“As reckless as a government shutdown is ... an economic shutdown that results from default would be dramatically worse. ... And the United States is the center of the world economy. So if we screw up, everybody gets screwed up.” 

~President Barack Obama

The March banking crisis has been contained (for now), but its impacts will reverberate in the real economy for at least the next 6-9 months as lending appetite contracts and the velocity of money slows down.

Recent weeks have seen the market bogged down by debt ceiling talks in the US, which were punctuated by a last-minute agreement and a passing of the deal into law last week. Additionally, there has been a surge in bullish AI hype, with NVIDIA's blowout earnings guidance adding to the strength of the sector.



In the near term, the real concern for the markets revolves around what happens after the debt deal, particularly regarding the buyers of the bonds. In the past, Asian sovereigns and banks accounted for a significant portion of these purchases, but this trend has been declining and is expected to continue doing so. Consequently, debate is centring around what combination of purchases will come from money market mutual funds (which is where the bulk of money withdrawn from deposits with banks has gone to) vs money remaining on deposit with US banks. In simple terms, the former holds money on deposit with the Federal Reserve (in their reverse repo program) where reallocation into the new Treasury issuance will not reduce the liquidity available for lending in the banking system, while the latter does take liquidity directly out of the banking system. To create the incentive for the former, the US will need to offer a premium to attract demand (i.e., the mutual funds have a fiduciary obligation to maximise return on a minimal risk profile).

The subsequent risk is that, depending on the split, a substantial amount of liquidity may be sucked out of both financial markets and bank deposits in the short term. Bank deposits have already been in decline following the collapse of SVB, and an increasing number of depositors in the US are realizing that they can obtain better interest rates and perceive lower risk by putting their funds to work with the US government via mutual funds rather than keeping them in a bank. As a result, banks must offer higher returns to retain funds, leading to solvency concerns for marginal regional banks and reducing the availability of credit capital.


Managing Expectations
While it often seems the case, Regulators of the monetary system understand the implications of their actions and in the case of what we are discussing above, they understand their actions may reduce the supply of credit and lead to an economic downturn. In fact, they may view this as an acceptable outcome. Why? Well, in simple terms, regulators are concerned with ensuring that consumer expectations of inflation don't become deeply ingrained, controlling wage growth in relation to productivity, and they navigate this complex environment with a set of tools that are insufficiently precise for the current situation, especially considering the demographic mix working against them. They also contend with a political class whose fiscal profligacy has been shockingly high, hiding behind the global pandemic as a smokescreen and may be ideologically in opposition to what is required for the present.

Kitchen and Boardroom Tables
Decisions on spending and their extent are made both at kitchen tables and boardroom tables and managing the expectations / changing the behaviour of both is difficult. At kitchen tables, the focus is on employment stability, cash reserves, the cost of necessities like food and utilities, as well as credit card and property debt. While employment is currently stable, expectations suggest it will weaken in the coming months. In the interim however, spending on airfares and holidays retreat, price increases in services such as health and education and other service components measured by inflation statisticians increase and continue to provide regulators with data that concerns them around whether their expectation management is working. 
Boardroom tables have faced challenges with supply chain uncertainties, rising input costs, a significant reallocation of the labour force due to changing work patterns during the pandemic, and a previously favourable credit environment. Although balance sheets are generally in better shape now, businesses are facing increased risk pricing, leading to failures that will likely persist. Boards are now confronted with decisions regarding continued investment in capital equipment to reduce reliance on labour, incorporating machine learning, improving supply chain security, while also contending with a tightening credit environment and uncertainties regarding the impact of more progressive government policies on their operations (from energy to industrial relations).

All these variables present opportunities but must be viewed through the lens of risk. Prioritizing sequencing of returns in alignment with portfolio objectives becomes crucial during these times. In our portfolios, we have reduced overall equity risk and, for the first time in recent memory, added government bonds to augment our overweight cash positions.

Our rationale is that if the potential liquidity issues unfold, probability weighted against weaker economic data and muted expectations, that they will result in Treasury Bill issuance that will reduce banking sector liquidity, central banks will ultimately be compelled to cut rates because of the impacts resulting from this reduction in liquidity. It is worth noting that it will probably show first in a market sell down before it shows in the real economy and some time may elapse before any interest reduction actions take place.

What does this mean for portfolios? Well, accepting that short term movements in the market will make us look equally smart or stupid, in all our portfolios we focus on where we are being “paid” to take risk and where we are not. Good opportunities to average into longer term rate sensitive assets are emerging – particularly those that are beneficiaries of the themes we have outlined in prior communications. Yield opportunities that provide real income with comparatively lower risk must however be part of the mix in the near term.