Market commentary
This year has been challenging. The positive sentiment on the economic outlook as energy costs fall has been countered with persistent inflation and banking sector concerns with the collapse of Silicon Valley Bank and Credit Suisse in March.
April saw banking worries subside following the lack of further major negative news but the collapse of First Republic earlier this week and subsequent sale to JP Morgan has reignited fears. Sentiment can play a key role in the health of the financial system and can quickly contribute to problems for banks. As we discussed last month, the banking system has been stress tested regularly since the Great Financial Crisis of 2007-2009 and remains robust. In addition, Central Banks have learnt the lessons from this period and have acted swiftly to provide support to banks in the last few months.
5th May 2023
-
Gavin Jones See profile
Economic activity has been more robust than was envisaged at the start 2023 and while a recession may still be on the cards for later in the year, it is now forecast to be far milder than previously thought. It is still likely to be a challenging environment for businesses and households with the impact of higher prices.
The recent turmoil in banks has led to the Band of England considering an overhaul of the UK Financial Services Compensation Scheme (FSCS), including an uplift in the current £85k limit.
Government policy will now have one eye on the next general election (expected to be in 2024) and with the Conservatives being behind in the polls for some time, they will be looking for opportunities to narrow the lead. Rumours have already started for measures in the Autumn Statement such as cuts to Income Tax and a National Living Wage increase, despite it only being April.
Data points to the European economy having avoided recession this winter despite the massive challenges from energy prices and the conflict in Ukraine.
The banking crisis saw Credit Suisse being bought by UBS in a deal brokered by the Swiss authorities. However, the financial sector seems to have recovered since with Credit Suisse’s problems largely seen as being contained.
US banking stress, while being managed, does not seem to be going away. The Federal Reserve has put in place significant support for banks and the reliance on this appears overall to be steady suggesting the problem is not getting worse. With the ease of moving deposits in today’s online world, any sign of weakness can lead to account holders leaving and this has a knock-on effect. It is also perhaps less well known that small regional banks in the US do fail reasonably regularly – there have been 70 failures in the last 10 years. The impact of this is usually limited.
Markets are now fretting over the debt ceiling impasse. The US have imposed a cap on the total amount of Government debt that can be issued. The Democrats and Republicans are no closer to an agreement to raise this $31.4trillion debt ceiling. If the limit is not increased, it means that everyday spending is affected. This means many federal services will not be able to pay their staff and many central services will stop. The US Treasury introduced ‘extraordinary measures’ in January to reduce the cost of Government departments but this is only expected to defer the possibility of US debt default until June, after which time payment of interest on treasuries may be at risk. The US has never missed a payment on its debt and failure to do so will have a major impact on markets. The Republicans did offer a $1.5trillion rise in the ceiling, contingent on $130bn of cuts in Federal spending and a reversal of other areas of the White House agenda. This was flatly rejected by Joe Biden, but he has invited representatives of both parties for talks. While still seen as unlikely the threat of a default in US debt will impact on confidence.
China’s growth in the first quarter reflected the end of the Government’s zero covid policy and showed a larger than expected rebound in activity. On an annual basis, economic output grew by 4.5%, beating the expected 4% rise. Monthly data for March was published at the same time and provided further signs that the Chinese consumer was back spending following the end of social restrictions.
With peak headline inflation around the world now seemingly in the rear-view mirror, the question is turning to when a pause in interest rate rises will emerge. In Asia this has already begun and Korea, benefiting from an increase in global optimism, is even mulling the prospect of reducing interest rates.
As markets reacted to fears of a banking crisis, Government bond markets went from pricing in rate hikes to discounting sizeable rate cuts in some markets.
For the major central banks, core inflation is proving to be more resilient than hoped for and it is thought there will be one or two more hikes in interest rates in the coming months. A pause in rate increases is within sight and market prices predict interest rate falls may happen in the US this year and next year in Europe and the UK.
In the UK, these market prices almost certainly expect another 0.25% increase from the Bank of England at its meeting on 11 May, taking the rate to 4.50%, a rate last seen in October 2008, just before the financial crisis-induced plunge to near-zero.
The strong possibility of another 0.25% increase in the US interest rate was confirmed at the Federal Reserve meeting on Wednesday. US interest rates now stand at 5 – 5.25%.
Recent speeches from European Central Bank council members continues to suggest more rate increases to come and the 0.25% increase at May’s meeting this week expected. The European Central Bank (ECB) deposit rate is now 3.25% but tightening started later, it was still -0.5% a year ago.
The global short-dated high quality fund has been a steady performer through this time with the index linked bond fund seeing some falls as the fears of the banking crisis subside. During the banking turmoil in March, we saw bond yields fall leading to some capital growth in these defensive assets and reinforcing the need for bonds at times of stress.