What next after the banking crisis?

The end to one of the most benign monetary policy environments in decades was never going to be easy for financial markets. As well as impacting security valuations, these conditions also feed through to the fundamentals of the companies in which we invest, which must navigate both a fast-changing rates environment and a world we believe is heading into recession. The recent banking stress has been the most visible consequence, but the banks are far from alone in feeling the pressures of this challenging backdrop.

Are we in the clear?

This year we have witnessed the second, third and fourth-largest failures in the US banking system’s history, along with the collapse of European heavyweight Credit Suisse. Despite this, we continue to believe that this isn’t a repeat of the global financial crisis, and that most banks worldwide are in much better shape than in 2008.

Broadly speaking, we continue to see value in financials, though with various US regional banks under stress and investors bracing for more failures, we are clearly not out of the woods yet.

Beyond banking

There is more to the financial sector than just banks: players such as pension funds, insurers and investment managers also play important roles in the global financial system. In credit and equity indices, insurers and asset managers are the most significant non-banks.

Insurance companies (like our parent Legal & General) broadly benefit from rising rates, as their liabilities apply higher discount rates, while asset managers (like us) receive lower revenues when financial market valuations are depressed.

The non-banks are a typically more opaque corner of the financial markets; last year’s gilt market volatility brought this segment squarely into the spotlight. As with previous such episodes, leverage played a role, and remains a risk. Like the recently failed banks, these financials could also be exposed to liquidity pressures if for any reason they should be unable to generate enough cash to satisfy redemption requests.

CRE question marks

Property companies are among the most exposed to rising interest rates. At the same time, remote work is leaving many office buildings under-utilised and therefore depressing valuations. This combination has understandably left commercial real estate in the spotlight – as Bill discusses – and feed back into concerns around the financials invested in this space

For our active portfolios, we believe dislocations in the valuations of real estate companies present opportunities as well as risks – but the quality of their underlying properties vary substantially, so differentiation is crucial.

Corporates in good health

Higher rates and tougher credit conditions impact all companies to some extent, but most corporates refinance a small percentage of their debt stack every year; rising rates are very slow to feed through to meaningfully higher interest payments.

This is less true in the high yield markets, however, where refinancing risk for the most leveraged corporates is a risk that we shouldn’t ignore.

Challenges ahead

US regional banks are not a substantial part of our investment universe. However, smaller banks have been the primary driver of credit growth in the country, so recent stresses have raised the spectre of a feedback loop between issues in the banking sector and the broader economy.

We worry that potential CRE losses for these smaller banks may be the next shoe to drop, which, combined with increased competition for deposits and more onerous regulatory burdens, is likely to accelerate the tightening of lending standards. This reinforces our below-consensus economic growth outlook, as outlined by Tim earlier, and we are bracing for volatility over the coming months.

Across LGIM’s Active Strategies team, we are positioning for this potential turbulence by adopting cautious stances, with defensive risk appetites and cutting our exposure to higher-risk areas. At the same time, we are strengthening our liquidity buffers, and growing both our duration and hedges.

This blog is an extract from our CIO Outlook. Read our full CIO Outlook.