disagreed with German 10-year yields now hovering just above 2%, well down from the recent high of 2.7%. Investors are saying that the latest hike may be enough, given the deteriorating financial conditions.

In the UK we had a budget – which had some significant changes for pensions, business investment and childcare. However, it got drowned out by market events. Yields on 10-year gilts finished at 3.3% with markets signalling that the UK bank rate would end the year at current levels.

Credit markets reacted true to form. Investment grade credit spreads widened last week, with indices moving out around 30bps. Bank debt was most impacted; as an example, a sterling subordinated bond issued by Barclays Bank at par in February, was trading 6% below issue price on Friday despite the rise in government bond prices. High yield debt was even more impacted, with credit spreads on mainstream indices 100bps above recent lows.

The bottom line is that the current turmoil will lead to tighter credit conditions and sagging confidence. This will dent those high corporate profit margins, setting off second round effects. It is ironic in the week that the Office for Budget Responsibility said the UK was going to avoid recession that events were developing that made a recession more, not less, likely.

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.