A Ripple Effect Of The Bank Crisis

This month has seen three bank failures in the United States (and one in Europe), emergency policy action by policymakers, hot inflation readings, more central bank rate hikes, and the indictment of the president.

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Nonetheless, markets have largely shaken it all off. So far this year, a 60/40 portfolio of global stocks and bonds has returned +5%.

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Technology has been a powerful force, increasing by an astounding 20%, thanks to companies with strong balance sheets and management teams acting as high-quality havens. European stocks have outperformed their American counterparts. Moreover, despite wild swings in interest rates, bonds have proven their worth as critical portfolio protection. Diversification's power is at work.

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However, this does not mean that all is well. Things tend to break when central banks raise interest rates and tighten the flow of credit to the economy. Different sectors of the economy break at different times, and this cycle has already seen corrections in housing, manufacturing, and technology. Now it's the banks' turn, which can be especially painful given their position at the heart of the economy. While markets appear eager to move on, we haven't seen the last of the aftershocks.

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Based on what we know now, this episode does not appear to be systemic, nor does it appear to be a repeat of 2008. However, the cracks are visible, and as investors, we are focused on calculating the impact. Two questions are critical here: Are there signs of contagion? What other pressure points could there be?

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1) Are there any signs of Contagion?

Customers of banks are now wondering how secure the money in their checking or savings accounts is in light of the recent shock. Deposits have been streaming out of small banks because of this concern and into large banks and money market funds (which invest in things like short-term bonds and low-risk cash-like securities and frequently provide greater rates). Money market funds have had the greatest inflows since the beginning of the pandemic over the past few weeks, increasing their total assets to nearly $5 trillion (the most on record).

Banks may be in trouble if this trend picks up speed and all depositors demand their money back at once. When Silicon Valley Bank encountered this, it was forced to sell some of its assets at a significant loss to compensate its erratic depositors (who were largely concentrated in an interconnected web of tech start-ups). And it was still insufficient. The worry that follows is: Would there be a chain reaction of contagion if faith in the financial system is shaken?

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There are encouraging signs that some of the anxiety is fading. For one thing, policymakers have made a concerted effort not only to bail out failed banks (such as SVB and Signature Bank) but also to provide liquidity to all banks (for example, through the Fed's discount window and the new Bank Term Funding Program). This ensures that banks have enough cash on hand to meet depositor demands.

The extent to which these facilities are used can provide insight into the level of panic that depositors are experiencing and, as a result, the pressure that banks are under. While banks have borrowed from the Fed and other sources of liquidity, this borrowing appears to be slowing (albeit remains elevated). This suggests that liquidity constraints are not worsening.

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Banks are borrowing from the Fed, but the rate is slowing.

Having said that, things can change quickly, and banking system stress remains high. If things deteriorate, policymakers will have to consider what else they can do. Several industry leaders have called for the FDIC to strengthen its deposit insurance, which currently guarantees deposits up to a limit of $250,000. This means that nearly half of all bank deposits in the United States are currently uninsured. However, while raising the limit and extending insurance to all banks may reduce the risk of further bank runs, such action is politically contentious and would necessitate congressional action. It is possible, but it would be a difficult task.

2) What other pressures are lurking?

Banks may be forced to offer higher rates to compete with other banks and money market funds to keep deposits coming in. In an uncertain environment, they may also be more hesitant to lend. All of this reduces bank profitability, and the upcoming earnings season should provide an early indication of these challenges.

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Furthermore, the bank shock has revealed flaws in existing regulations. Moving forward, regulators will most likely tighten existing rules while also introducing new ones. Yesterday, the White House called for regulators to tighten their grip on mid-sized banks, as an example.

Finally, the shock's effects are not restricted to the banking sector, which has many people wondering what might be the next big surprise. Here, it matters to whom smaller banks have extended loans, and worries about commercial real estate have grown (CRE). Interest rate increases have previously put pressure on the industry, but since nearly half of the small banks' loans are for CRE, this dynamic is now sharply in focus.

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Small vs. large banks: Breakdown of loan exposures

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Offices appear to be the most vulnerable area. Disrupted by the rise of remote work (which is still 7x what it was before the pandemic), office CRE is likely to face a serious reckoning, possibly as severe as the Global Financial Crisis. However, it is worth noting that the office subsector accounts for only 14% of total CRE (and office construction accounts for only 0.4% of total GDP). Furthermore, not all CRE is created equal: segments such as data centers, hospitals, apartments, and retail do not appear to be under the same pressure. Markets appear to be recognized at least some of this risk disparity:

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Office REITs have led the way in sector declines.

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Investment Implications: Defensive, not fearful

Even if market volatility decreases, banks will most likely lend less - but how much less is unknown. We are less optimistic because small banks have driven the majority of lending in the last six months and also make loans to small businesses, which employ 80% of the workforce. Overall, less credit flowing into the economy means lower growth, which could hasten the recession.

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Tighter credit conditions in the banking sector can accomplish the same thing as rate hikes, which means the Fed may not need to raise interest rates as much as it would otherwise. Nonetheless, sticky inflation is still a problem.

We are concentrating our efforts on more defensive investments that can protect us during a downturn. The sharp drop in yields over the last month demonstrates why bonds are so important. Structured notes, for example, can help investors stay invested in both good and bad days by protecting gains and providing a buffer against adverse moves lower. Sectors such as reasonably priced technology, healthcare, and industrials could be market bellwethers as other cyclical segments struggle. And, as growth in the United States becomes more scarce, prospects in Europe and China appear to be improving.

Above all, stick to your investment strategy. History suggests that this, too, shall pass, and investors are less likely to suffer losses over longer periods, particularly if they have a diversified portfolio. Your J.P. Morgan team is here to help you understand what it all means for you.

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