Weekly Investment Update (03/17/2023)
- Financial stability and the Fed: Concerns about financial stability joined economic, labor market, and inflation data as a key factor that the Fed will weigh during next week’s meeting.
- Europe: The ECB raised interest rates by 50 basis points and promised to be more data dependent going forward as Credit Suisse continues to struggle despite Swiss central bank intervention.
- Commercial real estate: Rising interest rates pressure commercial real estate lenders and borrowers; the space is better positioned than 15 years ago given better capitalization and liquidity requirements as well as tighter lending standards.
Financial Stability in Focus Alongside Economic, Labor, and Inflation Data Ahead of Fed Meeting
Concerns about financial stability joined economic, labor market, and inflation data as a key factor that the Fed will weigh during next week’s Federal Open Market Committee (FOMC) meeting. The recent failures of Silvergate, Silicon Valley Bank (SVB), and Signature Bank have brought attention to the financial stability risks associated with the Fed’s aggressive hiking cycle over the past year. We covered these events as they stood earlier in the week in our “Update on Regional Bank Volatility and Portfolios” Investment Update. Since the Fed began raising interest rates, the lagged impacts of tighter monetary policy have become evident, with bank liquidity and interest-rate risk front and center this week. The Fed is undoubtedly evaluating the headwinds to credit growth given slower bank credit creation at regional banks and the likelihood that this will hinder economic growth in the near term.
Economic data this week continued to show decelerating inflation as well as weaker growth. Annualized headline Consumer Price Inflation (CPI) declined from 6.4% in January to 6.0% in February, while core CPI decelerated at a slower rate from 5.6% to 5.5%. Core services excluding rents, the measure the Fed is watching closely, accelerated in February and remains elevated, driven by strong consumer demand for services. Lodging away from home and airfares saw notable price increases during the month. The shelter component continues to be a large driver of inflation but will begin to decline soon in our view, since it is measured for CPI purposes with a six- to nine-month lag. While we are likely to see this overall disinflationary trend continue as the impacts of interest-rate hikes permeate the economy, recent data suggest the path is unlikely to be linear.
The combination of several bank failures and a moderating pace of disinflation demonstrates the tension between the Fed’s financial stability and inflation-fighting objectives. As a result of recent bank volatility, the Fed’s next move with regard to tightening is likely to be less than previously expected, especially given the recent impact on credit creation. While market pricing has fluctuated markedly in recent days, investors are currently pricing in a 71% chance that the Fed will raise its policy rate an additional 25 basis points next week, a notable downward shift from last week's markets odds that favored a 50-basis-point hike. Should bank volatility continue or accelerate ahead of the Fed meeting, we would expect the Fed to seriously consider pausing rate hikes. While the Fed is currently in its blackout period and unable to comment on policy implications from the fallout of SVB, Nick Timiraos, the journalist the Fed has previously used to communicate during silent periods, published an article this week highlighting the two-sided risks facing the Fed.
ECB Raises Rates While the European Banking Sector Comes Under Pressure
The European Central Bank (ECB) met expectations and raised interest rates by 50 basis points on Thursday, taking the benchmark deposit rate to 3%. Notably, its prior commitment to keep “raising interest rates significantly at a steady pace” was dropped from the most recent policy statement, likely in response to recent banking sector concerns. Nervousness around the banking sector spread across the Atlantic with Swiss bank Credit Suisse shares falling 25%. Concerns about the bank were compounded on Wednesday after comments by its largest shareholder were misinterpreted. However, on early Thursday morning, in an attempt to shore up confidence, the Swiss lender accepted a $54bn lifeline provided by the Swiss National Bank.
In addressing the skittishness in the wider banking sector, Christine Lagarde, the ECB president, stressed that eurozone banks were “resilient, with strong capital and liquidity positions,” while emphasizing that the central bank had the tools to “provide liquidity support” if needed. Promising to take a “data-dependent” approach to future decisions, the ECB said it was “monitoring current market tensions closely and stands ready to respond as necessary to preserve price stability and financial stability.”
Markets took comfort in the central bank’s decision to remove its previously stated automatic rate-hiking path in case financial conditions fail to stabilize. Overall, the more dovish tone from the ECB and the intervention from the Swiss National Bank helped calm markets on Thursday. However, it is important to note the lagged impact of the ECB’s prior hikes, the full extent of which may not be felt for several months.
Although Bessemer’s portfolio managers have modestly increased their exposure to developed Europe, Bessemer’s All Equity Portfolio remains underweight the region (9%) compared to the benchmark (17%).
Commercial Real Estate Lenders Better Positioned Despite Rising Rates
As we pass the one-year mark of the Federal Reserve beginning its hiking campaign, there are a few areas to monitor given the lagged economic effects that follow monetary policy tightening as the recent episode of regional bank stress highlighted. One area of focus is the commercial real estate (CRE) market and, in particular, loans behind these properties known as commercial mortgage-backed securities (CMBS).
There was over $1.6 trillion in CMBS outstanding as of the end of 2022, with the asset owner base largely composed of institutional investors with loans split into tranches with different credit ratings. A portion of these loans with floating rates is pressuring landlords’ margins as rates have risen over the last year. To the extent the Fed keeps policy rates restrictive for a prolonged period, there may be resultant pressure on CMBS borrowers.
In the short-to-medium term, costs are increasing for borrowers, yet many commercial tenants are locked into leases. These borrowers often have a working relationship with their lenders, and if the borrowers succumb to stress, they may reach out to lenders to modify or extend their loans. Generally, lenders are neither in a position to take possession of and operate commercial real estate nor potentially sell the property at a discount. Therefore, as stresses surface in the CRE/CMBS market, it is often in the best interest of borrowers and lenders to absorb the shock, and some property price volatility is likely as these types of deal modifications are re-underwritten.
While delinquencies are rising, lenders are better positioned than they were 15 years ago. Regulation has kept larger banks in check with stricter capitalization and liquidity requirements. Lending standards have been tighter as well, with loan-to-value ratios at 60% to 70% on average. Additionally, it is important to note that local and regional banks are important lenders in the CRE debt market. A noteworthy focus will be the impact to the office subsector as reverberations of the pandemic are felt. In time, subsectors within CRE such as office and apartments are likely to evolve and stabilize, but the overall process could be volatile, and properties are likely to experience some price dispersion. Bessemer portfolios do not have exposure to CRE or CMBS debt and we will continue to monitor the ongoing and fluid situation with lenders.
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