At Allspring, we’re committed to being purposefully divergent. With this approach, investment professionals across our platform have the freedom to voice their own views, and their perspectives enable us to more holistically “see” potential opportunities as well as risks. Ann Miletti, Allspring’s head of Active Equity, polled some of our equity portfolio managers for their views on the state of the U.S. banking industry following the Silicon Valley Bank (SVB) failure and related events over the past week. Unexpectedly, their responses below share similar points of view.
Bryant VanCronkhite, CFA; Managing Director & Senior Portfolio Manager, Special Global Equity
Our economy requires a functioning financial system, and banks are the public’s visibility into that system. If the public can’t trust that their assets are safe at a bank, it ultimately leads to a lack of confidence in the entire financial system. From my perspective, the Federal Deposit Insurance Corporation (FDIC) had little choice but to backstop all deposits in order to stop a run on all small banks across the U.S. There’s a moral hazard question at play here, but we can’t leave it to individuals to do adequate research on the balance sheet strength and credit standards of their local banks when government officials themselves seem unable to adequately do that work.
From an investment standpoint, our team has long held that most banks are commodity businesses, as the saver and borrower can go to any bank and get largely similar products and services. This is obviously playing out now, as people have been freely pulling their money out of a bank they deem unsafe and putting it into other banks. This reaction likely pushes more market share into the largest banks in the country and will harm smaller banks that have no way to “show” evidence of their safety other than to say, “Trust us.” That’s likely to be insufficient for many people and businesses going forward.
The markets are rallying after this “bailout,” but I believe banks will further tighten their lending standards and hold more capital for the time being. Unfortunately, this approach will slow growth in the economy and will deepen the recession that I believe is still in front of us.
Michael Smith, CFA; Managing Director & Senior Portfolio Manager, Discovery Growth Equity
Three key points on this topic come to mind for me:
- I think of banks like a car without reverse. If deposits are moving forward (growing), the car works fine most of the time. If deposits are moving backward (shrinking), the car is very hard to operate. I think if you asked most regional bank CEOs in 2021 or even 2022, “What is your plan for when systemic deposits start to shrink because the Federal Reserve is tightening?,” they wouldn’t have had one. Hence: We’re now in this mess that I think Bryant has described accurately, and as we’ve already seen, things can escalate very quickly once the fuse is lit.
- Bryant’s last statement that banks will further tighten their lending standards and hold more capital for the time being—slowing growth and deepening a coming recession—is the critical point for me. Capital contraction had already begun before SVB’s collapse, and it’s likely to accelerate. The problem is bigger than just ensuring safe bank deposits and having tighter lending standards. The current earnings yield of the S&P 500 Index is below that of U.S. Treasury bills. So, there are “safe,” government-backed alternatives for money that yield acceptable returns—but at the same time, the money supply is contracting. It’s not just a banking problem we need to worry about: It’s a much bigger capital contraction problem.
- I know the top-of-mind question investors (including me) want the answer to is, “What does this mean for the big picture?” I think, though, it’s too early to know the full answer to that. As the situation plays out a bit more, we’ll continue our vigilance in monitoring and responding to all risks revealed through our investment and risk management processes.
Christopher Miller, CFA; Senior Portfolio Manager & Team Lead, Select Equity
Assuming the government actions calm the bank run fears, one path that could be considered is a big effort to raise deposits via very expensive (high rate) certificates of deposit to extend the duration of a bank’s liabilities and take liquidity risk off the table. This would have a few impacts:
- It would accelerate pressure on bank net interest margins (a measure of profitability). Part of the bank stock declines over the past week are likely due to the market pricing in accelerated earnings-per-share cuts for banks in the second half of 2023 through 2024.
- It would force banks to raise loan pricing to try to recoup some of the pressure. This in turn would increase the cost of capital for small and mid-size businesses.
- There would be tighter lending standards given the higher cost of deposits.
Amazingly, all the moves in bank stocks have come with credit at pristine levels. If credit moves against banks, the problems listed above would be compounded (but in theory should ease the securities mark-to-market losses that started this stress, assuming interest rates fall).
Derrick Irwin, CFA; Portfolio Manager, Intrinsic Emerging Markets Equity
Emerging markets tend to be farther along in their rate cycles, and most have seen the peak already. In general, emerging market banks—given their strong and resilient balance sheets—have held up well as rates have risen. Also, only a few emerging markets had anywhere near the fiscal and monetary stimulus that the U.S. enjoyed over the past few years, and as a result, distortions in the banking system have been less severe. Many emerging economies are accelerating, so a recession in the U.S. should cause the relative growth between emerging markets and developed markets to improve further, which could be positive for emerging market equities. However, as Mike said, the situation is fluid, and should the tremors in the banking system lead to a full-blown crisis, emerging markets would have trouble dodging the fallout.
Ann Miletti; Chief Diversity Officer & Head of Active Equity
The game has changed, and we’re in a new regime of higher rates and higher inflation. On the margin, investors weren’t rewarded enough for stock selection or quality in the prior cycle, but the cracks we’re experiencing in the market today are further evidence that not all companies are created equal. Active stock selection can potentially add even more value today than in the past—quality really matters.
This is why, I believe, active management is so important now and its importance will expand as this cycle progresses.
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