Market Musings 190323: Panicked by the shadow of 2008

Market Musings 190323:
Panicked by the shadow of 2008

What a week!

Summary:

• Waiting for further news on US regional banks, Credit Suisse

• European banks have suffered a huge reverse after a huge run-up since October

• Crude oil, oil & gas sector have been battered by increased recession fears

• Look to European Value - oil & gas, insurance companies

• Gold has been a big recent winner - look at royalty companies

Huge uncertainty returns

After a period of recovery since October last year, markets have plunged back into crisis mode this week on the back of soaring banking worries.

Since October last year, decent gains still in stocks (ex US banks)

Source: tradingview.com

Two seismic shocks have reverberated through financial markets, both emanating from the banking sector. Firstly, the failure of US regional banks Silicon Valley Bank and Signature Bank. Secondly , there has then followed the dramatic loss of confidence in Credit Suisse in Europe.

These two events have hammered the Euro STOXX Banks sector, which up to then has been leading European bourses higher over the last few months (up 50% from the October lows to recent peak, but down 18% since then in just over a week).

Eurozone banks have given back over half of their gains since October

Source: tradingview.com

There has been huge amount of comment already on Silicon Valley Bank and its failure to hedge interest rate risk, so I don't propose to spend a lot of time here, other than to say that it seems to have been a huge failure of management and in particular, of risk control due to the laxer regulation in the US on midsize banks that exists on the largest banks.

But given the huge drop in regional bank share prices down 29% In a matter of weeks, questions remain clearly over the robustness of the US regional banking industry. First Republic Bank has just been shored up effectively through capital injections from a number of the largest US banks.

And now apparently, Warren Buffett has also been approached regarding investing in US regional banks - we expect to hear more news on this in due course.

With regards to Credit Suisse, again, matters are evolving extremely quickly this weekend. So it's fruitless to say too much at present, but there are a couple of obvious points to make here.

Firstly, the problems that Credit Suisse is suffering are largely of its own making, and have been apparent for quite some time. The losses in its investment bank are clear. The repercussions in terms of loss of deposits from its wealth management business are also clear. And the dramatic loss that it suffered last year, wiping out a decade of profits, is also a well known fact.

Credit Suisse has been falling consistently since 2007

Source: tradingview.com

Unfortunately, the restructuring it had been planning to proceed with has clearly come unstuck due to the psychological knock-on effects of the US regional banking crisis and the loss of confidence in the ability of Credit Suisse to achieve this restructuring in the time available. But again, we expect to hear much more news on the restructuring or the new form of Credit Suisse by the end of this weekend.

LATEST FROM THE FT:
UBS has offered to buy Credit Suisse for up to $1bn, with Swiss authorities planning to change the country’s laws to bypass a shareholder vote on the transaction as they rush to finalise a deal before Monday.

The all-share deal between Switzerland’s two biggest banks is set to be signed as soon as Sunday evening and will be priced at a fraction of Credit Suisse’s closing price on Friday, all but wiping out the target’s shareholders, four people with direct knowledge of the situation said.

Crude oil takes a big hit too

If we look at the impact on stock markets, they've been quite varied as we can see from the chart below. Surprisingly, the major index that has suffered the most seems to be the FTSE 100

March: Most stock market indices correct off the back of US regional banks

Source: tradingview.com

Yes, of course, the FTSE 100 has a number of banks. But it is unclear why these banks should be under pressure from the US regional banking crisis

Lloyd's and Natwest are very much domestic banks these days. Yes, Barclays does have investment banking as does HSBC to some degree. But again, it doesn't seem to be a problem for their business models.

Lloyds and Natwest continue to recover post 2020 lockdown period

Source: tradingview.com

In fact, if we look at the FTSE 100 and its performance, down 7% from its recent peak, I would suggest that this is more down to the weakness of the oil and gas sector and names such as BP and Shell, rather than the US regional banking crisis per se.

If we look at Brent crude, it has taken a big dive, -24% over the last few weeks due to the increased fears of recession and short term oversupply of crude oil on the international markets.

