Ask the experts – Questions stirring our clients (and the financial markets) in May 2023

We are always available to our customers for concerns and questions about their portfolios. As a representative of this, once a quarter we summarize the most frequently asked customer questions and the answers provided by our experts, thus giving you direct insights into our asset management and investment advisory services.

Banks

First Republic Bank at the start of May was already the third US bank to disappear from the market this year. Will the wave of bank failures come to an end soon? And could the crisis spill over to Europe in the near future?

Kaiser Partner Privatbank: In the wake of the bankruptcies of Silicon Valley Bank (see “BREAKING: Lots of things”), Signature Bank, and most recently First Republic Bank, the wave of bank failures in the USA involving combined total assets of USD 548 billion at the defunct banks has by now exceeded the magnitude of bank collapses at the height of the financial crisis in 2008. After the third act of the ongoing drama, which saw the US Federal Deposit Insurance Corporation (FDIC) seize First Republic and then sell most of its assets to JPMorgan Chase, there was a small sigh of relief. It didn’t last long, however, because US regional banks remained under pressure in the first week of May. The share prices particularly of banks with big book losses on securities holdings on their balance sheets coupled with an allegedly unstable deposit base continued to fall. In the midst of the turmoil, Pacific Western Bank (PacWest) has already emerged as the next potential victim of the banking crisis. The management of PacWest announced that it was exploring an array of options – including raising new capital or selling itself to a new owner – to maximize shareholder value. With total deposits amounting to USD 28 billion as of the start of May, PacWest is much smaller than, for example, First Republic, and its net deposit outflow of 17% in the first quarter was far smaller than that experienced by First Republic (–60%!). Nevertheless, a continued chain reaction would hardly be helpful to maintaining trust in the US financial system. It’s precisely this lack of trust that could cause further dominoes to tumble. The fact that shares of many regional banks in the USA trade publicly on the stock market and are under attack by short sellers is hardly helpful in this context and could even fan the fire.

Another reason why an “all-clear” signal cannot be sounded yet is because the flight of capital away from small and midsized banks and into large banks and money-market funds isn’t the only problem facing the US banking world these days. Another risk is the precarious situation in the (credit) market for office real estate, in which regional banks control a market share of more than 70%. Substantial write-offs are expected here in the quarters ahead. The combination of liquidity problems, increased refinancing costs, loan losses, and a foreseeable tightening of regulations could prove to be a toxic cocktail for all US banks with the exception of the country’s giant financial institutions. This ultimately is also bound to adversely affect economic activity. Consequently, the turbulent last few weeks have further increased the risk of a recession.

It takes years to rebuild lost trust.

Speaking of regulation, the media in recent weeks have been heatedly discussing a lack of it as being the cause of the Silicon Valley Bank (SVB) debacle. It’s a fact, for example, that midsized US banks (with total assets ranging between USD 50 billion and USD 250 billion) have no longer been subject to mandatory annual stress testing by the US Federal Reserve ever since the partial rollback of the Frank-Dodd Act in 2018. However, there is doubt, at least among experts, about whether stress testing would have averted the collapse of SVB. For instance, SVB possibly would have passed the liquidity stress test that is performed only on big banks today. And on the other hand, in a recession stress test that simulates a drastic downturn in economic activity, SVB would not have been confronted with the kind of sharply rising interest rates that actually ended up causing the bank’s downfall in March of this year.

Do banks in Europe pose a similar risk factor? The banking crisis of 2023 has indeed already claimed a prominent victim: Credit Suisse (see “Credit Suisse: Too big to…ignore”). The shotgun wedding between CS and UBS made it crystal clear that stringent regulation alone isn’t enough to prevent a crisis of confidence. In the end, the demise of Credit Suisse wasn’t caused by an inadequate capitalization of the bank (on the contrary, CS ranked among the best-capitalized banks in Europe), but was instead brought about by customers’ lost confidence in the bank after years of strategic mistakes and scandals. It takes years to rebuild lost trust. One example of this rule is Deutsche Bank, which after many tough years is now back on the rise again but nevertheless briefly became a victim of a speculative attack after the downfall of Credit Suisse.

