By Colin Vella, Head of Wealth Management at Jesmond Mizzi Financial Advisors

With March’s mini-banking sector crisis seemingly under control, Jesmond Mizzi Financial Advisors’ Head of Wealth Management Colin Vella discusses what 2023 might hold in store. 

Last year ended on a somewhat positive note with positive figures for Q4. Has this continued during the first quarter of this year?  

Yes, we saw a strong rebound in January due to positive inflation figures, leading to market expectations of central banks easing interest rate hikes. Their narrative remained hawkish, however, with no sign that there was an imminent change in strategy, which led markets to lose steam in February.  

Then, in March we had the issues with the banking industry, emanating from the US, which spooked markets once again as fears ran high that the crisis would spiral out of control.  Luckily, the US Federal Reserve stepped in immediately and made it clear that it would do whatever was necessary to contain the crisis. This led to a recovery over the month as markets again predicted an easing off on interest rate hikes. All in all, I think global central banks acted prudently by pressing on with their programme, thereby sending the message that the crisis was contained and didn’t require any extreme decisions. The focus was on central banks’ tone as to what we shall expect going forward rather than the increases themselves – combined with slowing inflationary figures at 6% in the US and 6.9% in Europe, continuing to provide optimism that interest rate hikes might be nearing their peak levels.  

All in all, equity markets ended Q1 on a strong note, with double digit gains registered across most European indices. Similarly, in the US, the S&P 500 index rallied by 7% over the quarter, while the tech-heavy NASDAQ composite index closing the quarter just shy of 17% (in US terms).  

Performance in the fixed-income market was somewhat more muted, with around 3% recovery across the broader US and European high yielding market. Similarly, US investment grade (IG) bonds have also recovered well by the end of March, up by 3%, while European IG bonds were largely flat to positive.  

What caused the banking crisis?  

It all started with the collapse of Silicon Valley Bank (SVB), a medium sized bank with less stringent standards and fewer reporting requirements. The bank’s biggest issue was its exposure to certain types of bonds and poor duration management, which inadequately met the liability side of the bank’s balance sheet.  

When interest rates were low, the bank invested depositors’ money in government bonds, which are normally a safe investment. However, the bank bought long-dated bonds, which exposed them to significant losses last year when the bond market lost 20%+ of its value, as markets reacted to the sharp increases in interest rates over a span of a few months. 

News of the bank’s troubles then prompted a bank run, which in turn converted those bond losses from unrealised losses to realised losses.  

Nearer to home we also saw Credit Suisse being bought out by UBS – was this related to the situation with SVB? 

No, I wouldn’t put Credit Suisse in the same basket since it had its own issues – most notably years of scandals and mismanagement. The developments with Credit Suisse were a perfect storm of factors that came together and dealt the bank it’s final blow. 

In February the bank reported its biggest loss since the 2008 financial crisis. Then, with its share price declining, it was reported that the Saudi National Bank – the bank’s largest investor – would not be providing more financial assistance, causing its share price to drop by over 25% upon announcement.  

With the bank on the verge of collapse, with further withdrawals taking place after the CHF120bn+ withdrawals in Q4 2022 alone, the Swiss government stepped in and pushed through a take-over of the bank by its rival UBS with a considerable amount of assistance by the Swiss Central Bank.  

Do you think the problems are now behind us? 

We’ve already seen some recovery, though not yet a full rebound. The big winners from all of this, at least in the short-term were the big fund managers like Vanguard, JP Morgan and Fidelity, who benefitted from investors moving their money from the banking sector into their money market funds, in the hope that it would be safer with a big Wall Street name.  

So, all in all we saw bank stocks falling and recovering, though not fully for the time being. Understandably, US banks took a bigger hit than European banks, which are much more well capitalised and operate under stricter rules.  

Overall, I think the banks should recover well, though I’m less optimistic about certain types of high-risk bonds like AT1 bonds – having lower priority in the event of the issuer’s insolvency which may be written off or converted into equity if the issuer’s capital levels fall below a certain threshold 

How so?  

The Credit Suisse takeover was controversial because of the bank’s AT1 bonds. These high-risk bonds lost their entire value with holders of the bonds getting nothing, unlike the bank’s shareholders who did receiving a pay out, about CHF 75c per share, while $17bn worth of AT1 bonds were completely wiped out as part of the take-over deal. This is unprecedented because under normal circumstances, shareholders are meant to be the last people to receive payments. They’re meant to carry the biggest risk.  

So, what this has done is that it has spooked holders of other similarly risky bonds, who were given a glimpse of what could happen to them should the crisis spread. Because of this, it will probably be more costly for banks to issue these types of bonds going forward. 

What will the rest of the year bring with it? 

As time goes on, it becomes likelier that interest rate hikes will stop or even start to be reversed. The market is currently pricing in two possible eventualities: that inflation continues to come down and no longer necessitate a high interest rate environment, or the global economy falls into recession. This would also indirectly bring down inflation and cause central banks to stimulate the economy rather than slow it down.  

The winners this year are likely to be government bonds and equities in bigger growth companies. Essentially, everything we saw decline sharply this time last year when interest rates started to be dramatically increased. The same can’t really be said for small to medium-sized enterprises.  

This is very clearly borne out by the Nasdaq-100 (Q1 +20%) and Russel 2000 indices (Q1 +2.4%). The former is made of large growth companies while the Russel 2000 includes smaller companies. Both took a significant hit in the beginning of March, but while the Nasdaq-100 recovered immediately, we didn’t see this with the Russel 2000.  

The reason for this is that Nasdaq companies are well capitalised and concentrated around the tech sector. Their valuation as growth companies is also very much sensitive to changes in interest rates. They’re well positioned to navigate their way through both a recession or a return to normality.  

With government bonds we’re seeing a small recovery, but there’s a long way to go for a complete recovery of what this segment has lost in 2022. The goal is now to anticipate the point where it makes sense for one to enter and participate in the upside and how best to play the duration game as we reach a turning point on the interest rate battlefield. We did in fact start to see somewhat of a recovery across the longer-dated government bonds since the beginning of March, as anticipation for further aggressive interest rate hikes by global central banks start to abate.  

 

This interview does not intend to give investment advice and the contents therein should not be construed as such. The Company is licensed to conduct investment services by the MFSA under the Investment Services Act and is a Member of the Malta Stock Exchange and a member of the Atlas Group. For further information contact Jesmond Mizzi Financial Advisors Limited of 67, Level 3, South Street, Valletta, on Tel: 2122 4410, or email [email protected]