The Crisis of
All of the action was in bond markets in the first quarter and it was all concentrated in the final month. On March 7, just prior to the collapse in Silicon Valley Bank and Signature Bank, financial markets were factoring in a peak official US interest rate of 5.7%, with no rate cuts expected in 2023. Within the space of 10 days, the expected peak rate fell to 4.8%, roughly where it is currently, and 100 basis points worth of rate cuts by year end.
Reflecting this dramatic change of heart by the bond market, 2-year bond yields on both sides of the Atlantic saw dramatic moves. In the US, 2-year bond yields saw the largest daily fall in March since 1982. German 2-year yields had the largest decline in the history of the data (that goes back to reunification in 1990) following the forced takeover of Credit Suisse by UBS.
Whilst banks were the epicentre of the volatility in the quarter, as a sector they are not a cause for concern. For the US it was a case of less regulated smaller banks having poor risk management practices and highly concentrated deposit bases. For Europe, it was a case of a poorly managed bank that had been struggling under the weight of its own mistakes for the past three years.
1. Tighter financial conditions
Even before the recent mini banking crisis there was evidence of a tightening in US bank lending standards. The yield curve was the first indicator that this was happening. It inverted back in July last year when long term interest rates fell below short-term interest rates for the first time. This tends to lead lending standards which in turn leads the economy.
The US Federal Reserve have woken up to this, with Chair Powell stating that the monetary policy committee anticipates recent events will lead to a broader tightening of credit conditions that will impact household and business financing, and ultimately weigh on economic activity and inflation. In this sense, tighter credit conditions will likely act as a substitute for additional monetary policy tightening.
Net % of Domestic Respondents Tightening Standards – Loans for Large/Medium Banks
2. Not the GFC 2.0
Early in the month of March banks were at the epicentre of a crisis of confidence. For the less regulated smaller US banks it became clear that some of their business models were nowhere near as diversified or robust as their larger more regulated counterparts. And in Europe, Credit Suisse had a very different and concentrated depositor make up to the rest of the large banks on the continent and was the negative outlier in terms of profitability.
This is not the Global Financial Crisis 2.0. Corporate leverage is far higher now than in the GFC but in contrast, bank leverage is far lower. The correct parallel may be something closer to 2001-2003; where corporates faced an extended default and downgrade cycle engineered by overly tight monetary policy. It is harder to default today than in 2001, given the proliferation of covenant-lite bond agreements, but we should expect defaults to rise from the record lows.
So tough times are ahead but banks will not likely be at the epicentre of it.
US Financial and Non-Financial Corporate Debt (% GDP)
3. Different strokes
One of the interesting things about the mini banking crisis in March has been the disconnect between how the bond and equity market has responded. Bond volatility exploded while equity markets remained relatively calm. Part of the reason for the disconnect may be related to investor positioning. Bond investors were heavily positioned toward higher (not lower) interest rates while (non-retail) equity investors had relatively light allocations prior to the shock.
The reaction from the bond market has been to effectively price in a recession. A recession will undoubtedly bring higher equity volatility if and when it happens. So maybe the bond market moves first as interest rates repricing is more immediate but the equity market moves will take time as the economic impact is eventually felt.
Bond and equity market volatility
The collapse of Silicon Valley Bank and the rescue of Credit Suisse by UBS in a matter of weeks has led to a sharp sell off in banking indices across the US and Europe. An index of US regional banks, in particular, has lost more than a third of its value since the beginning
of March. The Australian banking sector, however, has been relatively immune to these developments, losing just 3% in this time compared to a marginal gain in the ASX 200. At this stage, the liquidity issues that have been the catalyst in the US and Europe do not appear to be replicated across the Australian majors. The funding and balance sheets of each of the big four remain in a healthy position, with tighter regulatory oversight from APRA since the global financial crisis having the desired effect.
Australian banks not caught up in global contagion
Australian small caps have lagged large caps now in seven of the last nine quarters extending back to the beginning of 2021, for a cumulative underperformance of 29%. A larger P/E derate for small caps compared with large caps through 2022, however, only tells part of the story. The more significant driver has been more robust earnings growth from large caps, particularly from the large resources and financials sectors of the market. A ‘higher quality’ aspect to large caps is likely playing a part in recent months, with more resilient earnings expected in a slowing economic environment through 2023.
Australian small cap underperformance extends into 2023
- Despite retreating across February and March, the Australian equity market generated a solid total return of 3.5% for the first quarter of 2023, primarily on the back of strong gains made in the first few weeks of the year.
