The financial turmoil is not over

The writer is co-founder and chief investment strategist at Absolute Strategy Research

There’s an old investment saying that bull markets last longer than you think possible and bear markets hit harder than you can imagine. This is one reason why investors should be positive most of the time. However, once every eight to 10 years it pays to be cautious. The recent spate of bank failures suggests that now is one such moment.

Policymakers want to present these bank failures as idiosyncratic and unlikely to trigger a broader systemic crisis. We are unconvinced. First, we have a different view of the nature of systemic risk. And second, a decade of low rates and easy money has distorted capital allocations in ways that increase the risk of systemic crisis.

Successive financial crises have shown that systemic risk is multiplicative. The failure of a small entity can have severe consequences for the whole system. Faultlines tend to show up in the weakest links in systems, not necessarily the largest. Despite this, policymakers continue to obsess about the larger institutions as systemically important, only to be blindsided by smaller players that are less well-capitalised and less tightly regulated.

The recent spate of US bank failures is also a symptom of what we call quantitative destruction: the systematic unwinding of the institutional structures that emerged and thrived in a decade of near-zero rates and easy liquidity. The largest, fastest and broadest tightening of policy rates seen in 40 years, combined with central bank balance sheet reduction, is challenging parts of the financial system. Many models for business operations, funding and default have not been road-tested adequately for such a sudden shift. We saw this last year when crypto and the strategies of UK pension funds came under pressure.

And if 2022 was about the repricing of capital, 2023 is likely to be about the reduction in the quantity of capital, as “quantitative destruction” puts alternative assets and non-bank financial institutions to the test after their recent rapid growth.

A decade of zero rates triggered a search for yield which led to pension fund portfolio allocations to commercial real estate and alternatives rising from 15 per cent in 2007 to 23 per cent by 2022, according to Willis Towers Watson’s Thinking Ahead Institute. Real estate could be one key flashpoint in 2023. Residential property prices have already been hit hard by higher rates, and now commercial property prices are also falling. Eventually, asset owners and lenders will need to reprice their property assets. With about 60 per cent of $2.9tn US commercial real estate loans funded by smaller banks, stress looks set to rise.

Private debt and equity also gained from their higher yields and lower reported volatility (since their valuations are often not marked to market). When liquidity was plentiful, private companies could easily access debt and equity markets. This becomes harder as rates rise and liquidity evaporates.

Asset owners may have to make good their commitments to invest in funds when called on. To do this, they may need to sell publicly listed assets, liquidating what they can sell, rather than what they want to (as happened in the UK pension fund crisis over so-called liability driven investment strategies). A recent New York Federal Reserve Board paper highlighted how these kind of asset fire sales by non-bank financial institutions — which now account for $60tn of global assets — could inject systemic risk back into the banking system.

Increased financial risks are also a symptom of broader debt deleveraging. Between 2008 and 2021, the expansion of central bank balance sheets led to a sharp rise in borrowing. Global non-financial debt rose in that period from 182 per cent to 257 per cent of gross domestic product.

As central banks shifted to quantitative tightening, that non-financial debt has fallen back to 238 per cent of GDP (with US non-financial debt consistently falling as a percentage of GDP for the first time since the early 1950s). While central bankers may see balance-sheet reduction largely as a technical process, the financial sector is experiencing it as classic debt deleveraging.

At the start of every systemic crisis, financial failures tend to be labelled as idiosyncratic. As the pace and scale of financial failure spreads, that narrative becomes harder to maintain. A decade of zero rates and easy liquidity have provided the preconditions for systemic crisis, with rapid asset growth and financial innovation encouraging new entrants into lightly regulated areas. We believe that “quantitative destruction”, fuelled by a toxic mix of rising rates, debt deleveraging and elevated equity valuations, has the potential to turn those financial risks from idiosyncratic to systemic.