In the wake of that attack coming to nothing, the European banking sector looks comparatively robust at the moment. This is partly attributable to the fact that in contrast to the USA, the tightened banking regulations in Europe prompted by the financial crisis of 2008 have not been loosened at all since then. European banks explicitly must hold sufficient capital to cover a sudden increase in refinancing costs. Other factors also suggest that the interest-rate turnaround and its knock-on effects pose a smaller risk for banks in Europe: European banks, for example, hold fewer bonds on their books than their US counterparts do (government bonds account for a 12% share of bank capital in Europe vs. 30% in the USA) and instead hold more (risk-free) cash. Moreover, the deposit base at European banks is much more stable and diversified than it was in the case of SVB, Signature, and First Republic.

Searching for a floor | Loss of trust = share-price plunge

S&P regional bank index and S&P 500

Sources: Bloomberg, Kaiser Partner Privatbank

US debt ceiling

The US federal government looks set to run out of money in the weeks ahead. Is it all just theater, or does a national bankruptcy really loom this year?

Kaiser Partner Privatbank: Our blog post from January (“What to watch in 2023: The next US debt fracas”) is more topical today than ever because we’re right in the midst of the foretold debt-ceiling showdown these days. A look at the impact of the debt-ceiling debate on the financial markets also corroborates our view expressed at that time. To wit, the cost of credit default swaps on US Treasury debt has climbed to a record-high level at last look and by now is even much higher than it was in, for example, 2011 when the USA was on the verge of national bankruptcy (and the rating agency Standard & Poor’s revoked the USA’s triple-A sovereign credit rating). Aside from illiquid CDS trading, elevated nervousness is also discernible in the short-term US Treasury bond space. However, there is nary a trace of tension, let alone panic, on the equity market at the moment, though that could change in the weeks ahead. During the 2011 debt-ceiling episode, the S&P 500 index registered several days of daily volatility in excess of 4%, and during the most critical days of the debt showdown, the VIX volatility barometer spiked from below 20 points to above 40 points.

A similar scenario this year as well cannot be ruled out precisely because politicians in Washington, D.C., have long grown accustomed to typically always reaching a last-minute agreement just before the deadline. However, the risk that this “kick the can down the road” approach may not work for once increases each time and is especially high in 2023. The Republicans want to use the debt-ceiling debate to force the Biden administration to make substantial spending cuts and thus far have shown little willingness to compromise. It’s impossible to predict with pinpoint accuracy when the US government will run out of cash to pay its bills. US Treasury Secretary Janet Yellen’s warning that federal coffers could be empty by as soon as June 1 likely has been calculated far too overcautiously and probably includes a USD 20 to 30 billion reserve buffer. However, things could indeed get dicey during the course of July. Although an actual default in the sense of failing to service payment obligations on outstanding US Treasury bonds probably wouldn’t loom even then, a temporary suspension of other payments such as for salaries and pensions for federal employees, support payments for the needy, or Medicare and Medicaid payments would be enough to trigger friction on the markets and to prompt another rating agency to call the USA’s triple-A sovereign credit standing into question. This would have serious consequences because many asset managers then likely would no longer consider US Treasurys to be top-tier debt securities and would have to sell them in some circumstances. Whoever would like to hedge against a risk of this kind still has a cheap opportunity to do that at present thanks to the low volatility at least on the equity market.

How can this sorry spectacle be brought to an end? Recurrently proposed gimmicks like the idea of minting a trillion-dollar coin and transferring the (seigniorage) “profit” to the US Treasury are just as unpracticable as the recently emergent idea of invoking the 14th Amendment to the US Constitution as a pretext to ignore the debt ceiling. Despite all of the polarization in US politics, the only really viable option is for the Republicans and Democrats to strike a deal. An agreement eventually being reached is again the likeliest scenario this time around. But it remains to be seen whether the will to stay in agreement will be strong enough only for a near-term stop-gap fix for a half year or will be sufficient for a longer-term solution. The latter actually is bound to be in the best interests of both parties. In any case, the government debt problem is unlikely to win either party brownie points from voters.

