Assessing Contagion Risk Following UBS-Credit Suisse Tie-Up

Jeff (00:00):

 

Hello everyone, and welcome to the latest LPL Market Signals Podcast. Jeff Buchbinder here, your host for today with my friend and colleague Lawrence Gillum. Lawrence, I have to warn you I'm coming to see you tomorrow. I'm heading to Fort Mill, South Carolina for a little research shindig, and I hear we're going to be cooking. You better stay away from anything I cook. That's nicest thing I'll ever do for you is provide you with that warning.

 

Lawrence (00:30):

 

Yeah, no, I, I appreciate that. And looking forward to seeing everybody. We're having the entire team come over and come into the Fort Mill offices. We are doing a cooking event. I'm a better eater than cooker, so we'll see how that plays out tomorrow.

 

Jeff (00:45):

 

Well, maybe we'll be able to fire up the grill, because if you want somebody to just throw a burger on a grill, I'm your guy. Anything more than that, look elsewhere. So, looking forward to seeing you and the team Lawrence. That'll be fun. So, and to see, our producer Neal. So, let's get into our agenda. Of course, you all could have guessed this before you saw this slide on the screen, right? The UBS Credit Suisse. We have to lead with that, certainly, the big news over the weekend. But as we always do, we'll do a market recap after we talk about this deal. And of course, preview the week. Then we will, talk about contagion risk, right? We have several ways we can measure contagion risk. In fact, that was the subject of our Weekly Market Commentary, which you can find on lpl.com.

 

Jeff (01:33):

 

It's Monday as we are recording this March 20, 2023. And I did see that that commentary was indeed posted just a few hours ago. So oh, and of course while we preview the week, we'll preview the Fed. That's really the only big event of the week, other than just folks keeping an eye on the banks. So, UBS Credit Suisse I'll set it up, Lawrence, and then I want to get your thoughts. I mean, clearly the most important thing here is that this shotgun wedding, as a lot of people are calling it, reduces the risk of contagion, right? Credit Suisse was clearly a problem. You combine it with a stronger UBS, the Swiss government provides some backstops to contain the risk, some loss absorption, I guess you could call it, to contain the risk that Credit Suisse became a bigger problem. And you know, that's a clear, that's a clear positive. What else should investors be thinking about here? Other you know, sort of level two takeaways. I think that's the highest kind of level one is contagion is reduced.

 

Lawrence (02:45):

 

Yeah. For sure. So, I mean, the issues with Credit Suisse they've been going on for a few years now, right? So, this isn't just an abrupt happening where UBS came in at the last minute. I mean, this is long overdue, right? And it does take that risk off the table now. So, Credit Suisse has always been in the background. Will they default, will they, you know, will they go under and now that's, that's off the table because of UBS. Is it merger, acquisition? I don't know how we're framing it, but the shotgun wedding that took place, it does take that Credit Suisse risk off the table, which is something that I think a lot of folks will be happy about.

 

Jeff (03:27):

 

Yeah, I'm sure books will be written about this one. These two bitter rivals, right? Over many, many, many decades, I think, you know, Credit Suisse has been around for 150 years or something like that. Now coming together, it's really, and unfortunately a lot of folks are going to lose their jobs as a result of this. So, you know, kind of following how they put these pieces together and what the new organization looks like down the road, that'll be interesting to follow. But for our purposes, for, you know, U.S. Investors, in general, what they care about is the contagion risk. And so, it's down, it's not gone right? Because those Credit Suisse balance sheet risks are really translating over it. They're being sort of transferred to UBS. So, they're not gone, they're contained, they're limited, mitigated, but they're not they're not gone.

 

Jeff (04:26):

 

And frankly no other systemically important financial institutions that get the regulatory scrutiny that Credit Suisse is getting is under attack like Credit Suisse was. So, I think we can sort of move past that as a source of contagion. And now we have to focus on the regional banks a little bit more. We have to focus, you know, maybe commercial real estate risk is a little bit higher, things of that nature. But you know, the big banks are safe. In fact, they're getting stronger as a result of this. The big banks in the in the U.S. So, I think that's where we'll stop there. On that topic, let's get into, you know, broad market recap here. I think, I mean, actually after I priced this chart, we rallied even more into the close today.

 

Jeff (05:21):

 

So, we're now above the 200-day moving average again, which frankly is remarkable given what's happened. In fact, you know, stocks really haven't moved in the last, let's call it 10, 12 days. We're right back where we were before, prior to the Silicon Valley Bank failure, right? So, we're going to continue to watch 200-day, hopefully this holds but if it doesn't, and we pull back, we'll be as this slide indicates kind of in technical no man's land. I will add though, that, you know, we have higher lows from October. And if you ignore the news and just look at what the market's telling you, it's telling you that it, maybe it wants to go higher rather than lower here. So here are the returns for last week across the various regions, asset classes, sectors.

