moral hazard (noun): a situation in which people or organizations do not suffer from the results of their bad decisions, so may increase the risks they take.
Cambridge Business English Dictionary
For the first quarter of 2023, most global equity markets delivered gains (and some double-digit increases), while the Canadian bond market posted a return north of 3%. Given the Q1 seesaw price moves in global capital markets, this may come as a surprise to some.
March saw the second and third-largest bank failures in U.S. history. Switzerland’s iconic Credit Suisse was rescued in a hasty takeover by a rival bank. These failures prove the old adage that central banks tighten monetary policy until something breaks.
We believe the banking situation is currently under control because we have a liquidity concern, not a solvency concern. What’s the difference?
Liquidity is a measure of a bank’s cash and other assets, although they aren’t accessible on demand. Liquidity is less about the quality of a bank’s assets and more about the timing of cash flows. The U.S. banks in question had ample, high-quality assets, but they had too much money tied up in long-maturity government bonds. They were caught short when depositors decided they wanted their cash immediately and caused a run on the bank.
If a bank’s debts are greater than its assets, it has a solvency problem, which is much more serious than a liquidity problem. This happens when depositors want their money back, and the bank doesn’t have the assets to meet that obligation (i.e., loans or mortgages to households or businesses that have gone sour). It’s not merely a timing problem; the money is gone (we recommend the film classic It’s a Wonderful Life for Oscar-winner James Stewart’s speech that explains how banks work – and staves off a bank run at Bailey Building and Loan).
Silicon Valley Bank had a liquidity problem after it invested too much money in long-term U.S. government bonds. It was forced to sell them at a loss (thanks to rapidly rising interest rates) when depositors demanded their money.
To avoid a banking crisis, the U.S. central bank, deposit insurance agencies and Treasury Department swooped in to put out the fire. Most important, to prevent contagion the rules were changed so that banks could swap their government bonds for cash at par. If this had been a solvency situation, the quality of the assets would be dubious (as in default-worthy) and this swap-out provision would not be an option.
In this particular liquidity scare, the risk-off environment across the capital markets saw money flow into government bonds, sending the yields down and the prices up. As the prices of government bonds rose in value, they were easy to sell or post as collateral, thus avoiding the cycle of doom. This is the opposite of a solvency crisis, where the value of the assets at the heart of the problem continue to go down in price.
This banking shock brings financial stability (the fundamental job of all central banks) to the top of the central banks’ to-do list while they also work to tame inflation and bring back price stability. Although the risks of broader contagion are likely limited, we do expect some pullback in the amount of credit flowing to the economy. We have said before that capital markets are adjusting to high inflation, higher interest rates, less easy money, slowing growth, and increased geopolitical tensions. We continue to believe a lot of progress has been made on these fronts. Even though inflation is falling, the economy and financial system have become more fragile. In our view, North American central banks need to back off on raising interest rates.
Weathering this financial system crisis might have jolted central bankers just enough to make them adopt a more wait-and-see approach to rate hikes. The positive performance from both stocks and bonds in March suggests the capital markets believe central bankers got this message. In fact, current bond-market pricing points to the Fed Funds rate being closer to 4% than the current 5% by December.
Canada – Appropriate pause
For March, the S&P/TSX Composite fell 0.6% and remains up 3.7% on the year. The Bank of Canada (BoC) raised the overnight rate to 4.5% in January and signalled it would hold steady to assess whether the cumulative rate increases are curbing inflation. The BoC was the first major central bank to begin raising rates and is the first to pause, so it wins the award for smartest central bank. A breather seems appropriate while the economy is giving mixed signals. Canada’s housing market remains weak, and businesses are dialling back their capital investments. However, employment, household spending, and incomes remain strong.
Canada boasts one of the lowest inflation rates in the G20. Annual Consumer Price Index (CPI) inflation eased for a fourth month, slowing to 5.2% in February from 5.9% in January. However, profligate government spending and endless deficits at a time of more than full employment will not help.
Global banking turmoil weighed on Canadian bond yields, boosting bond prices and sending the FTSE Canada Universe Bond Index up 2.2% for March (up 3.2% on the year). Canadian 2-year yields fell from 4.20% to 3.73%, and 10-year yields fell from 3.33% to 2.90%. Increased concern of a global recession weighed on oil prices. The price of West Texas Intermediate oil fell 1.8% for March and 5.7% for the year to US$75.67 per barrel. The loonie fluctuated between US72¢ and US75¢ over the first quarter. Last month, it gained 1% to US$0.740, or C$1.352 per U.S. dollar.
United States – “May” pause
Much of 2023's volatility was caused by the U.S. Federal Reserve (the Fed). The central bank’s messaging flip-flopped from dovish to hawkish back to dovish, sending the bond market on a wild ride. Equity markets celebrated the quick containment of the banking turmoil.
Markets hope that banking woes will persuade the Fed to halt rate hikes sooner than expected. However, in the larger context banking problems aren’t good for the economy. Corporate earnings expectations have come down to reflect some economic weakness, but it’s not clear how much things will soften.