Oil & Gas sector dragged down by recession fears over oil demand

Source: tradingview.com

If we focus on the oil and gas sector and on the price of crude oil, then the question is, do we expect global demand to be substantially lower than forecast going into the second half of this year for crude oil?

Or is this a very short term effect indirectly exacerbated by the US regional banking crisis and the greater likelihood of recession in the US economy as a result of tighter credit conditions?

Clearly, commodities have been somewhat volatile this year. After a fantastic performance in 2022, contrary to the performance of the stock and bond markets, which both suffered last year.

Commodities soared from mid-2020 to mid-2022

Source: tradingview.com

However, if we look to the longer term, I believe that we are still in a position where, looking at supply and demand, that supply of crude oil on international markets will remain constrained.

We know that we see increased sanctions on Russia, and in any case Russian oil supply is likely to decline in future quarters, given the difficulty of securing components for maintenance of the oil pipelines, and of the oil production facilities.

This is perhaps similarly true of OPEC countries, where there seems to be very little spare capacity in the longer term except perhaps, in the United Arab Emirates and Saudi Arabia.

Even in the US, which in recent years has seen huge increases in its oil and gas production capability thanks to shale oil, the outlook for production growth seems extremely limited.

Shale oil wells are struggling to see much growth and production, and where there is growth and production, this seems to be much more in terms of natural gas production than in crude oil production.

On the demand side, therefore, the question remains: do we see a global recession prospect or not?

China is forecast to see economic growth of more than 5% both this year and next year thanks to the reopening of its economy post COVID lockdowns. Recent activity indicators in China seem to support this recovery in demand, including in transportation, which suggests that Chinese oil demand should continue to recover. This could add as much as 1 million barrels per day of extra demand back to the global oil market, representing around 1% of global demand.

We should also note looking at crude oil, that in previous years, global oil demand has very rarely dropped except in times of deep recession such as 2008.

But even in mild recessions, global oil demand has managed to grow particularly given growing demand from developing countries.

My suggestion then, is that we could be coming into a buying opportunity for oil and gas companies - after all, remember the very, very healthy dividends being paid out. Another way to buy indirectly into the oil and gas sector is to buy a value-focused fund or ETF. These value-focused funds, particularly in Europe, have a relatively high weighting in oil and gas companies, as well as in Financials.

Banks: Good Value or Value Trap?

Turning to the financial sector. The question then remains are banks a value trap? Or are they truly good value at the moment, particularly in Europe? We know that valuations are very cheap and that the sector has sold off heavily in the wake of the Silicon Valley Bank and Credit Suisse news flow.

Balance sheets have remained solid for the most part, with very high tier 1 capital ratios thanks to the much tighter regulations that were put in place after the Global Financial Crisis.

European banks are also in principle benefiting from higher central bank interest rates, as typically their own deposit savings rates do not rise as quickly as the central bank rate while lending interest rates can run as much faster.

This in theory allows banks to benefit from higher net interest margins, i.e. higher profitability from the gap between the savings rates and their lending rates while interest rates are rising.

However, against this, we must offset the greater risk of recession. Recession tends to drive banks to recognise higher bad debts as companies go bankrupt and as personal households also default on borrowing, for instance on credit card debt and also potentially even on secured lending such as mortgages.

So when looking at the banks, we have to weigh up three factors.

• Firstly, is there really a systemic risk to the banking sector globally, as clearly there was during the global financial crisis in 2008.

• Secondly, how deep is any economic recession going to be in the US and in Europe? And therefore, what will be the potential increase in bad debts for these banks as a result?

• And thirdly, to what extent is all of this offset by higher profitability at least in the short term from higher short term interest rates?

Focusing our discussion on banks in the UK in Europe and leaving aside the US, I would argue that if we can avoid a systemic crisis in the US regional banking sector, which I think is quite likely, then the risk of a major recession in the US spreading to the rest of the world, including Europe is relatively small still.

I certainly do expect to see a recession in the US because we clearly are going to see tighter lending tighter credit conditions. When credit conditions tighten, this tends to be a leading indicator for economic recession, as companies find it more difficult to borrow and therefore find it more difficult to invest for growth.

However, we should offset against this the fact that at the moment at least, economies have been surprisingly resilient in the face of higher interest rates, and of course, in the face of the energy crisis in Europe.

