Following the collapse of SVB and the risk of a banking crisis, the Fed may need to choose between price stability and financial stability
Walter Bagehot in his book Lombard Street said, (and I paraphrase a long chapter to its essence), that ‘Every lender of last resort ought to lend freely to solvent firms, against good collateral, and at a penalty rate’.
He must be turning in his grave.
A swirl of recent events focused investor attention on the US banking system. Silicon Valley Bank and Signature Bank shut operations. Bond yields across the world plummeted and gold prices rose as risk aversion took hold. An old adage – ‘When the Fed raises rates, someone gets thrown out of the window; we just don’t know who it’s going to be’.
Depositors of the shut banks were made whole. Yet the announcement by the Federal Reserve that it intended to buy Treasuries and Mortgage Backed Securities from banks facing liquidity stress, at par, was stunning. Are we at a point where the Fed is pushed by concerns of financial stability to pause its rate increases? Or is the risk of inflation still high enough that the Fed must raise rates even as things break?
There is now a much higher probability of a US economic slowdown. Add to effects from rising interest rates, lower disposable incomes and moderating corporate margins the tighter lending standards that banks will surely impose following the SVB fallout. If the Fed chooses financial stability, monetary conditions loosen as they don’t raise rates and even contemplate another round of quantitative easing. If they stick to ensuring price stability, they will force a recession, which might postponing quantitative tightening. The choice is daunting; the unintended consequences could be both varied and deep.
Asian equities are not islands of calm in this turmoil. There is little doubt that Korea and Taiwan will likely face the worst effects of a slowdown in the US, being more export focused and tech heavy economies. Hence the large underweights in our fund. China, on the other hand, despite its reliance on exports, should get a cushion from a recovery post-lockdown – it’s simply a normalisation of economic activity. Besides, our fund holding comprises companies with rising cash flows and relatively cheaper valuations, attributes we consider essential. The likelihood of looser financial conditions should be a big positive for Asian equities, bringing a much needed to boost of liquidity to lift asset values.
I am not naïve. I recognise there are pitfalls ahead. The risk to assets in general is if this episode of risk aversion turns to a financial panic and we collectively make a dash for cash. I am not qualified enough to opine on macroeconomic outcomes. Yet, over the next year or so, asset allocators must surely reevaluate their exposure to US stocks. When the dust settles, the attractiveness of Asian equities only rises in my opinion.
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