 

Jeff (06:17):

 

I think, I mean, what stands out to me, Lawrence, is the dispersion, right? I mean, we had the S&P up 1.5%, again, despite what was going on, digesting the news of the bank failures in the U.S., while waiting to see how Credit Suisse would play out. And what does the S&P 500 do? It goes up one and a half percent. What does the NASDAQ do? It goes up over four. That's about as big of a spread as you will ever see between the Nasdaq and the S&P 500. So that jumps out. And then, you know, more dispersion, Lawrence, and then I'll, I'll send it back over to you. Look at the sectors last week. We had comm services, right? The mega cap tech names did really well. Double digit gains in Microsoft, double digit gains in Alphabet/Google, right?

 

Jeff (07:07):

 

And Alphabet/Google is in the communication services sector up 7%. Tech up almost 6%. But look at energy and financials, right? We all know that financials have been weak. That makes sense. We had a more than 20% drop in the regional bank group last week, but I think that 7% drop in energy surprises people, you know, oil was down double digits. And that is certainly a concerning signal of economic growth. It's a positive signal regarding inflation, but a negative signal about economic growth and maybe the reopening in China. So that's a lot. But any thoughts on any of that, Lawrence, or anything else you want to flag on this page?

 

Lawrence (07:51):

 

Well, I mean, to your point, the dispersion has been pretty remarkable and positioning matters. And if you picked correctly, you're having a great week, great month, but if you've, you know, not necessarily picked the right sectors, then it could be a lot worse than what the index level returns are showing. So maybe sometimes it's better to just take a holistic S&P 500 type approach and, you know, just accept what the index gets you and not try to pick winners and losers. But yeah, it's been quite a remarkable story between the haves and the have nots recently.

 

Jeff (08:29):

 

Yeah, this is really when active managers can shine, right? If they avoid the landmines they can generate some outperformance by being in the areas of the market that are particularly strong. You know, for much of the last decade, kind of everything moved together and there weren't as many opportunities to add value by looking different than the index. The only other point I'll mention here on this table is, you know, international struggled last week, kind, you know, supports our preference for the U.S., still. When mega cap tech leads, it's very difficult for international markets to keep up. Plus, you have the strong dollar and a flight to safety kind of environment. So here's the table that Lawrence likes best. This is the fixed income page. So, you know, we got a rally in bonds. We have a chart of rate volatility coming up a little bit later. But you know, bonds are really you know, adding some value here recently, Lawrence, as we've, you know, taken some rate hikes out of the market and you know, markets were worried about contagion related to the banks.

 

Lawrence (09:39):

 

Yeah, for sure. So, fixed income has had a good week, month, year this year so far. But really talk about the haves and the have nots, we've seen a maybe a bifurcated response between the interest rate markets, the treasury markets, the mortgage-backed securities market, et cetera. And then the riskier high yield bond market. For the longest time, the high yield bond market has kind of been maybe ignoring all the risks associated with all these rate hikes and the potential of a slowing economy. Over the last two weeks, we did see the high yield bond market kind of wake up and spreads move higher, not to levels where we think that they're attractive again, but we have started to see the high yield market move higher and really start to pay attention to those additional risks out there, which has kind of been our view and our expectations since we've made the recommendation to move out of high yield bonds a couple weeks ago.

 

Jeff (10:33):

 

Yeah, we shored up the quality of our bond portfolios internally and certainly that looks like it was a smart move there a few weeks ago. Turning to commodities. I mean, gold has been on a nice run, you know, contained within this precious metals index. So that actually looks like an interesting opportunity to us. Technically and fundamentally, you know, once we kind of get through this this period of stress we think the dollar will move lower, and that's bullish for gold. And then you know, lower gold likes lower interest rates too. And so we think we're probably in an environment where interest rates at least stay where they are, if not even move potentially a little bit lower. So gold is an interesting investment to consider here.

 

Jeff (11:26):

 

And then I mentioned the energy sector was bad last week. The energy index, you know, oil and natural gas down last week quite a bit. In fact, actually, I think natural gas is now done 90% from its highs in Europe. It certainly helped Europe withstand the impact of the Russia, Ukraine conflict. But at some point, natural gas needs to stabilize to help the energy sector turn around. We still have a positive view of energy, but that is getting to be a more painful position each day. So, we're watching that one closely. We would say energy sector investments on watch based on the technical deterioration there. So, let's, while we are still talking about the broad market wanted to show this chart from our chief technician, Adam Turnquist.