The Fed’s job has become trickier. Its primary goal is financial system stability, with price stability (inflation) viewed as a longer-term prerequisite to that goal. Although annualized U.S. CPI inflation fell to 6.0% from 6.4% (the Fed’s preferred inflation measure), core inflation, which is based on Personal Consumption Expenditures (PCE), isn’t falling as fast. In the thick of March’s banking turmoil, the Fed pressed ahead with a quarter-point rate increase. Fed Chair Jerome Powell said, “some additional policy firming may be appropriate," later emphasizing “some” and “may.” We sense that the Fed wants to stop hiking rates, but if wage growth and inflation don’t cooperate, it will have to continue to respond.
For March, the S&P 500 gained 3.5%, leaving the index up 7% on the year. U.S. 2-year government bond yields fell from 4.82% to 4.03%, and 10-year yields fell from 3.92% to 3.47%.
Europe – No pause yet
European equity markets were among the top performers for Q1. The troubles at Credit Suisse and Deutsche Bank to a lesser extent rocked markets, but the hastily forced marriage between Credit Suisse and rival UBS saw markets quickly rebound. Mirroring the failed U.S. banks, management decisions at Credit Suisse and Deutsche Bank are to blame rather than broad-based banking sector woes. Both European banks have been scandal-plagued for many years.
Equity markets cheered better-than-feared economic data and energy prices continued to fall. Eurozone CPI fell to 6.9% in March, down from 8.5%. Core inflation rose one tenth to 5.7%, an all-time high, so the European Central Bank still has work to do. However, the Credit Suisse scare means financial stability must also become a priority. The U.K. is an exception; inflation is running hot (10.4% year over year in February), but the economy is proving much more resilient than expected. Some are now pencilling in growth for 2023.
For March (and the quarter), the Euro STOXX 50, German DAX, and U.K. FTSE 100 stock market indices posted returns of 1.8% (13.7%), 1.7% (12.3%), and -3.1% (2.4%), respectively.
Asia – Can’t pause what hasn’t started
China’s reopening continues to progress, although manufacturing is cooling amid slowing global growth. The services-oriented economy is snapping back with purpose as a key indicator (non-manufacturing PMI) punched a 12-year high. Geopolitical tensions simmered over the quarter. The tit-for-tat battle playing out with technology-company sanctions continues, with both Chinese-owned TikTok and U.S.-based Micron Technology in the headlines. Monetary policy in Asia is a stark contrast to the rest of the world. Tepid inflation in China means a green light for monetary and fiscal stimulus. Japanese inflation is creeping up from low levels, but Japan is continuing its ultra-easy monetary policy.
For March (and the quarter), the MSCI China Equity Index rose 4.5% (5.3%), and the Nikkei 225 rose 2.2% (7.5%).
Our strategy – Balanced
Our asset-mix strategy remains well balanced: we’re slightly overweight to equities and underweight to fixed income.
Volatility in the fixed-income market remains high. Our well-diversified exposure to bonds is delivering strong running yield. Coupon income and maturity proceeds are being reinvested at higher yields.
Investors with a balanced exposure to bonds and well-diversified equity portfolios were well served in the recent volatility.
Trading during the quarter was targeted to specific themes. Given that every client situation is unique, not all accounts required trading. Overall, trading activity moved portfolios toward our strategic benchmarks and increased diversification – it doesn’t pay to reach too far afield in volatile times.
Specifically, we lightened up on mega-cap U.S. technology stocks, taking advantage of their recent strong performance. Through this trade and, where necessary, trimming other large-cap U.S. positions, we now hold a neutral weighting in U.S. equities. Offsetting these sales, we bought international developed-market equities, bringing that weighting up to neutral. The combined effects leave our equity-market view overweight Canada – and neutral U.S., international, and emerging markets.
The last word – Moral hazard
Moral hazard is a situation that encourages excessive risk-taking because it’s clear there will be a bailout from any consequences. It’s hard to rescue a big bank without increasing moral hazard across the board.
The banking system is built on a fragile foundation of trust. Over centuries, it has evolved into a combination of good management (reputation and brand equity), good regulation and oversight, and appropriate backstops (depositor insurance).
In the U.S., bank regulation is political and has changed repeatedly over the last 25 years. The banking system leans more toward the belief that capitalism and competition will lead to good outcomes. Debate will now be centred around the future balance of capitalism, regulation, and insurance. These priorities are generally at cross purposes. You either let the system police itself (capitalism and competition) with consequences so high (multiple bank runs in the late-19th and early-20th centuries) that everybody behaves. Or you run it more like a regulated utility.
Our Canadian system, with a small number of very large banks, makes the stakes very high for all and comes with strict levels of supervision – achievable since there are so few banks. Although, compared to some international peers, the Canadian system has been criticized for being boring, we haven’t had a bank failure in 100 years. Prudent shouldn’t be mistaken for boring.
Post 2009, the largest U.S. banks were deemed too big to fail – but that’s not the case for thousands of smaller banks. Recent events suggest they won’t be allowed to fail, either. If taxpayers are on the hook no matter what, then we have a situation of moral hazard: few or no consequences for imprudent risk-taking. Under these circumstances, even if it goes against our libertarian and capitalist instincts, our only remaining option is to tolerate a system where governments play a larger role.
Please contact your Investment Counsellor if you have any questions or would like to discuss your investments.
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