March 31 2023

Are You Entertained?

The stress on banks has receded, and a full-blown financial crisis looks less likely. US and Europe bank stocks seemed to have found a bottom, after diving 25% and 12% respectively in Mar23. Even Deutsche Bank’s Credit Default Swap, the price of an insurance on its senior debt, decreased by 40bps over the past 3 days, ~20% down.

Are we done then? Well, no. Money continues to flow out of bank deposits, to go into money market and other safe short-term US Government backed instruments. Total assets in Us money market funds rose by $305bn in Mar23, reaching an astonishing $5.5TN, this highest ever, and 35% higher still than the flight-to-safety during the outburst of the covid pandemic.

Think of it, why would it stop when the choice is between bank-risk deposits at 0.4% and government-risk money market at 4.5%? This trend will continue depleting the balance sheet of smaller banks, thus restricting their ability to lend at local level, further slowing down SMEs growth. For banks, it is compounding pre-existing issues of deteriorating asset valuation, not only in treasuries but also in loans. And the downward circle goes on.

Most banks can’t afford paying up to retain deposits, as their asset side is locked in as lower yields inherited from the low-rate environment of the last 3 years. Some others will offer “high-yield” certificate of deposits (CDs), with interests rivalling money market rates. Don’t be candid, CDs imply that you lock your money for up to 18 months. Besides, you still take a banking risk, and the banks that are more likely to pay up are potentially the most desperate. Read the small prints.

What does the investor do? Savers never had it so good. It is quite customary that in rate-tightening period, ultra-short high-quality fixed income is the performing asset class. Until it lasts, pocketing 4.5% to 5% almost risk-free is THE deal. As the economy is rolling over, and the Fed rate path remains uncertain, this is the best risk-adjusted return you can get. Risk premiums elsewhere look unappealing. Here are a few deals though that don’t look crazy.

Whether it is imminent of not, we consider that rates are close to peak and economy will be showing more signs of slowdown in 2H23. Fixed income is attractive on investment grade with a bit of duration. I’d avoid going all in on bonds from Financials, but would pick the larger as they appear more fairly valued, all the more considering that they’ve benefited from the recent financial stress. I’d stir clear of high-yield credit risk, as the economic slowdown will hit harder there, and spreads should widen. On commodities, we are uncomfortable with the trajectory of oil, as the rebound in China’s activity has not offset the slowdown of Western economies. We believe that China is getting cheaper oil from Russian back-channels, which keeps the official market price depressed.

Overall, we have increased our bond exposure at the expense of private assets, and anticipate further bouts of volatility in 2Q23, mainly driven by an increased systemic financial risk, and geopolitical tensions.

About –

360 Advisory LLC is a Boston-based RIA managing investments