No 2008 redux, but recession coming

The Bid Episode 121: Can Investors Expect More Inflation or Market Stability?

Episode Description

In an effort to bring calm to financial markets and some stability to the banking sector, UBS announced it would be acquiring Credit Suisse, a merger of two of Switzerland’s largest financial institutions. The merger has brought some near-term stability to financial markets; however, U.S. and European banking shares remain under pressure as investors assess the impact of the fastest rate hiking campaign since the 1980’s.

Kate Moore, Head of Thematic Strategy and part of BlackRock’s Global Allocation investment team joins host Oscar Pulido, to help explain these developments.

Sources: NYT article Feb 9th, 2023 “Credit Suisse Reports Huge Loss as It Seeks to Revive Fortunes”; Investment Week Article March 21st “Ratings agencies cut UBS outlook to 'negative' after Credit Suisse takeover

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<<THEME MUSIC>>

Oscar Pulido: Welcome to The Bid, where we break down what's happening in the markets and explore the forces changing the economy and finance. I'm your host Oscar Pulido

Since our last episode on Friday where we discussed the impact of continued rate hikes on the economy and the banking sector, we learned that UBS would be acquiring Credit Suisse, a merger of two of Switzerland's largest financial institutions.

This action was taken in an effort to bring calm to financial markets and some stability to the banking sector. While the announced merger has brought some near-term stability to financial markets, US and European banking shares remain under. As investors assess the impact of the fastest rate hiking campaign since the 1980s.

Here to explain these recent developments and what investors can expect. I'm pleased to welcome Kate. Head of thematic strategy and Portfolio Manager on BlackRock's Global Allocation Team

Kate, thank you so much for joining us on The Bid.

Kate Moore: Oscar, thanks so much for having me. It's great to be here during this very difficult period in markets.

Oscar Pulido: Well, Kate, it's Tuesday, March 21st. It's only been a few days since our last episode, but there's been a lot of developments in the markets, particularly in the Swiss banking sector, between UBS and Credit Suisse. So maybe tell us a little bit about what happened over the weekend.

Kate Moore: I think Oscar, that was a master understatement right there. There have been enormous developments in the financial system and of course in market sentiment and expectations around policy. So, what's happened in the last couple days?

UBS is going to be purchasing Credit Suisse. I think we all know that at this point, but just a couple facts around that worth going through. Credit Suisse had been losing trust and faith of investors and of clients for years. This was not necessarily an early 2023 phenomenon. In 2022, they recorded a huge loss, I think it was around, $8 billion. It was their largest loss since the financial crisis, that further shook investor sentiment. And last week, what little confidence was left on the part of investors in the market was entirely wiped out when Credit Suisse acknowledged, and this is a quote, “material weakness” in its bookkeeping. That just shattered any expectation that Credit Suisse could be a going concern.

So, UBS, which is Switzerland's largest bank is buying Credit Suisse for what is a 3 billion Swiss francs. It's about 3.25 billion US dollars and that's a 60% discount to what Credit Suisse was trading at last Friday.

So, a huge markdown and an over the weekend rescue by the number one player in that banking market. And I think really importantly here, the Swiss National Bank has stepped in with some extraordinary statements as well, in terms of guaranteeing liquidity to both Credit Suisse and UBS's going concerns.

And that level of kind of oral commitment, has led to slightly more confidence in the overall financial sector and certainly across the broader equity market.

Oscar Pulido: There was definitely a shade of 2008 to, to the weekend that I had flashbacks to sitting on the edge of our seats, seeing if a deal was going to be done and if it would bring stability to markets and so far, that seems to be the case.

But one of the details in this acquisition that you described was the difference between how certain bond holders in Credit Suisse were treated versus the shareholders in Credit Suisse. And can you tell us a little bit about that nuance and why is it important?

Kate Moore: Yeah, I think the big drama is the AT1 bond holders are entirely wiped out, and AT1 stands for Additional Tier One bonds. There’s a clause in the AT1 agreements that basically said if the government has to step in, these bond holders will not be made whole, and that's $17 billion worth of debt that is going to zero. That's a tremendous shock to the system. At the same time, equity holders will have something out of it. Credit Suisse shareholders are going to receive one share of UBS for every basically 22 and a half shares they had of Credit Suisse. So, there is some equity transfer. But it's certainly at a massive discount.

And the regular bonds, between Credit Suisse and UBS are starting to converge in terms of pricing, but it'll take some time as the merger gets worked out over a number of years. Credit agencies came out this morning Tuesday, the 21st of March and downgraded, and put on negative watch, both UBS and Credit Suisse in large part because there's an acknowledgement that it will take a number of resources, and a significant amount of time to combine the two entities over the next couple years.

Although we expect that UBS and ultimately Credit Suisse legacy bonds are actually a good investment in the medium term.

Oscar Pulido: So, it's interesting that the headline over the weekend says there's been this merger, but you just described something that is going to be ongoing for potentially several years.

So, is this having the calming effect on markets and the economy that it was intended to have, or what are you seeing?

Kate Moore: I think it has some calming effect on the market, but what I will suggest is, it's going to be a painful process as UBS gets rid of Credit Suisse's investment bank. We know they don't want those assets. It's going to have to get wound down. There are going to be losses associated with that and yet it's going to be a huge addition for UBS to add on the wealth management and asset management of Credit Suisse. In fact, after this merger, or this acquisition, UBS will be the second largest wealth manager in the world.

