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12 May 2023
Navigating the storm of recent bank defaults
Investors are contending with the highest rate of bank failures since the global financial crisis. We assess the potential risks to financial stability over the next year.
Fundamentals
The Southern Ocean is one of the most challenging bodies of water to navigate anywhere in the world because the weather is highly variable and sudden crashing waves catch unseasoned sailors off guard. Investors are experiencing similar conditions in 2023 after a calm start to the year. Monetary policymakers successfully managed to hike interest rates at the most aggressive pace since the 1970s, yet growth remained robust and inflationary pressure was beginning to subside. However, the fast-changing environment has resulted in the largest banking failures since the collapse of Washington Mutual Bank in September 2008. Despite the pressure on the banking system, central bankers have continued tightening monetary policy. Following the collapse of First Republic, the US Federal Reserve (Fed) implemented its tenth consecutive policy rate increase in just over a year. Fed Chair Jerome Powell insisted that the US banking system remained “strong and resilient” but acknowledged that the turmoil would likely weigh on economic growth, potentially justifying a pause in the current hiking cycle.
Quantitative valuations
With the macroeconomic climate in a state of flux, the debt of the banking sector remains highly volatile. Prior to the recent turmoil, bank debt was seen as relatively strong within the corporate markets. In Europe, Common Equity Tier One (CET1) ratios for banks are at approximately 15% of total risk-weighted assets, putting the financial system on a much stronger footing than in 2008. In the US, the stress has been generally contained to the regional banks and the larger banks remain healthy. Despite these signs of health, the yield-to-worst on the Bloomberg European Bank CoCo Index, which shows the yield on subordinated bank debt, has risen from 9.7% at the start of the year to 11.5% as of 9 May 2023. The disconnect between robust fundamentals and the significant sell-off in valuations highlights the nervousness investors have towards the banking system, despite the recent reassurances from monetary policy officials.
The yield on European Financials has risen sharply vs. European Industrials
Source: Bank of America Merrill Lynch, Bloomberg, J.P. Morgan Asset Management. Financials index is the ICE BofA Euro Banking Index. Industrials is the ICE BofA Euro Non-Financial Index. Data as of 10 May 2023.
Technicals
Portfolio positioning surveys indicate that investors in both Europe and the US have embraced long-duration fixed income in an attempt to protect their investments in the event of an economic downturn. History would support this positioning, especially if the Fed pauses its rate-hiking cycle in the near future: since 1995, in the 60 days prior to the end of the Fed’s rate hiking cycles, Treasuries have posted sizable excess returns of between 40 and 90 basis points.
What does this mean for fixed income investors?
The turmoil in the banking system will likely bring forward the start of the next recession as waves in the financial system disturb activity in the real economy. This turbulence means that the Fed will likely opt to pause its rate-hiking cycle in the near future. While bank balance sheets remain relatively robust, valuations have sold off significantly in this stormy environment. Investors should continue to seek the safety of longer-duration and high-quality fixed income, particularly considering its historical performance at the end of the Fed’s rate hiking cycles.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors
include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations
is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors
are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum
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