- A notable feature of markets in the quarter was the change in market leadership, with stocks and sectors that underperformed through 2022 instead leading the way in the early part of 2023. This also applied to the Australian equity market – after outperforming through last year, domestic equities lagged their overseas counterparts in the March quarter.
- The evolving inflation outlook and implications for monetary policy was a key factor through the quarter. With inflation easing from recent peaks in several key developed economies, markets increasingly look towards a near term end to central bank tightening and potential rate cuts in the second half of the year.
- Long bond yields thus fell from recent highs, a trend which accelerated after the collapse of Silicon Valley Bank in the US. Longer-duration growth stocks were the beneficiaries and for the Australian market, IT and consumer discretionary sectors led the way. Defensive sectors also performed well, as investors positioned for slowing economic growth in the near term and stocks that have a more resilient earnings profile.
- Cyclical sectors were more mixed; mining stocks were helped by a rebound in iron ore on the back of China’s reopening, while financials lagged on fears around peaking margins and amid concerns around the global banking sector.
- This environment was conducive to better performance from growth-orientated managers such as Selector, with the portfolio generating alpha of more than 3% for the quarter.
- Other large cap managers to do well included Pendal, whose outperformance was more driven by stock selection.
- Australian small caps again lagged their large cap counterparts for the quarter and have now underperformed large caps by 13% over the last 12 months.
- Performance across our managers was relatively mixed, though the standout was Spheria, who generated a return of 5.2% and continued to benefit from corporate activity and a focus on companies with sustainable cash flows.
Financial stocks were the worst performing sector in the S&P 500 in the first quarter of 2023 as the failure of SVB and Signature Bank lead to a change of heart by the bond market about the likely course of interest rates. Prior to the start of the end for SVB, the bond market was expecting a peak official interest rate of 5.7%, with no rate cuts expected in 2023. Within the space of 10 days, the expected peak rate fell to 4.8%, roughly where it is currently, and 100 basis points worth of rate cuts by year end. Lower interest rates are a positive for longer duration sectors like technology which is why the IT sector put in the best performance for the quarter.
S&P500 Sector Returns (Q1-2023)
While the lowering of interest rate expectations over the last month of the quarter has supported equities generally and technology shares
specifically, it hasn’t quite been a case that buying any tech-related name has paid dividends. In January, the decline in yields helped pump up what we might term as low-quality tech personified by the UBS Profitless Tech Index. That metric rallied 35% from the start of the year, versus 15% for the NASDAQ. Fast-forward to today, and the NASDAQ is up some 20% on the year, while profitless tech has seen its year-to-date gains slide, with the index lower than it was at the end of February. Equity investors – to their credit – appear to be sticking with higher-quality names that actually make money.
Not all tech is the same
- The MSCI World Index rose 7.3% in the quarter as dip-buyers rushed back into riskier assets amid easing stability worries. The S&P 500 index closed the first quarter at a 6-week high rising by 7.0% since the start of the year while the Nasdaq entered a bull market. European shares outperformed the US with banking contagion risks fading into quarter-end.
- Emerging market (EM) equities posted moderate returns over Q1, rising by 3.5%, helped yet again by a weaker US dollar. Chinese tech shares surged on Alibaba and JD.com spinoff plans. The big winners in emerging markets were the tech-heavy South Korea and Taiwan markets, boosted by lower bond yields.
- Uncertainty is high. The great sector rotation set in motion by equity investors in Q1 underscores that. Fourth-quarter laggards, such as technology, flipped to being market leaders in Q1. Banks, which enjoyed their best quarter since early 2021 at the end of last year, are enduring their worst month since the pandemic devastated sentiment three years ago.
- Growth stocks rose, but cyclicals that rely on strength in the economy – like large industrials and airlines – were resilient. Defensive shares are struggled but remained just in positive territory.
- The Australian dollar fell 1.9% against the US dollar but fell more against the euro and UK pound. Global funds that were unhedged therefore benefited.
- The decline in bond yields over the quarter provided a support for our growth-heavy funds. This was particularly the case for the Loftus Peak Global Disruption Fund and for our small cap funds.
There’s still a possibility the US Federal Reserve will be able to pull off a soft landing with its interest rate hikes, but turmoil in the banking sector has heightened the risk of recession. This is reflected in the still inverted yield curve. The Fed will need to maintain its credibility and keep rates high until inflation has come back down.
