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  • ChetwoodWM

Client Update - 31st March 2023

We very much understand why we have had questions over the last few weeks on the banking sector and our portfolios exposure in this area. Investors and markets have had their confidence in banks rocked. The interest rate market seems to know how this story ends – interest rate cuts, and central banks may end up having their hands forced on this later in the year. If rate cuts do materialise, fixed income (bond) returns will be very attractive. Other than a tiny exposure in global index funds (less than 0.05% of the main fund we use), we had no direct exposure to Silicon Valley Bank or the other US regionals, and our portfolios remain well positioned and are recovering well from the market wobbles a week or two ago.

Banks fail because they do not hold enough capital to absorb losses, because they are not able to meet deposit outflows, or they face a general lack of customers, thus preventing them continuing with business as usual. Valuing a bank from an equity or creditworthiness point of view relies on having transparency on all these things. However, as current events have highlighted, things move quickly. In a world of digital banking, deposit flight can be rapid – and this speed can outpace a bank’s ability to liquidate assets to meet the outflows.

Large US banks have been highly regulated since the global financial crisis and have doubled their core equity capital since then and are actually in good health. They are subject to annual stress tests which assess bank capital requirements against adverse economic scenarios like a recession, rising unemployment and a decline in residential property prices. The issue that became evident in March was that smaller regional banks are not subject to the same tests and were not subject to scenario testing in a rising interest rate environment.

This is very different to 2008 and it is clear, if required, that the US Federal Reserve (Fed) is likely to do all it can if required (and it is an important if), including cutting interest rates and stopping its quantitative tightening programme. This has already partially reversed, given the recourse to the Fed’s balance sheet already used by banks facing liquidity problems in March 2023. The bigger banks have come out relatively unscathed with depositors choosing to move their cash into perceived ‘safer havens’, but the damage to the reputation of the banking system across the world appears to have been done.

The expectation is that banks will start to tighten their lending standards and credit allocation, making it more difficult for people to borrow, which will cause less demand for credit and represents a tightening of financial conditions. The knock-on effect is that central banks may not need to act to the extent anticipated. It was anticipated that the Bank of England would raise interest rates by 0.5% in March, but both the Fed and the Bank of England put rates up by 0.25% - recognition that there is weakness in the financial sector; they need to get inflation down, but they can’t tighten too much due to the natural tightening that is likely to come. Before recent events, it was hard to imagine that interest rates would come down anytime soon but now there is talk that we may even see rate cuts by the end of 2023.

With Easter approaching this will be our last communication until the 14th April. Should you have any questions in the meantime, please do not hesitate to contact us directly. Thank you for your patience and fortitude through a difficult market environment. One thing we do know is that recoveries happen very quickly and often when least expected, so we will keep working hard on your behalf and we look forward to better times ahead.

Do have a good weekend.

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