No Time To Be Too Brave

12 May 2023

Pascal Blackburne

The US banking troubles may not be over, after all. The most recent failures pertain, however, not to accessing central bank liquidity, a matter that was fixed by the Federal Reserve immediately after Silicon Valley Bank went under, but rather to the quality of some banks’ loan portfolios. Which in turn has to do, amongst others, with the fragile state of some segments of the US real estate market, notably commercial space and office buildings that have become harder to rent out since the Covid crisis. Also on our current watchlist is the drop in oil prices, clearly not warranted by physical supply and demand considerations. Could there be a geopolitical aspect to this sudden and sharp downmove?     

We were perhaps a little hasty last month, in writing that the Federal Reserve (Fed) decision to accept government bonds at face value (rather than market value) as collateral for liquidity provision was a “game changer”. Indeed, depositors continue to pull their money out of mid-sized US banks, shifting it to larger and better-controlled establishments, or to money market funds that now offer decent returns. Faced with such large deposit outflows, the impacted banks are having to rapidly sell off parts of their loan portfolios. For the asset side of their balance sheets consists, of course, not only of “safe” long-dated US Treasury bonds, but also of loans that are not eligible for collateral at the Fed or, at best, for only a part of their face value. Add to that the problem, especially for listed mid-sized banks, of hedge fund shorting, which is driving stock prices down sharply and making it difficult to raise additional capital.

That bank failures have so far occurred mostly in the US, with the notable exception of Credit Suisse, certainly has to do with the fact that the strict Basel III standards, established in the wake of the Great Financial Crisis, seem less respected there than on this side of the Atlantic. Indeed, US banks with balance sheets of under USD 250 billion – especially regional banks – are less tightly controlled than was initially designed. A decision made by the Trump administration, which is now backfiring sourly.

Given the strong global interconnectedness of financial institutions, banking woes may, however, not remain contained to the US. And even absent further failures, what seems clear at this point is that credit conditions will continue to tighten across the globe during the coming quarters – not a good omen for economic growth.

This unfortunately comes at a time when consumer spending is already showing signs of weakening, especially in categories that were particularly in demand during the Covid crisis (such as IT hardware, home improvement or garden equipment, amongst others). Manufacturing order intakes are falling rapidly, as evidenced by recent PMI readings.

Are recession worries also what has depressed energy in recent weeks, despite OPEC’s surprise announcement of production cuts, or is there something else going on? Looking at supply-demand dynamics in the physical oil market, it is indeed difficult to understand why the price of WTI crude has lost so much ground – falling below USD 70 in the first days of May. Global production continues to struggle to meet demand, the situation having become so bad that OPEC put out a press release in April titled “IEA – International Energy Agency – should be very careful about further undermining oil industry investments”. According to the “Banking on Climate Chaos” report, lending to the oil industry peaked in 2019 and has since dropped by 22%. Demand, meanwhile, is proving resilient across the Western world and bouncing back in China even more strongly than expected. As for inventories, both of crude oil and refined products, they remain well below their 5-year average.

Does this then mean that the current drop in energy prices is more of a financial move (short sellers) and who stands to benefit?

An important consideration in this regard is the USD 60 ceiling imposed by G7 countries on Russian crude oil exports – not via a direct price cap, impossible to enforce, but indirectly by making it impossible for vessels carrying Russian oil to obtain transport insurance above that level. Should the price of oil fall to USD 60, then Russia would effectively be back “in the game”. This would not change supplies to China, India and Saudi Arabia, the major current purchasers of Russian oil (in the case of Saudi Arabia to be refined for domestic use, while virtually all of the country’s own production is sold internationally!). Nor would it have an impact on Europe, given the continent’s earlier decision to step away from Russian oil altogether, irrespective of its price.

Could the ultimate beneficiary actually be the US, with lower energy prices seen as a means to remove the competitive advantage that Chinese and Indian companies currently enjoy, by virtue of their access to cheap Russian oil? And also a means of reducing China’s current exceptional refining margins? This idea may seem far-fetched but is corroborated by the fact that US strategic reserves are being routinely sold to drive down the price of oil. And we know that energy prices have always been a part of the geopolitical game.

Continued cheaper oil would unfortunately remove an important incentive for the crucial energy transition. But the silver lining would be a pullback in headline inflation indices and lesser associated upward pressure on wages. In turn meaning that interest rates could back down, helping sustain the economy.

Needless to say that we are closely monitoring energy price developments, and well as banking issues, standing ready to make any necessary adjustments to our asset allocation.

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