 

Jeff (12:20):

 

This is a really powerful story here. This is a December Lows indicator that shows that when the S&P 500 holds its December lows in the first quarter the years tend to be much better. This is going back to 1950, and you see the orange line, which ends up being a gain of about 18%. If the December lows hold in Q1, that's the average year, up 18%. If the December lows don't hold in Q1, and by the way, we're about 3% above the December lows right now, maybe a little more than 3% after this rally into the close today. If you break the December lows in Q1, you end up on average with a flattish year. That's this dark blue line at the at the bottom. And then the gray line in the middle is just your average, you know, high single digit kind of year.

 

Jeff (13:18):

 

So not only are you more likely to see better returns, the batting average is like 94%. So, we're really rooting for <laugh> for those to several those to hold for just the next, you know, six, seven sessions here. It's March 20th, we're almost there. These things don't always hold, right? They're exceptions. It's not a hundred percent it's, you know, in the nineties, but boy, that'll be a real strong feather in the bulls cap if that holds. So, let's get into contagion. And this is where I'm really glad I have a fixed income expert on with me, Lawrence, because we're getting into some fixed incomey kind of things when we talk about contagion risks. So, the Weekly Market Commentary, we basically had four measures of contagion. So, the four of them are, you know, European bank CDS, the VIX, the TRIN, which I'll explain in a minute. And then the MOVE index interest rate volatility measure. So, let's start with European Bank CDS and Lawrence, you can explain what a CDS is and then just talk about what you see when you look at this chart.

 

Lawrence (14:35):

 

Yeah, so a CDS is really just an insurance policy in effect, the prices against default. So, if a company's about to default their CDS prices would go higher because it would cost more to insure against a default. So, what we're showing here are the European Bank credit default swap rates. And as you can see, the last week or so, we did see rates spike higher so that the cost to insure against default has increased, but not to the levels where we would, we would think that these are, are flashing any types of warning signs, right? So, we're still at levels that are lower than what we saw back in September, October, November of last year. You know, when frankly no one was talking about contagion. So, we don't think that just because that word has come up more in conversations these days, it doesn't mean that it's actually true that the contagion risks have increased. If you look at this chart and all the other charts that we're going to look at today, we would argue that the contagion risks are still pretty low.

 

Jeff (15:39):

 

This is amazing to me that, you know, at the October 2022 lows in the S&P 500 default risk for European banks was higher in the market's eyes than it is now. <Laugh>. Now today, this chart was priced last Thursday. So today, you know, the risk has gone up a bit as the market transfers, the Credit Suisse default risk over to UBS default risk. So, you know, we're a little bit more contained broadly maybe <laugh>, but the risk in UBS the market is saying is higher. So, you know, we're not in the clear, but still this really suggests that that the risk of contagion is low. So, we don't think, I mean, this is just the first piece of evidence, but we don't think this is a full-blown banking crisis. There'll be some other little stumbles. We still have to wait for a plan maybe to contain First Republic, which is you know, which was down 70% last week, I think it was down another 40% today. So, there's still more you know, let's call them unsettled situations that the market needs to wait for regulators or the banking industry to address.

 

Lawrence (17:00):

 

Yeah, and I think that is the important point that you make right there, Jeff, is that there are going to be some idiosyncratic, more individual issues with some banks, but just by looking at this index right here, broadly, the health of the European financial system still looks like it's in pretty good shape, but there will be some episodes where individual banks come under stress.

 

Jeff (17:22):

 

Yeah, absolutely. I tell you, if it's a competition for mismanagement of banks, though we might already have seen our winners <laugh>, I'll say it that way. So next is the VIX, right? The fear gauge, a lot of people call it, or the Fear Index this is just a measure of the implied volatility from the options market in the stock market, right? So, what is the option market saying about how volatile stocks will be? And this looks like a pretty calm reading. We're around 25 right now. This chart actually was priced when we were a little higher, like 26 and a half. That is about a 40th percentile reading. So really not high at all. And you compare it here again the VIX now is lower than it was in October of last year, right?

 

Jeff (18:19):

 

When the S&P bottomed, and it doesn't even register as a blip compared to the pandemic, right? Or if you took this back further, the financial crisis in, you know, 2008, 2009. So, the stock market is saying, it could be wrong, but the stock market is saying that the crisis is contained, and there's really not a whole lot to worry about here. So, let's go to the TRIN. You know, I actually, I mean, I see this index cited Lawrence, but I don't really have much of a of a background in it. So, I'm relying on George Smith from our team who put this chart together and you know, made these observations. It's a measure of the velocity of selling. So, it's not just our stocks going down, it's how much selling is happening as stocks are going down.