I continue to expect economic recession in the USA and perhaps also in Europe. But any recession, I think will be relatively short lived, and mild for the moment.

Of course, this can change as it depends crucially on consumer psychology. We have to recognise the fact that if households believe that a recession (and associated job losses) is around the corner, then they will act accordingly to save more and spend less, which then hastens the reality of recession. This is still a negative spiral that can still occur. We will have to watch closely to see what happens.

But one thing I would say is that central banks and regulatory authorities seem to have learned the lessons of the global financial crisis in that they have acted swiftly both in the US and indeed in Switzerland to try to stem the risk of a dramatic loss and confidence in the banking sector.

Whether they succeed is still open to question; but I think that we should prepare for a significant buying opportunity - If not today, then very soon.

Value sectors: Oil & Gas, Insurance

In particular I look to Europe, looking to the value sectors such as banks, insurance, and oil and gas. Income investors are very well compensated in these sectors today.

I understand that investors may be unwilling to go back into the banking sector. And this makes some sense because banks are very difficult to understand the best of times, with very complicated operations and balance sheets.

However, one can still look at the oil and gas sector and indeed the insurance sector within the value factor. Insurance companies such as Legal and General and Aviva in the UK are yielding on a prospective basis somewhere between 8% and 9% at present, after the recent sell offs - and this can be seen as very attractive for income-oriented investors.

Since these dividends seem relatively well backed. I would argue similarly in the oil and gas sector, where profitability of the oil and gas majors remains relatively high despite the drop in Brent crude oil.

Not only do they make money from the upstream operations, i.e. getting oil out of the ground, but they also make surprisingly high profits at the moment from sustainably high refining margins, i.e. turning this crude oil into refined oil products such as petrol, diesel, kerosene, and heating oil.

Given the lack of growth in refining capacity, and sanctions on Russian refined products this refining market remains very tight and is allowing for higher than higher than historically average profit margins in refining.

Nasdaq 100 as a safe haven?

One aspect that I find most surprising is the strength of the NASDAQ 100 index in the US. One clear reason for the performance of the NASDAQ over the S&P 500 for instance, is the complete absence of banks. Now, there are banks in the NASDAQ index, if you look at the NASDAQ Composite, but interestingly not in the NASDAQ 100 index of the biggest 100 companies by capitalization.

The NASDAQ 100 is dominated as you would expect by Information Technology at over 50% plus Communication Services at 17%, followed then by Consumer Discretionary. Note that Communication Services is of course, very technology oriented given it includes Alphabet (Google) and Meta (Facebook) matter. But even the consumer discretionary sector is tech-oriented as it includes both Amazon and Tesla.

Adding up the weighting of these three sectors, we arrive at 85% of the NASDAQ 100.

It is perhaps one of the reasons why the NASDAQ 100 is seen as the relative safe haven within stock markets bizarrely despite its sharp underperformance last year.

Conclusion: Buying opportunity soon

In summary I don't think we are in the midst of a systemic crisis right now. We should perhaps sit on our hands for a few more days to see what further measures and actions are taken with respect to the US regional banking sector and also with respect to Credit Suisse.

But it could well be that we see a return of relative confidence to stock markets sooner rather than later.

Check out Gold

One final note, one refuge that has certainly performed well of late is gold. Today, gold is close to $2,000 an ounce and on a monthly basis. This remains one of its highest closing levels ever. For those looking for diversification, some exposure to gold and by extension gold miners may not be such a bad idea at present, particularly if you focus on gold miners that have strong balance sheets and generate good cash flow today.

Gold rallies close to $2000/ounce

Source: tradingview.com

My favourite way to gain exposure to gold mining is actually through royalty companies. Why? Because royalty companies have economic exposure to the gold price. But without the operational risks of actually running a mine as they provide financing to gold mining companies in return for a share of gold production typically that results. Gold royalty companies in the US include Franco Nevada.

In the Related commodity silver, Wheaton Precious Metals is a royalty company relating to silver. In the UK, we can think of companies such as Ecora and Trident Royalties that are two interesting royalty companies related to commodities in general.