The Crucial Questions
Membership required
Membership is now required to use this feature. To learn more:
View Membership BenefitsIn moments like these when events are rapidly unfolding and investors struggle to keep up with volatile markets, it is important to step back and ask three crucial questions:
- Is a systemic financial crisis unfolding?
- Will central banks stop hiking rates?
- What actions can policymakers take to stabilize banks, financial markets and the economy?
Here are our current thoughts:
A decade of cheap funding and deposit stability had ended. Over the past decade, zero interest rates made for stable bank deposits because nothing offered a more attractive return. Following 4.75 percentage points of US Federal Reserve (Fed) rate hikes that began 12 months ago, deposit holders have choices, such as money market funds that offer more compelling returns and are nearly as liquid.
Rising rates pose challenges to the asset side of banks’ balance sheets. That became plainly evident at Silicon Valley Bank (SVB), where losses on unhedged bond holdings blew a hole in the bank’s earnings, leading to its collapse. Other banks may have managed interest-rate risk better, but given the opacity of their holdings, their hedging strategies and their reporting, this lack of transparency is unsettling.
The rapid and aggressive tightening of monetary policy will undoubtedly put some, but not all borrowers at risk. First signs of trouble are emerging in commercial real estate, as well as in subprime auto loans and leases. Equity investors are beginning to discount increased provisioning against write-offs of bad loans.
Recent central bank tightening could be a positive signal. The European Central Bank (ECB) hiked rates 50 basis points (bps, one basis point equals 0.1%) last week, sending a message to markets that policymakers do not think the situation is as bad as many have thought. Similarly, the Fed raised rates 25 bps this week, and also stated that it sees the US banking system as “sound and resilient.” By their actions and their words, the ECB and the Fed are trying to bolster confidence that the financial system and economy are stable enough for them to remain focused on their priority of bringing inflation down to more acceptable levels.
Depositors must be reassured. Banking crises are pernicious because once depositors question the strength of banks, rapid withdrawals quickly follow, putting at risk both weak and strong banks. In the United States, the Fed, Federal Deposit Insurance Corporation (FDIC) and Treasury have taken significant steps through expanded deposit insurance and liquidity provisions to reassure depositors. The Fed has also extended US dollar swap lines with other central banks to ensure that other countries have adequate access to dollar liquidity. Longer term, bank regulators must expand their efforts to properly supervise banks, including using new stress tests. They must also merge or consolidate failing banks where necessary. One area of particular importance is to review bank holdings of marketable securities that could be a source of future write-downs in the event of asset sales to meet liquidity needs. To bolster depositor confidence, regulators must be empowered to force changes to bank risk management practices where necessary.
Central banks must not shy away from making clear statements about cyclical risk and how banks should view the quality of their loan portfolios. Rapid and aggressive monetary policy almost always produces a recession. Central banks must apprise banks of economic risks and regulators must undertake scenario and stress-testing of loan books to assess proper provisioning policies and, where necessary, potential capitalization needs. Those examinations must be made in advance of any cyclical deterioration in credit quality.
As beneficiaries of deposit protection, banks must be adequately supervised and regulated. Increasing transparency of banking is in everyone’s interest. Greater transparency helps to stabilize the economy and financial markets.
Banks have always been and will remain systemically risky because of the liquidity mismatch between banks’ assets and liabilities. The onset of aggressive monetary policy tightening has increased systemic risk on both sides of bank balance sheets. When depositors are fearful, runs can be indiscriminate. Steps taken since the failure of SVB to implicitly extend deposit insurance, to provide central bank liquidity and to absorb Credit Suisse into UBS have calmed market fears. While the opaque nature of banking should always caution us against firm conclusions, the available information leads us to conclude that systemic risk is receding. That will allow central banks to remain focused on reducing inflation.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors or general market conditions.
Investments in fast-growing industries like the technology sector (which historically has been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing scientific or technological advancement or regulatory approval for new drugs and medical instruments. Buying and using blockchain-enabled digital currency carries risks, including the loss of principal.
Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio.
IMPORTANT LEGAL INFORMATION
This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. This material may not be reproduced, distributed or published without prior written permission from Franklin Templeton.
The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The underlying assumptions and these views are subject to change based on market and other conditions and may differ from other portfolio managers or of the firm as a whole. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. There is no assurance that any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets will be realized. The value of investments and the income from them can go down as well as up and you may not get back the full amount that you invested. Past performance is not necessarily indicative nor a guarantee of future performance. All investments involve risks, including possible loss of principal.
Any research and analysis contained in this material has been procured by Franklin Templeton for its own purposes and may be acted upon in that connection and, as such, is provided to you incidentally. Data from third party sources may have been used in the preparation of this material and Franklin Templeton (“FT”) has not independently verified, validated or audited such data. Although information has been obtained from sources that Franklin Templeton believes to be reliable, no guarantee can be given as to its accuracy and such information may be incomplete or condensed and may be subject to change at any time without notice. The mention of any individual securities should neither constitute nor be construed as a recommendation to purchase, hold or sell any securities, and the information provided regarding such individual securities (if any) is not a sufficient basis upon which to make an investment decision. FT accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user.
Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FT affiliates and/or their distributors as local laws and regulation permits. Please consult your own financial professional or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.
Issued in the U.S. by Franklin Distributors, LLC, One Franklin Parkway, San Mateo, California 94403-1906, (800) DIAL BEN/342-5236, franklintempleton.com – Franklin Distributors, LLC, member FINRA/SIPC, is the principal distributor of Franklin Templeton U.S. registered products, which are not FDIC insured; may lose value; and are not bank guaranteed and are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation.
CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute.
Membership required
Membership is now required to use this feature. To learn more:
View Membership Benefits