Equities: Into the world of unknowns

Financial conditions still not tight enough to curb inflation, and mild weather in Europe averting an energy crisis were also two important factors in the strong animal spirits helping equities to advance. However, in February, after the initial sprint higher in equities, Fed Chair Powell sent a strong message to the market, which, in short, can be phrased as recession by design. This means that the Fed is intending to do whatever it takes to cool inflation, which means higher policy rates, and higher for much longer than previously thought. This signal got US bond yields to rally hard until something broke, which happened to be Silicon Valley Bank, the second largest US bank failure in modern times, resetting the idea of higher policy rates at all costs to cool inflation.

The strong equity market in the first two months of the year -- despite mixed Q4 earnings and a blurry outlook due to cost pressures -- has pushed our MSCI World valuation model considerably above the historical average, lowering the future expected real rate return. At the current equity valuation, there is a 30% probability that equities will not deliver a return above inflation, which, in a historical context, is a bad starting point. But most investors will look at bond yields and think that those returns do not look any better, and especially not if inflation is sticky. We live in a world of lower expected returns until asset classes have adjusted to lower valuations amid the acceptance of structurally higher inflation.

Fragmentation means pain, but also opportunities

Globalisation, measured by world trade volume, was running hot in the years 2001-2008, when China’s inclusion into the WTO changed the game, unleashing a race to offshore manufacturing as fast as possible to unlock higher operating margins and shareholder gains. Global trade volume rose 7.8% annualised during this period. The financial crisis killed the credit boom and China’s economy was also not the same, and over time it lost its momentum due to increasing regulation, state centralisation, debt leverage, and recently a real estate crisis. Trump’s trade war did not help either and 2019 looked weak in terms of trade volume, as the global economy slowed. In the years 2011-2022, global trade volume has slowed to just 2.2% annualised growth, reflecting that the low hanging fruits of globalisation are over.

The Fragmentation Game is essentially a strategic geopolitical dynamic of ensuring more robust access to energy, technology and defence among large competing nation states. Electrification and the green transformation are a direct strategy towards independence in energy delivery, which, after the war in Ukraine, is evidently a key strategic variable for any nation state. The green transformation will be positive for metals such as lithium and copper, and it will be positive for growth in electric utilities, everything related to solar power, and energy storage systems. Opportunities in these areas will be big for equity investors, and everyone is waiting for the EU to roll out their own version of the US Inflation Reduction Act.

Semiconductors play a key role in our modern economy and without a stable supply chain of semiconductors, military equipment, cars, advanced machinery equipment, computers and data centres are impossible. The US CHIPS Act has changed the semiconductors industry and a large amount of investments are now being deployed in both the US and Europe. Our semiconductor theme basket is our best-performing theme basket this year, reflecting the strong growth outlook helped by this big new US industrial policy shift. Our defence basket is another theme that is performing well this year, reflecting the fact that the war in Ukraine could take years to resolve, and Europe will have to do more on its own in terms of defence. We remain overweight in both themes.

The Fragmentation Game will also mean reshoring, with countries such as India, Vietnam and Indonesia winning relative to other emerging market countries. Logistics companies will continue to thrive and maybe even more in the Fragmentation Game, because logistics will become more complex, thus yielding higher margins. It will also mean stronger fiscal policies to guide the transition, and the consequences will most likely be higher costs for companies, and thus lower margins. Fragmentation of the global economy will likely put inflation at a higher structural level, and the cost of capital will likely go up, squeezing low quality and leveraged companies.

Fighting inflation puts banks under pressure

Could the Fed hike the policy rate by 450 basis points without breaking anything? That was the big question everyone was asking, and financial conditions suggested that was the case. But then SVB Financial ran into trouble, losing deposits to a degree that forced it offload $21bn in available-for-sale bonds, triggering a loss of $1.8bn. The subsequent equity offering to plug the hole and avoid offloading its almost $100bn held-to-maturity bond portfolio at steep losses spooked the market. The last depositors out the door could lose a large share of their uninsured deposits. The US government stepped in with a full guarantee of all uninsured assets.

However, the damage had already been done. In a few trading days there was a rush to convert deposits to short-term bonds, causing the US 2-year yield to plunge 109 basis points over just three trading days. The move reverberated through all markets, upending trend-following hedge funds and causing two consecutive trading sessions with a 0.1% tail-risk loss for CTA funds, including the biggest single-day loss for this type of hedge fund.

The banking system was put under pressure, with several smaller banks in the US scrambling for deposits, pushing the Fed’s discount window balance to $156bn in a single week and to the highest level since the Great Financial Crisis. Big unrealised losses in held-to-maturity bonds suddenly looked fragile and dangerous, in case a bank’s deposits were not stable. A big deposit game has been initiated. The big blow to confidence in banks ended up with the Swiss government’s shotgun marriage of UBS and the troubled Credit Suisse. To make things worse, the Swiss rescue design of Credit Suisse included money on the table for shareholders and a complete wipe-out of the additional tier 1 (AT1) capital holders, who are above shareholders in the capital structure.

The long-term consequences of the US government’s full guarantee of uninsured deposits and the Swiss move to wipe-out AT1 capital are unknown and could come back to haunt the economy and markets for years. One potential outcome is weaker banks losing access to deposits, their main funding source, which could lead to fewer banks and more concentration in the banking industry. The AT1 market might never be the same, or at least trading at such a premium that banks will rush to call these bonds, as the current yields will destroy shareholder value .

Banking stocks, especially the European banks, were the key trade among macro investors, as the net interest margin was rapidly expanding in 2022 as banks were not pressured to pass on the higher rates to depositors. The US 3-month yield is around 4.51% (as of 20 March) compared to the average 3-month time deposit rate in the US at 0.61% in February, according to the FDIC. A closure of this yield gap will mean the end of the macro bet on banks. The SVB fallout could lead to depositors questioning the deposit rate relative to short-term bond yields, causing a significant jump in the short-term funding rate for banks and thereby squeezing their profitability. Or even worse, if aggregate deposits continue to fall, which is currently on a scale not seen since 1948, then forced selling of assets, with many sitting on unrealised losses due to higher interest rates, could be the next risk lurking on the horizon for markets.