And between wealth management and asset management will have about 5 trillion of assets. It's pretty significant. We're talking about a big stronghold in the wealth management and asset management business, but the investment bank unwind is going to be difficult and probably incur some losses.

Oscar Pulido: And we're talking about two Swiss banks, just a week or so ago we were talking about a couple of US regional banks. So, do you see more banks in the headlines here, in the foreseeable future? Should we brace ourselves for more of those headlines? And then maybe just as importantly, what should investors be thinking about in their portfolios at

this time?

Kate Moore: Yeah, Oscar, I don't think we're out of the woods when it comes to the US Regional Bank turmoil either. while we were really focused on this UBS acquisition of Credit Suisse over the weekend, the truth of the matter is that a lot of regional banks were speaking with different funding sources to shore up their own institutions. So that was happening in the background even while the Swiss banks were getting the headlines. I don't think we're out of the woods yet when it comes to the regional banks. Regional bank shares have fallen 24% over the same period, they've stabilized somewhat in the last few days as deposit outflows seem to have slowed up, but we don't have hard data there. And I think that's the big question for markets right now is that even if we've slowed down or, in some cases stopped, will those deposit outflows we saw over the last, call it seven business days, really shake the foundation of these regional banks and the big question after that is, what is the government going to do to regulate regional banks?

There have been lots of proposals from both sides of the aisle, almost no agreement on the approach. And we know this is going to be hotly debated in Congress with very little resolution in the near term. That may mean that some weaker regional banks with strong gearing towards things like commercial real estate and very concentrated industries may require bailouts or support sooner, rather than later, before that regulation gets finalized.

Oscar Pulido: So, we made it this far without talking about the Fed, but here we go, last week we talked to Alex Brazier, and he said the Fed is unlikely to pause with their rate hikes, because inflation is still an issue and the Fed has other tools, as Alex described, that they can use to address some of the financial stability concerns.

What's your take on Fed policy?

Kate Moore: There are few jobs I think that are more challenging right now than being a monetary policy decision maker. You're damned if you do and you're damned if you don't. In this case, inflation remains elevated around the world, particularly in the developed world, and at the same time, there's tremendous fear of economic slowdown or impending recession.

And you add on this additional layer of stress in the financial system and it's an almost impossible task to make everyone happy and to really assure markets that you are on the front foot. So, I don't envy Jay Powell and the rest of the FOMC and their decision making.

The market has changed its opinion on what the Fed is going to do pretty dramatically over the course of the last three weeks. At the end of February, because of stronger than expected economic data and inflation remaining quite hot, labor market remaining really tight the expectation was the Fed would raise policy rates by another 75 basis points and then perhaps cut 25 basis points at the end of the year, and now in just a very short period of time, less than three weeks basically, the market is now pricing in 75 basis points of interest rate cuts by the end of this year.

It's almost like 130 basis point move in terms of the Fed fund future's expectations by year end, I mean that level of rate expectation, volatility is nauseating to say the least.

So, it's been this huge move in terms of expectations for Fed Funds futures, and I don't think we've seen the end of it, Oscar, I actually think we're going to continue to see expectations evolve as we take in additional macro data, stresses in the financial system, and as the Fed reflects some of the regulatory changes in the banking system.

Our base case right now is that the Fed does raise policy rates here at the March meeting, and they raise by 25 basis points, but they offer a much more dovish and softer tone and really talk about continuing to incorporate not just the economic data but the events in the financial market into their decision making. You know, markets love certainty and equity markets love certainty, so maybe that level of uncertainty doesn't assure the market as much as otherwise a dovish tone might have. We'll be watching really closely the market reaction, but I just have to say, we prefer a much more cautious approach to risk taking at this point, even though the economic data hasn't collapsed, and even though we know that the policy makers will step in as needed.

The level of uncertainty, the lack of clarity, and the lack of clarity from companies and what their businesses are going to be doing and what their earnings are going to look like through the balance of the year, make it really hard to put on a lot of risk.

Oscar Pulido: Fair enough. It sounds like it's an evolving situation. I have to ask you, because you've been a guest in the past, is there a particular genre of music that you listen to in these periods of uncertainty? Because I know that's another passion of yours.

Kate Moore: Yeah, I am obsessed with music and putting together playlists that encapsulate the period and the mood.

So, I'm an alt rock kind of girl. If anyone listens to SiriusXM, I'm a Channel 36-er. and my favorite song right now is a collaboration between The National and Bon Iver called Weird Goodbyes that would be my, number one recommendation for everyone who's looking for diversion from these markets.

Oscar Pulido: Insights on financial markets and music recommendations. Thanks, Kate, for joining us on The Bid.

Kate Moore: It's great to be here, Oscar.

Oscar Pulido: Thanks for listening to this episode of The Bid. Be sure to subscribe to The Bid wherever you get your podcasts.

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This material is intended for information purposes only, and does not constitute investment advice, a recommendation or an offer or solicitation to purchase or sell any securities, funds or strategies to any person in any jurisdiction in which an offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The opinions expressed are as of the date of publication and are subject to change without notice. Reliance upon information in this material is at the sole discretion of the listener. Investing involves risks. BlackRock does and may seek to do business with companies covered in this podcast. As a result, listeners should be aware that the firm may have a conflict of interest that could affect the objectivity of this podcast.

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