At Allspring, we’re committed to being purposefully divergent. Our investment professionals are free to voice their own views, and their perspectives enable us to more holistically “see” both potential opportunities and risks.
Last week, five of our equity leaders offered their views on the state of the U.S. banking industry following Silicon Valley Bank’s (SVB’s) collapse. Since then, we’ve seen more events affecting banks taking place, and so we’ve asked more of our equity leaders to provide us with their insights on the state of the banking system and its impact on investing.
Stephen Giggie, CFA
Portfolio Manager, Special Global Equity
The banking turmoil that originated among smaller regional players in the U.S. has claimed its first overseas victim in Credit Suisse. Although its $3.2 billion government-backed acquisition by UBS is intended to allay fears of global systemic risk, investors remain skeptical that there are more dominos to fall as the world digests the impact of higher interest rates due to central bank policies around the globe.
Credit Suisse Additional Tier 1 (AT1) bonds have received a lot of attention following news of the acquisition. Given that the acquisition involves financial support from the Swiss government, AT1 bondholders will be wiped out, even though Credit Suisse equity holders will receive 1 UBS share for every 22.5 Credit Suisse shares held. This development has the potential to affect the broader market for similar instruments used in bank funding as investors weigh the potential asymmetry of returns and risks. As liquidity wanes, banks tighten credit standards, fewer businesses and individuals receive loans, and future growth is adversely affected. Regardless of whether there are additional bank failures or bailouts, there will be economic ripple effects from these recent events.
The events since the collapse of SVB on March 10 are consistent with our view that banks exhibit characteristics of a “commodity” business where it’s hard for an individual company to competitively differentiate itself. There are businesses within Credit Suisse (and many other banks) that are unique and advantaged, but the core business of banking isn’t one of them. The fear of asset loss drove banking clients to rapidly move money out of banks that were deemed to be at risk, and there were limited to no frictional costs to doing so (all upside and no downside) for the depositors.
The plausible set of impacts on banks from this event ranges from reactionary functions by bank regulators to enhanced regulatory oversight and increased rhetoric around banks functioning as fully regulated businesses within certain countries. Although we don’t favor nor have conviction in what steps should be taken by regulators and legislators, as investors we have to consider the probability of each potential outcome. It seems safe to say that the cost of operating a bank will incrementally increase compared with the recent past and could negatively affect expected returns on equity and thus valuations. Furthermore, our conversations with bank management teams over the past week leave us confident in stating that lending standards are going to increase, which will serve to reduce investments in the economy and thus future growth.
Thomas Ognar, CFA
Managing Director, Senior Portfolio Manager, Dynamic Growth Equity
Most of the market turmoil related to UBS, Credit Suisse, and smaller regional banks has been confined to the banking sector, with some collateral damage across the broader financials sector. Banks make up approximately 7.7% of the Russell 1000 Value Index and 18% of the Russell 2000 Value Index. By contrast, at 0.10%, banks represent a nearly negligible component of the Russell 1000 Growth Index. In our view, core banking is a commoditized service that’s highly dependent on cyclical factors—we don’t include banks in our portfolios because they often lack the sustainable growth drivers that are a precondition for our investment.
The recent move lower in interest rates is generally positive for long-duration assets like growth equities. Meanwhile, recent bank turmoil has increased the odds of recession and has caused a sell-off in cyclicals. Growth stocks already went through a painful re-rating in 2022, which improved expectations coming into 2023. For March and year to date, growth equities have outperformed other categories by a wide margin.
Looking forward, we’re closely monitoring whether the Federal Reserve (Fed) starts easing, which may usher in a period of growth or economic acceleration. However, in our experience performance can come in spurts, so we believe the key is to stay invested.
Garth Nisbet, CFA
Senior Portfolio Manager, Essential Value Equity
In recent years, SVB’s tech startup/venture capital customer base has experienced a pause in market enthusiasm and confidence. For investors, the SVB sentiment shift may be as significant as the current regional bank solvency debate.
In fact, we’re less concerned about regional banks. Unlike past banking crises that have had liquidity, credit quality, and regulatory capital concerns at their core, the current crisis is focused on deposits and the quality of the customers behind those deposits. Bank common equity tier 1 capital and asset liquidity levels of the past decade are materially higher than in the pre-2008 period.
As financials are interest rate sensitive, we’re keeping a close eye on the Fed’s efforts to defeat inflation via increases in short-term interest rates. This effort has renewed an issue within the banking community: competition for deposits. Since the Great Financial Crisis, deposit rates have remained low, providing financial institutions with a low-cost funding source. As interest rates rise, investors and depositors now have additional options for funds that have long languished in low- or no-interest accounts and provided banks with plenty of liquidity.
With investors starting to move these assets elsewhere, banks are looking to alternatives such as brokered time deposits through brokerage houses and wholesale funding from the Federal Home Loan Bank. These options offer plenty of liquidity but at a higher cost of funds than banks have been accustomed to and act to reduce their margins. Additionally, the yield curve has become inverted, leading some investors to express concerns over the banking sector’s health. While an inverted curve is not beneficial to banks, it’s not fatal.
While borrowing short at higher rates and lending long at lower rates would appear problematic, banks have several options available to them to offset the yield curve inversion. First, many banks have slow-walked the rates paid on deposits. They increase them only when the risk of customers going elsewhere grows to the point that funding might be an issue. Second, most non-consumer-oriented loans have a variable rate that gives the banks leeway in creating a spread between what they receive and what they pay. If a loan is for a term longer than five years, there are often triggers to allow spread adjustments to maintain profitability for the bank. For all these reasons, the interest rate environment for banks is challenging, but we believe most banks likely will survive—and, in some cases, thrive.
In conclusion …
Understanding fundamental differences between companies—in this case, banks—becomes increasingly important when we’re in the midst of a paradigm shift, like the one we’re in today. If there are structural and/or cyclical headwinds that make operating a certain company more challenging, it’s helpful to either be invested in other companies that are less exposed to those cyclical headwinds or in companies with experienced management teams that have a competitive edge or a playbook on how they intend to remain competitive.
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