While researching the material for my previous article, I came across a valuable insight - every time over the past two decades, the Fed's tightening cycle has been followed by a recession in the US. Going back to 1955, there have only been two (relatively small) rate hike cycles - peaking in November 1966 and August 1944 - that were not followed by a recession.
Last week, the US Federal Open Market Committee (FOMC) met and decided on another 25-basis point interest rate increase, which may have been the last one before taking a pause. At least, this is the current consensus around the markets.
Ray Dalio, an American billionaire investor and founder of the world's largest hedge fund, Bridgewater Associates, has an important principle: "If you worry, you don't have to worry. And if you don't worry, you need to worry." You might think of this article as a list of reasons why you should worry so that you don't have to worry. Does that make sense?
More banks prone to bankruptcies
Although a well-worn theme since the first bankruptcies in the US financial sector, it has lost none of its topicality as last week another bank - First Republic - succumbed to the pressure of mounting withdrawal requests and a plummeting share price. Can the collapse of the second largest of the banks declaring bankruptcy in the US be considered the end of the US financial system's troubles? Unfortunately, there may not be many reasons to believe so.
Right after the First Republic's bankruptcy, numerous regional bank stocks experienced a decline, including Pacwest Bancorp dropping by 51%, Western Alliance by 21%, and Metropolitan Bank by 19%. The volatility of the situation led to multiple trading halts throughout the day and caused the Regional Bank Sector ETF to reach its lowest level since October 2020. Furthermore, bank analysts have noted that the current situation feels different than the one in March when Signature Bank and Silicon Valley Bank failed, as investors are now more concerned about the broader regional bank sector. With increasing funding costs and interest income reaching its peak, banks may possibly experience losses in the coming months, which may put regional banks at risk.
The environment in the US financial sector has become more challenging than before following a further increase in interest rates after the bankruptcy of the First Republic. In addition to tighter credit conditions, most regional banks are now facing a growing lack of public confidence and an increasing number of withdrawal requests. According to the research published in the Social Science Research Network, "Monetary Tightening and US Bank Fragility in 2023: Mark-to-Market Losses and Uninsured Depositor Runs?" the true market value of the US banking system participants is 2.2 trillion USD lower than suggested by their book value. At this point, more than 2000 financial institutions in the US may be using their capital buffers to meet the withdrawal requests of depositors.
Although the official line remains that the US financial system is "sound and resilient", the reality may be different. This can be seen in the actions of some financial institutions. For example, the Canadian Toronto-Dominion Bank Group called off its 13.4 billion USD takeover bid of First Horizon Corp last week. Although the official reason for terminating the deal was TD's inability to secure regulatory approval for the takeover, the announcement resulted in an almost 40% fall in the share price of the US regional bank. Another bank's PacWest Bancorp shares plunged over 50% after it confirmed its plans to explore a sale or other strategic options.
US commercial real estate may be next in line
Regional banks are facing a significant risk not only in their fixed-income assets but also in their commercial real estate portfolios, which include lending for projects such as apartment buildings, office towers, and shopping centres. As the market is being stressed by higher interest rates and more than 1 trillion USD in commercial real estate loans are set to mature before the end of 2025, many banks tighten their underwriting, and many borrowers may find it challenging to refinance their debts, which could become a broader economic problem.
The vacancy rates for office buildings are particularly problematic, and delinquency rates on commercial real estate loans are advancing upward. Moody's downgraded 11 regional banks in April, citing their commercial real estate exposure and the impact of remote work trends on the office market. On average, banks have around 25% of their assets tied up in real estate loans, whose values have decreased due to rising interest rates. If commercial real estate defaults increase significantly, hundreds of banks may find themselves in a situation where their assets are worth less than their liabilities.
US commercial property prices have fallen by 15% in the 12 months leading up to March, with office prices dropping by 25%. The strong growth in interest rates has caused pre-existing pieces of real estate worldwide to be worth less, resulting in a significant dislocation in the short term. However, Berkshire Hathaway Vice-Chair Charlie Munger has stated that although US banks are "full of bad loans", it may not be as bad as in 2008. Nevertheless, combined with the overvalued fixed-income portfolios on the banks' balance sheets, it may contribute to one or more bankruptcies in the near future.
Who may benefit from the current situation?
In such an unstable environment, investors need to weigh their risks, but keeping an eye out for investment opportunities may also be beneficial. In the case of failing US regional banks, one may ask, who is the beneficiary of the current situation? The first guess would be the largest banks in the US, such as Bank of America – the second largest holding in Warren Buffett's portfolio – and JPMorgan Chase – the bank acquiring First Republic.