Obviously nervous | Default is priced in

US Credit default swaps (1 year)

Sources: Bloomberg, Kaiser Partner Privatbank

Currencies

Interest-bearing assets denominated in euros have by now become much more attractive than those denominated in Swiss francs. Why is the euro’s exchange rate against the franc nevertheless still weak?

Kaiser Partner Privatbank: The interest-rate differential between euro- and franc-denominated assets was negligibly small for years, but that changed in the wake of the global turnaround in interest rates. The yield spread between 10-year German government bonds and Swiss Confederation bonds of the same tenor stood at almost 1.5 percentage points in favor of the European single currency at last look. Nevertheless, the franc has stayed strong in recent months – after dropping below parity in July of last year, the EUR/CHF exchange rate has never been able to lastingly break back through this psychologically important sound barrier. The Eurozone’s somewhat higher interest rates apparently are insufficient to lure enough capital out of safe-haven Switzerland to weaken the franc – it perhaps would take a much bigger interest-rate advantage to do that. There are other reasons, though, behind the strength of the Swiss franc. Switzerland’s current-account balance, for instance, is back in a surplus of more than 10% after a dip caused by the COVID-19 pandemic – this creates constant excess demand for Switzerland’s currency, which strengthens the franc. Another factor favoring the franc in recent months has been the Swiss National Bank, which has sold currency reserves on the open market and, by doing that, likewise has created demand for francs.

But one point is even more important: nominal interest-rate differentials aren’t the sole key determinant of the attractiveness of a currency. Real interest-rate differentials that factor in the different rates of inflation in respective currency areas are arguably even more relevant, particularly for long-term (institutional) investors with diversified currency exposure. A look at the real interest-rate spread in the example of the euro versus the Swiss franc reveals that the latter currency is at a big advantage. The real yield spread on 10-year government bonds currently amounts to more than 2 percentage points in favor of the franc. According to the purchasing power parity model, a currency with lower inflation must appreciate in the long run to retain its real value against a currency with higher inflation. In this sense, the EUR/CHF exchange rate has behaved entirely in textbook fashion over the last 12 months. Between mid-May 2022 and mid-May 2023, the euro depreciated by around 5% against the franc, which roughly matches the inflation differential between the Eurozone and Switzerland observed during that period. However, the EUR/CHF exchange rate has been oscillating in a narrow range between 0.98 and 1.00 for half a year now. The longer this rangebound trend continues, the weaker the superficially strong franc becomes in real terms because even though peak inflation is over now also in the Eurozone, inflation there looks set to stay higher than in Switzerland for the foreseeable future. So, in the long term, the path of least resistance for the EUR/CHF exchange rate is likely to continue to point downward.

The bottom line is what matters | Real interest-rate differentials favor the franc

EUR/CHF exchange rate and yield spread between 10-year German and Swiss government bonds

Sources: Bloomberg, Kaiser Partner Privatbank

Private equity

Private equity strategies significantly outperformed public stock markets last year. Is that justified, or are valuations in the private equity asset class “artificial” and detached from reality?

Kaiser Partner Privatbank: While the MSCI World index ended 2022 down a good 18% for the year in the final reckoning, private equity strategies exhibited relative strength. Although their definitive performance figures for last year aren’t out yet and will first become available in the weeks ahead, preliminary indications (taken, for example, from the annual reports of publicly traded private equity firms) give reason to expect that the broad private equity sector closed out 2022 with a low-single-digit percent loss for the year. Some sub-strategies posted significantly stronger (secondaries) or weaker (venture capital) performances, but on the whole the private equity asset class outperformed public markets by a wide margin.