US 3mth-10 year yield curve (bpts)
If inflation data continue to moderate, it is more likely than not the US Federal Reserve will take a pause in their rate hike cycle, particularly given growth concerns in the economy. A look at the Fed’s own data underscores these concerns. The central bank’s survey of senior loan officers at banks have flashed a serious warning that economic pain was approaching, with the percentage reporting some tightening of standards jumping above 40% to levels only seen before or during recessions.
Core US inflation (yoy %)
- Government bond yields fell in the March quarter. The banking crisis shifted perceptions of policy and the economy dramatically in March, and on a literal level has led to a previously-unexpected rise in the size of the US Federal Reserves balance sheet thanks to the imposition of emergency programs.
- 10-year government bond yields fell by 75 basis points in Australia and by 41 basis points in the US. The US Federal Reserve and the Reserve Bank of Australia each raised interest rates twice over the quarter taking the official interest rate to 5.0% and 3.6% respectively.
- Credit markets performed well with gains in January and March more than offsetting losses in February. This provided some support for our credit funds such as the PIMCO Global Credit Fund and the Bentham Global Income Fund.
- The decline in bond yields over the quarter boosted the returns of the funds in our duration bucket. This was particularly the case for the Legg Mason Western Asset Management Australian Bond Fund.
- Our liquidity funds, Realm and Alexander, performed inline with expectations for the quarter.
Private debt fundraising finished the year on a strong note. The asset class saw steady sequential gains throughout the year, culminating with $60.7 billion in total fundraising in Q4. Private debt has surpassed the $200 billion mark for the third consecutive year. Direct lending continues as the most sought-after private debt sub strategy by far among capital-starved borrowers and yield-hungry investors, with the latter seeking a hedge against rising interest rates and the former combating a wholesale retreat by bank lenders.
Private Debt Fundraising Activity
Private Equity (PE) backed sales of portfolio companies slowed significantly in 2022 and has continued into Q1 2023 as PE fund managers instead look to hold on to profitable businesses and wait for broader market uncertainty to dissipate. Whilst managers report fundamental performance of portfolio companies has remained resilient, the environment to realise profits by selling stakes in private companies has become challenging as earnings multiples continue to contract. Pitchbook report total PE exit value has declined by 34% versus the same quarter a year ago. PE managers continue to focus on sales to other PE sponsors or corporate acquisitions while the IPO market remains broadly shut as just 3% of total exits for 2022 were to IPOs down significantly on the long run average of 17%.
Private Equity Exit Activity Slows
- Equity long short manager Munro Global Growth finished the quarter +2.1% against the backdrop of a volatile market environment. The fund’s gains were driven in March, as the market rallied.
- Long equities positively contributed along with currencies, while short equities and portfolio hedging negatively contributed to performance. The top contributor over the period was Microsoft following a successful product announcement that integrated ChatGPT. NVIDIA and AMD were also strong performers as the key enablers of the underlying infrastructure of AI. LPL Financial was the largest detractor, impacted by falling rates, which reduces their earnings power. The Fund has started to deploy some of the portfolio’s elevated cash levels during the quarter. In a similar manner, Tiger Global benefited from core positions across ecommerce and fintech. The manager continues to maintain a conservative level of exposure.
- PE activity continued to trend lower however there were pockets of activity in strategies such as M&A and consolidation in fragmented industries as PE sponsors look to take advantage of discounted valuations on companies in healthcare, industrials and parts of technology.
- For the three months ending February 2023 Partners Group Global Value Fund added 2.9% and Hamilton Lane Global Private Assets Fund Hedged added 3.5%. Partners Group saw positive contribution from PCI Pharma, and Techem, both gaining on the back of stronger revenues and earnings. Hamilton Lane gained from secondary positions in software cybersecurity, and water and waste focused businesses.
- Merrick’s Partners added 2.5% over the three months ending February 2023. Underlying loan income performed strongly for the month, with floating rate loans continuing to pass through rising interest rates in Australia and New Zealand. The portfolio currently comprises senior secured loans diversified across sixteen sub-sectors and is additionally diversified by geographic spread and borrowers. Credit default Swap (CDS) protection continues to provide the Fund with a cost-effective macro credit hedge.
- Barwon Healthcare Property Fund fell by 2.7% for the first quarter of 2023. Softness in cap rates detracted against performance whilst income yield continues to remain resilient at an annualised rate of 4.3%. Charter Hall Direct Office and Wholesale Property Series No.2 Funds gained 0.3% and 0.2% respectively over the prior three months benefiting from income yield.
- Macquarie Private Infrastructure Fund continues to benefit from longer-term structural trends in the sector. Significant opportunities continue to open up for investment into next generation infrastructure such as renewable energy and digitization.