 

Jeff (19:11):

 

And so you see here you know, over 10 or over two rather is panic selling. And on March 9th, we got panic selling. That was, you know, right before Silicon Valley Bank failed. But if you look to the right of this chart, we're back below average, neutral is one. We're below average kind of late last week, and certainly we were below average today. I mean, the market was up almost 1% today. So this is a really encouraging sign too, right? The amount of fear based on the TRIN index is suggesting that this is kind of a normal, average, average market. What do you think, Lawrence? You buying it?

 

Lawrence (19:53):

 

I mean, it's, yeah, if, I mean, if you look at the price action for those couple days where things looked like there may have been a, a broader selloff or broader spillovers into other industries or sectors, but which was on, you know, March 9th, but since then, things have calmed down. We've seen that in other financial indicators as well. So, I'm buying it. I believe it.

 

Jeff (20:18):

 

Yeah, me too. I mean, we're putting enough indicators together to create a big picture and they're all pretty consistent. So, the last one we have is, is all you Lawrence, the MOVE index. It's basically the volatility of rates.

 

Lawrence (20:32):

 

It is, so this is similar to the VIX index that we just talked about. This is the implied volatility for interest rates. We have seen this index move higher, right? So, the interest rate volatility within the fixed income markets is at the highest levels, frankly, since the GFC (great financial crisis). Higher levels than what we saw experienced back in the COVID-19 shutdowns too. So if you're looking for things that maybe seems out of sorts, this is it. And we know that, and for those of us that follow the markets every day, we see all the volatility in the rates market. You know, there's been seven sessions of the 2-year treasury yield plus or minus 20 basis points in a day. You don't expect that kind of stuff coming out of the U.S. Treasury market.

 

Lawrence (21:19):

 

This index here confirms that we are in unusual times as it relates to interest rate volatility. What's it mean? It means that the Fed is engineering an aggressive rate hiking campaign and there may be more or there may be less <laugh> right now this is saying that there's a lot of uncertainty with the path forward with interest rates and that's kind of what that spike there represents. It doesn't speak to any sort of contagion or spillover impact from the banking crisis. It really speaks to the I guess the difficult job that the Fed has ahead of it ahead of their meeting this week, for sure.

 

Jeff (21:56):

 

Yeah, it's one of the more interesting Fed meetings I can remember leading into it, I guess. I mean, when you, when you hike rates over four percentage points in less than a year, and then you, you know, throw the whole market on its head with this banking stress and take a bunch of rate hikes out <laugh> of the fed funds market all in a very short period of time. I mean, it's no wonder we're seeing such high-rate volatility. Plus, we're in a very high inflation environment, as we all know, which, you know, rates have to respond to maybe differently than they did a few years ago. So there, you know, there's some unique factors here going on, but I, I can tell you that I've paid more attention to rates now, you know, in the last probably few months than I ever have in my entire life, <laugh>.

 

Jeff (22:43):

 

So, and that'll continue through the Fed meeting no doubt. So yeah, buckle your seat belts. We're seeing interest rate volatility and that maybe underscores just how volatile or how unique this environment is and how confusing it is, right? People just really have different views of the market, and we keep getting different information you know, every day that can move peoples to use around. So that's that. Let's talk Fed, here's another reason why I'm glad you're with me, Lawrence, because you know the Fed as well as anybody on our team. I mean, we alluded to it a little bit, right? The Fed, the market has taken out several rate hikes, right, as a result of the banking crisis. So, the question people are asking them, and I'm not sure how much 25 basis points means in the grand scheme of things, but the question everybody's asking is are they going to go 25 or are they going to pause? And I can make a strong case for either, but I think what's probably more important is what's been taken out of the fed funds market for, you know, the last for the next several meetings, right? And how much the terminal rates come down.

 

Lawrence (23:58):

 

Yeah, it seems like it was only a couple weeks ago, and it was when market markets were pricing in a terminal rate above 5.50 maybe, and we had some people out there talking about a 6% terminal fed funds rate, or even six and a half, 7%. All that is out the window according to market pricing. Markets are saying maybe there's one more rate hike, maybe this meeting, maybe May. But then over the course of this year, starting in June, looks like markets are pricing in rate cuts. Which seems to be, I don't know, I don't really fully believe the market pricing. I think maybe the market's gone a little bit too far too fast. But I think what is interesting is that yeah, just the rapid repricing that we've seen over the last two weeks, over 150 basis points of rate hikes have been taken out of the market, which is, I can't remember the market moving that quickly. When we're talking about, you know, expected rate hikes turning into rate cuts.