A look at the fundamentals verifies that this outperformance is solidly underpinned. Privately held companies grow much faster than publicly traded corporations in the long run. Their revenue-growth advantage has averaged out to approximately 4 percentage points per annum over the last 20 years. Another factor is operational improvements, which generally lead to a (substantial) boosting of profit margins. Even amid the especially tough climate that prevailed in 2022, companies owned by private equity firms achieved a better business performance on aggregate than publicly traded corporations did. According to data from Hamilton Lane, their revenue grew by 11% year-on-year for the first three quarters of 2022 (compared to 8% for publicly traded companies) and their EBITDA increased by 6% (3%). The disproportionately large drawdowns on public stock markets have now reduced their overvaluation relative to private equity and has brought valuations on public and private markets more in line with each other. Privately held companies are more expensively valued, though, only in rare cases.

The most compelling proof that the valuations and the superior performance figures don’t owe to window dressing by private equity managers comes from the deal and exit prices actually realized. Even in the challenging year 2022, private equity funds were generally able to sell their portfolio companies at prices above their book value as of the last prior valuation date. The exit premium on average amounted to more than 20% above the valuation four quarters prior to the sale. This confirms that private equity managers tend to value their portfolios conservatively and that the valuations relatively closely reflect reality.

Fact or fiction? | Private equity managers tend to be conservative

Realized exit premium upon sale (compared to last valuation)

Sources: Hamilton Lane, Kaiser Partner Privatbank

Cryptocurrencies

The price of Bitcoin has rocketed since the start of this year. Is the second crypto winter already over?

Kaiser Partner Privatbank: A great deal has happened in the world of digital coins since we published our last article on cryptocurrencies (“Crypto winter 2.0?”) in October of last year. In November, the price of Bitcoin found a floor at a level of around USD 16,000 and has since risen by as much as more than 80% at its interim peak. Strictly by definition, the bear market in the leading cryptocurrency can be declared over in the wake of such a vibrant rally. It remains to be seen, though, whether this now also already marks the start of a new bull market. From a technical-analysis perspective, Bitcoin faces major chart resistance in the USD 30,000–32,000 zone. This level provided key support for Bitcoin on multiple occasions in summer 2021 and spring 2022. On Bitcoin’s way up, one can thus expect to see lots of selling at this level by those investors who want to close their positions without incurring big losses. The resistance therefore is unlikely to be breached on the first attempt.

But a different question should be the more important one for investors: Have Bitcoin and the like proven their validity (and added value) as an asset class of their own in recent months? “Yes” more than “no,” we would tend to answer. Bitcoin at least exhibited the attributes of a safe-haven asset during the recent bank crisis in the USA. During the first ten days of March, prior to the final demise of Silicon Valley Bank, the price of Bitcoin likewise briefly came under downward pressure. Since then, however, Bitcoin has seen its price soar despite the continued turmoil in the banking sector. It has behaved like the price of gold, upholding Bitcoin’s reputation as “digital gold.” The (short-term) performance correlation between Bitcoin and gold accordingly has increased markedly in recent months. Crypto bulls view the recent developments as a validation of Bitcoin’s reputation as an antifragile asset. According to the concept of antifragility put forth by Nassim Nicholas Taleb in his book “Antifragile: Things That Gain from Disorder,” antifragile assets are not only resistant to volatility, uncertainty, and disorder, but actually even become stronger with each challenge or (financial) crisis. Such a desirable trait should ultimately also translate into a low performance correlation with traditional asset classes and particularly with stocks. And in fact, the 6-month rolling correlation between Bitcoin and the S&P 500 index has decreased noticeably lately. But this in itself doesn’t mean that the digital currency has truly decoupled – the trend would have to continue for a lot longer to confirm a decoupling. Periods of low (or sometimes even inverse) correlations have occurred now and then in the past, but have never lasted for long. The debate about the pros and cons of the crypto asset class remains open – every investor should form his or her own view on the matter. From the standpoint of a well-structured asset allocation, we reiterate our stance that only   5% (or no more than 10%) of one’s wealth should be invested in a broadly diversified basket of digital currencies. In the past, one could boost the return on a balanced portfolio of stocks and bonds this way without having to expose oneself to much higher volatility.

Safe haven or risk-on/risk-off? | A debate with no definitive answer

Performance correlation (6-month rolling) between Bitcoin and other assets

Sources: Bloomberg, Kaiser Partner Privatbank

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