• Morningstar said bear markets don’t tend to end until there is a credit issue in monetary tightening cycle
  • Collapse of Silicon Valley Bank and Silvergate Capital in US could be credit issue in this cycle of higher rates
  • Investors urged to proceed with caution as central banks deal with inflation and stress on financial system

Is there a silver lining to the collapse of Silicon Valley Bank (SVB) and Silvergate Capital (SI) in the US? The fallout of the two California-based banks and largest bank failure since the Global Financial Crisis (GFC) more than a decade ago is only now starting to be realised.

However, Morningstar head of equities research Peter Warnes said it could signal we are coming to the end of a bear-market cycle.

Warnes, who has been working in financial markets since 1968, said bear markets don’t end until there is a credit issue in the tightening cycle of central banks.

“The tightening cycle causes a credit issue and then that usually is the last part of a bear market – in other words, you go back in history and you’ll find that is the case,” Warnes said.

“Silicon Valley Bank and Silvergate could be the early-warning signals of something happening as interest rates have surged quite dramatically over the last eight to 10 months and there is going to be a cause and effect.”

 

Three excesses contributing to collapse

Warnes said he is not surprised by the collapse of SVB, a key player in tech and venture capital, along with crypto-focused SI.

“It doesn’t really surprise me that this is happening, because if you look at where the excesses have been over the last couple of years it has been in Silicon Valley venture capital, which has been funded at breakneck speed, cryptocurrency and the bubble of high prices and record low yields in US treasuries,” he said.

“The Silicon Valley Bank collapse is playing out because of those excesses and were created by central banks with, one – their accomodating monetary policy, and two – through up to US$25 trillion into the global banking system allowing easy access at a cheap price to enable the gambling going on.”

Warnes said a tightening in monetary policy with higher interest rates is yet to rein in the balance sheets of central banks, with excess liquidity they created still out there and still an issue.

“It starts with depositors getting nervous. And over in the US, like here, there is a $250,000 limit on insured deposits so they get a bit nervous looking at deposits which aren’t insured and taking them out and then if there’s a run, banks have to look at how they replace those funds,”  he said.

“Banks look at the other assets they have and it just so happens they have a big bond portfolio.

“They’re sitting on significant unrealised losses because the yields have gone through the roof and prices have collapsed, but that’s the only asset they can sell and so they become realised losses.”

He said then the banks have to raise equity to get the balance sheet back in shape but the equity window closes.

“Bang, you’re gone because you can’t do business and the receiver walks in,” he said.

“That won’t happen here but you might see some nervousness in some of the people who have excess deposits over $250,000 and they’ll start moving them around,” he said.

Warnes said that could have an impact on banks such as the Commonwealth Bank of Australia (ASX:CBA), which recently announced a record half year profit of $5.15 billion, where its deposit to loan ratio is one of the highest it has ever been at 75%.

“In other words 75% of their loans have been funded by customer deposits and if they start getting a run will have to go to the wholesale market, which is a lot more expensive than the retail market so their margins get crunched,” he said.

“I’m not saying that will play out here but in the US no one knew what the situation was in the GFC as to where the sub-prime debt was being held and it would’ve been syndicated and thrown out into the marketplace by investment banks.

“But in this situation, you have so much liquidity out there you don’t know where it is. And we were in interesting times before the Silicon Valley and Silvergate Capital collapse – now we are even in more interesting times.”

 

Amber light flash faster as bond yields fall

Warnes said the warning lights are starting to flash more quickly with a rush to bonds as investors seek a safe haven.

“The amber light might have been flashing once every 10 seconds, now it is flashing once every five,” he said.

Warnes points out yield on the two-year US Treasury note has shed around 47 points over a two-day period as investors looked to safer havens.

“Maybe even depositors hooking money out of the banks were buying bonds,” he said.

“That upsets what the central banks are trying to do in their tightening cycle, so there are a lot of moving parts out there at this point in time and the heightened uncertainty is not positive for financial markets.”

Warnes said central banks are now dealing with two issues – inflation and some stress on the financial system.

 

Proceed with caution

While markets rallied in January, Warnes said he started the year cautioning participation with the outlook challenging.

“I’ve been cautious for a little while because history is on the side of a credit issue before bear markets come to an end,” he said.

“I do study what happens in those markets and it works out just about every time, so I would be very cautious.”

Warnes said investors need to be careful about where they put their money in the current environment.

“There is no doubt we are getting closer to where you would start putting money back to work but it’s just not yet,” he said.

“You have to be very careful at this point in time and later in 2023 there will be opportunities but it’s too early at this point.”

 

Tougher economic challenges for companies in 2023

Warnes said the recent reporting season was all about 2022 and the economic conditions in 2023 will be far more onerous.

“The fourth quarter GDP in Australia was an annualised rate of 2.7%,” he said.

He said the RBA and many economists have GDP growth at 1.5% in 2023 and 2024, around half of what it was last year.

“Corporate earnings can’t go up if the economy is shrinking, their rate or growth is also going to be mirrored by what is happening in the macroeconomic picture,” he said.

“There will be isolated incidences where some corporates do better than others but generally speaking corporate profits will be under some pressure.”

 

Don’t bet on a fall in interest rates

In its 10th consecutive hike the RBA raised the cash rate by 25 basis points last week to 3.6%, the highest level since mid-2012 as it works to bring inflation back to its target of 2-3%.

Australia’s latest monthly CPI figure reveals inflation was 7.4% for the year to January, a drop from the 8.4% rise for the year to December 2022 with the unemployment rate rising from 3.5% to 3.7% as higher interest rates trimmed the growth of new jobs.

But Warnes forecasts the only reason interest rates will come down is if Australia has a hard landing and recession.

“If it wasn’t for unemployment being where it is then interest rates might ease but at the moment it has a three in front of it not a five,” he said.

“You have to have a reason to bring rates down when inflation still has a 7 in front of it because that is not getting it under control.

“If you don’t crunch demand you’ve lost the war and they don’t want to lose the war.”

 

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