Will there be further casualties of higher interest rates?

The first quarter of 2023 began with the optimistic hope that US inflation and interest rates would peak with minimal economic damage. It ended on a far more cautious note, as investors assessed the fallout from the largest US bank failure since 2008 and the rescue of Credit Suisse by UBS.

It was always likely that the regime shift we have seen in interest rates over the past year was going to cause some casualties. The UK pension system was close to being the first, as unexpected policy shifts in Downing Street sent the struggling bond market into meltdown. Almost six months later, investors were caught off-guard by the collapse of Silicon Valley Bank, a specialist bank focused on the venture capital and technology communities.

US banks have given up their post-pandemic lead
Performance of key regional bank indices

Source: Refinitiv Datastream. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up.

The technology sector has been under pressure since interest rates started rising in late 2021. Valuations have fallen, venture capital funding has been scarce and the IPO market almost closed. SVB’s clients were impacted by all of these factors, but the bank’s downfall was not caused by speculative investments that went wrong. It came unstuck because it got two basic elements of banking badly wrong – ensuring a diversified deposit base and managing its interest rate risk. It is an unfortunate coincidence that its fall came just as artificial intelligence looks set to unleash a new era of technological innovation.

Steps taken by US authorities to protect depositors should stem the risk of contagion. Even so, fears about investment losses and deposit flight have spread across the global banking system – especially in Europe. In aggregate, the global banking system is in a robust position as a result of the reforms introduced in response to the crisis of 2008. But there could well be other “weak links” exposed in this more risk-averse environment, giving rise to further volatility. It’s an important reminder that increasing interest rates – especially at the pace we have seen over the past year – comes with a significant impact on economies and businesses. And while SVB was an extreme and unintended example, it is worth remembering that tighter monetary policy is meant to slow banks’ appetite to lend, as well as consumers’ to borrow.

So far, data suggests that US economic activity has been surprisingly resilient - despite the rate increases we have seen to date. Initial estimates indicate that the economy added over 300,000 jobs in February. Core inflation remained at 5.5%, only marginally lower than the year-on-year pace recorded at the end of January. In the wake of SVB’s demise, markets were quick to assume that the Federal Reserve’s may move to a more accommodative policy stance. This could prove optimistic and the Fed may push ahead with further interest rate increases.

Inflation may have peaked but remains very high

Core inflation (excluding food and energy) in the US, UK and Eurozone. 

Source: Refinitiv Datastream

Against this backdrop, the rally we saw early in the year has petered out and global equities and bonds remain significantly below their peak levels from late 2021 and early 2022. Following its relatively strong performance last year, the UK’s FTSE100 inched its way towards a record high in February. However, this was very quickly followed by public handwringing about the future of the UK’s capital markets as a number of high-profile companies opted to list in more dynamic markets abroad. Since then, the index has lagged global markets as it has been dragged lower by its high exposure to the financial sector.

The China effect

Following the end of zero-Covid restrictions, China’s coronavirus exit wave appears to have been less disruptive than many feared. This has paved the way for a rebound in consumer spending. Schroders’ economists have raised their expectations for Chinese GDP growth in 2023 to 6.2%, from 5.0% previously. Given the country’s size, this demand boost is likely to mean global economic growth in 2023 will also be higher than previously expected.

On a relative basis, China’s recovery may not be as striking as the rebound experienced in the US and some other developed markets. The US provided significant direct support to households, creating a large savings buffer that boosted consumption long after pent-up demand from the pandemic had run its course. In China, by contrast, savings rose only modestly during the pandemic. This makes it less likely the economy will overheat. And with the rebound being driven by demand for services, rather than more resource-intensive sectors, there may also be less of a boost for commodities than we have seen in previous Chinese recoveries.

Ukraine and the new world order

It has now been over a year since Russia’s invasion of Ukraine and sadly the conflict shows little sign of deescalating. The picture on the ground remains grim, with both sides preparing for renewed military offensives. As things stand, however, the conflict is no longer really a focus for markets.

That could change, of course. Ukraine needs to be seen as a symptom of a more complex, fragmented world order in which the US and China are increasingly at odds with one another. Last month, US officials raised the worrying prospect that China is considering providing more military support to Russia. This could lead to a very unwelcome escalation of the conflict as well as a significant deterioration in Sino-US relations. The consequences for the global economy could be severe. As investors, this new world order is something we are very cognizant of. To the extent that it leads to higher volatility, it could require more active management of portfolios. It is also likely to open up new thematic opportunities. Automation is one area we are focused on, as companies increasingly look to localise their supply chains. So far, Asia has led the way in automation. The US and Europe could be on the verge of a significant catch-up.