 

Jeff (25:02):

 

Unbelievable. Yeah. So if you look out to the end of the year, you know, you're talking about going from like 5.40 to 3.90 <laugh>, you know, in just a few weeks. It's really unbelievable. These are just the three fed funds curves February 16, March 9, March 15. And that arrow just shows you how the terminal rate has come down from, yeah, about 5.50, to a little over 4.50 close to 4.70, probably close to 4.70. So just a historic move no doubt. And yeah, I agree with you Lawrence. Even though I'm kind of an amateur Fed watcher, not a pro, but I think the market has gotten a little too aggressive pricing in these cuts. And after the the ripples from the banking stress calm we'll likely see the, you know, these curves move higher.

 

Lawrence (25:57):

 

Yeah, I think if the Fed is looking at the same sort of financial indicators that we're looking at, and they do, I think they'll see that maybe the chances of contagion, the chances of that spillover risk maybe aren't as great as one would expect. So, you know, and to your point earlier, I think it's exactly right. We can make a cogent argument for a pause or for a 25 basis point hike at this next meeting given kind of all the, you know, the events that have happened over the past two weeks, our view is that the Fed's going to hike rates by 25 basis points at this meeting. But again, it wouldn't surprise me at all if they said we're going to take it slower and raise rates by 25 next, next meeting. So, we'll have to see how this one plays out.

 

Jeff (26:44):

 

I'm from Kansas City, so anytime I can bring up the Kansas City Fed, I have to take advantage of it. So, Tom Hoenig ,the former Chair of Kansas City Fed, or president of the Kansas City Fed, said that the Fed hasn't decided this yet, <laugh>, right? So, they're going to let like right up until the last minute and look at what's going on with the banks before they decide what to do. And I actually, I think I buy that <laugh>, I think I buy that. It's really, it's a close it, it's, it's a close call.

 

Lawrence (27:12):

 

So, the only thing I would add too, is that the ECB raised rates by 50 basis points last week during all of this tumult. So I think there is a history, there is precedent of central bank hiking during kind of financial stresses like this, especially if they think that these financial stresses are, are behind us. So it would be interesting if the ECB hiked rates by 50 basis points last week, and then the Fed does nothing, I think that would be an interesting dichotomy because normally the ECB is extremely dovish versus a Fed that's a little bit more aggressive. So again, a lot of moving pieces for this week's meeting.

 

Jeff (27:54):

 

Yeah, you hit on the reason why I'll still bet on the hike rather than the pause. And of course, if they pause, people will wonder, you know, what do they know that the market doesn't? And you know, that could spook markets, so, and they probably would rather not deal with that. So, you know, meeting, I guess the decision is Wednesday or the announcement is Wednesday, but meeting starts Tuesday, we'll be watching that closely. Just to, we'll wrap up on that, Lawrence, because I don't think there's anything else on the economic calendar that anyone cares about. <Laugh>, and I said it right here, few will pay much, if any, attention to this week's economic data calendar. In fact, people didn't really care about retail sales or the CPI all that much last week because we were watching banks so closely. Well, same story this week, right? I don't think any, I mean, you could challenge me on that if you see a data point here that you really think the market's going to care about, but frankly I think it's all about all about the Fed and then, you know, watching bank headlines.

 

Lawrence (28:58):

 

Yeah, for sure. I agree with you. This meeting it also comes with an updated summary of economic projections. So we're not only going to get potentially another 25 basis point rate hike, but we'll also get the Fed's expectations on inflation growth, where the dot plot is going to settle out over the next few years, which may be interesting to see how, or if those expectations have changed. I would have to imagine they would. So, we'll have to see how that how that looks on Wednesday as well. But no, to your point, there's really nothing else on the calendar this week that's going to trump the FOMC rate decision on Wednesday.

 

Jeff (29:37):

 

Absolutely. So, I guess I'll end with another promo for the Weekly Market Commentary. Please take a look at that on lpl.com. We actually put some investment ideas in there at the end for this environment. So that I think should be of interest to many of you. Thank you Lawrence, for joining. Thank you all of you for tuning into another LPL Market Signals podcast. Lawrence, I look forward to seeing you tomorrow in Fort Mill. Hopefully the flight is on time. Safe travels for sure. We shall see. And again, reminder, don't eat anything I cook. We'll see you next week. Thanks everybody.