Overall, the KBW Banking Index has fallen by around 30% since the start of 2023 and by almost 40% since its peak in 2023. Even the strongest (read: largest, "too big to fail") banks' stock prices are affected negatively by the overall dip in the banking sector. They potentially may continue to slide lower in case of further bankruptcies. This may pose an opportunity for investors to purchase such bank stocks before they start to recover.
Let's take a closer look at the JPMorgan Chase – First Republic deal. JPMorgan Chase will acquire First Republic's nearly 213 billion USD worth of loans and 92.4 billion USD worth of deposits in exchange for a mere 10.6 billion USD payment to the FDIC and 25 billion USD return of funds previously deposited to First Republic by other banks in an effort to save it a couple of weeks ago. Furthermore, the FDIC will cover 80% of any losses that may occur on the First Republic's portfolio of commercial loans and single-family residential mortgage loans over the next 5-7 years. JPMorgan Chase will also not take over the First Republic's corporate debt and will receive 50 billion USD in financing from the FDIC. According to JPMorgan Chase, such a sweet deal will contribute over 500 million USD in incremental net income per year and a one-time upfront gain of 2.6 billion USD.
Interestingly, JPMorgan Chase - the largest financial institution in the US - already holds more than 10% of all US deposits and was, therefore, ineligible to acquire another financial institution under the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994. It may seem that someone really wanted this deal to go through. Or, as the saying goes, you know things are really bad when laws are changed (or disregarded).
Lowering commodity prices potentially indicating on reduced global demand
The banks are not the only ones expressing doubts about the global economy. The decline in major commodity indexes may be due to shrinking global demand, which in turn may be due to lower household incomes and fears of recession. According to the World Bank, the global economic slowdown is one of the main risks affecting commodity prices this year.
Source: Euromonitor International from World Bank
The World Bank anticipates that commodity prices will experience a 21% decrease in 2023 compared to the previous year, with energy prices expected to fall by 26% this year. The average price of Brent crude oil in US dollars is projected to be 84 USD per barrel in 2023, a 16% decline from the 2022 average. Furthermore, natural gas prices in Europe and the US are forecast to be cut in half between 2022 and 2023, while coal prices are expected to drop by 42% in 2023. Fertilizer prices are also expected to decline by 37% in 2023, which would be the most significant annual drop since 1976. The good news is that such a dramatic drop in prices among all key commodity sectors could translate into decreased inflation, at least from the supply perspective.
The US may be approaching a default
Another worrying factor is that the US may actually run out of funds as early as the beginning of June. Yes, you read that right – the nation's federal government that is considered to issue risk-free debt instruments and holding the world's key reserve currency is as close to default as it has ever been.
According to the latest data, the US is the 11th most indebted country in the world measured by the debt to GDP ratio (129%). The current debt ceiling – the limit set by Congress in late 2021 – of 31.4 trillion USD was reached in January 2023. Since then, the Treasury has been resorting to "extraordinary measures" that are now said to be depleted as well. The new proposal would raise the debt ceiling by 1.5 trillion USD, but the problem is that the Republican and Democratic parties are unable to agree on it. The Republicans are currently open to agreeing on raising the debt ceiling under strict spending restrictions. Meanwhile, the Democrats, including President Joe Biden, insist that the debt ceiling must be raised with no strings and restrictions attached. At this point, the negotiations appear to be at an impasse, with no deal in sight.
According to warnings from lawmakers and experts, the US economy could face catastrophic consequences in the event of a federal government default. While a recession is anticipated later this year, a default could hasten this outcome and potentially cause a severe economic downturn. Furthermore, considering the size and global influence of the US economy, such a downturn could be contagious to the rest of the world. A combination of reduced borrowing and spending would impact lending, borrowing, and financial markets, leading to a recession. Moreover, a default could lead to higher interest rates on the national debt, making the US a less reliable borrower, potentially harming the economy, and hindering its ability to navigate a possible recession.
Even if both political parties could reach an agreement regarding the new debt ceiling, it may signal to lenders and other involved parties that the US government may not be as "risk-free" as previously believed. The US credit rating was downgraded for the first time in history by the credit rating agency Standard and Poor's from AAA (outstanding) to AA+ (excellent) in 2011 following the US Congress's decision to raise the debt ceiling via the Budget Control Act of 2011. Although there have been no further downgrades since then, Moody's has revised the outlook for the US banking system to negative in response to bank failures in March 2023.
Santa Zvaigzne-Sproge, CFA, Head of Investment Advice Department at Conotoxia Ltd. (Conotoxia investment service)
Materials, analysis, and opinions contained, referenced, or provided herein are intended solely for informational and educational purposes. The personal opinion of the author does not represent and should not be constructed as a statement, or investment advice made by Conotoxia Ltd. All indiscriminate reliance on illustrative or informational materials may lead to losses. Past performance is not a reliable indicator of future results.
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