Investor Spotlight: stock markets on edge as risks to banking system grow

Investors remain gripped by uncertainty as turmoil in the global banking system continues.

In this week’s Investor Spotlight, we take a look at the latest developments in the banking system, discuss the possible causes and implications, and dig into three stocks that remain sensitive to the situation.

Volatility increases as more banks teeter

Investors grew increasingly nervous last week, as stress in the global banking system appeared to spread. After the Silicon Valley Bank collapse and the winding-up of Signature Bank, which we detailed last week, signs of stress again emerged in the US and European banks.

As depositors continued to flee smaller, regional banks, US bank First Republic looked on the verge of failure, prompting authorities and the major US banking institutions to intervene by injecting additional liquidity.

Of even greater concern, growing and persistent rumors of financial weakness at Credit Suisse sparked fears of a Lehman-like collapse in Europe, with the Swiss National Bank (SNB) providing up to CHF50 billion in emergency loans to the institution.

The Credit Suisse situation stoked particular concern and amplified fears of broader contagion, due to either the direct effects any collapse would have on other banks, or because of other systemic vulnerabilities it might be symptomatic of. While SNB’s swift action temporarily calmed investor's nerves, it proved a band-aid solution.

In developments over the weekend, UBS will take over Credit Suisse, in what amounts to a forced acquisition. UBS will acquire Credit Suisse, in a deal valued at $2 billion, with the Swiss National Bank guaranteeing a $US100 billion liquidity line to backstop the bank.

Is this the beginning of a financial crisis?

Naturally, with the number of failures or near-failures occurring in the banking system, the question becomes whether this is the beginning of a greater, global financial crisis. For the time being, financial markets aren’t flashing warning signs of an outright catastrophe.

When it comes to short-term funding markets, spreads have pushed higher but don’t indicate yet that anything has broken in the so-called “plumbing” of the market.

Also, while credit spreads - which are a measure of default risk in corporate debt markets - have widened, they are some way from levels typically associated with a crisis.

Bond market volatility has picked up significantly, with the MOVE Index spiking to levels not seen since the dislocations that occurred during the pandemic-panic.

The VIX is still below 30 for now, despite a slight increase in recent days, suggesting heightened uncertainty in the equity market, but not outright crisis levels of fear.

What could go wrong?

As with any crisis, there remain unknowns that mean circumstances could still deteriorate still from here. There are several things that could go wrong and turn this situation into a broader financial crisis.

The most pertinent issue is whether larger institutions may succumb to the problems that have befallen US regional banks, and the notoriously mismanaged Credit Suisse. One possible concern is the strength of bank balance sheets, as they continue to adjust to a world of higher interest rates.

There are several risks

A crisis of confidence could prompt more severe and widespread bank runs, that could evolve very quickly due to the ubiquity of internet banking. Funding markets could become much tighter if the combination of lower bank reserves and confidence issues drive banks to hoard capital.

There could also be the knock-on impacts of huge mark-to-market losses on the bank's assets, as higher interest rates undermine the value of Treasury bonds and the bank’s capital base.

One underappreciated risk could also be unfolding in the “real” economy. Financial crises typically emerge out of a credit crisis, when an over-leveraged area of the economy begins to come under stress. The Global Financial Crisis was rooted in excess household debt that, when interest rates rose, led to a cascade of defaults and asset write-downs as borrowers struggled or outright failed to cover their repayments.

While such excesses aren’t evident in the household sector, debt levels in the corporate sector are around record highs. The interest coverage ratio – a measure comparing earnings to interest expenses - is at eye-watering levels amongst US businesses and could get worse as earnings fall and interest rates stay high.

This raises the risk of bad loans and higher default rates, which could cause or fuel greater stress in the banking system.

Does this mean the end of interest rate hikes?

As the ructions in the global banking system evolve, market participants are pricing in less aggressive policies from central bankers. Fed Fund Futures are indicating a significantly lower peak in rates, with the curve also implying several rate cuts by the end of the year.

The US Federal Reserve meets this week, with traders split on a 25 basis point hike, a hold, or even a possible cut to interest rates.

When it comes to the RBA, the central bank’s recent, less-hawkish shift combined with the crisis in the US and European banking system has priced out any further hikes from here. Traders are also implying the strong risk of rate cuts before the end of the year, even despite inflationary pressures that are expected to remain elevated for the short-to-medium term.

Notably, the European Central Bank met last week and opted to raise interest rates by a further 50 basis points, despite making the decision in the midst of Credit Suisse’s existential crisis. It emphasized the need to continue to tackle inflation, possibly indicating that policymakers will look to other tools to manage problems in the banking system.

For one, the US Federal Reserve’s new lending facility, along with its traditional discount window, has provided some much-needed support to vulnerable institutions and the banking system at large.

US banks tapped the Fed for roughly $US300 billion of short-term loans last week amidst fears of a liquidity crisis, resulting in a jump in the size of the Fed’s balance sheet.

Three stocks to watch

The uncertainty created by the events in the global banking system has led to broad-based declines in equities.

However, owing to fears about the future of the banks, along with an aggressive repricing of interest rate expectations, gold stocks have rallied, owing to a surge in the underlying gold price.

Here are three Australian gold stocks to keep an eye on.

• Northern Star Resources

Northern Star Resources has pushed above its 200-week moving average and broken resistance at $11.60. The next major level of resistance is around $13.30, while support could be found at the 200-week moving average at $11 per share.

Northern Star Resources weekly chart

• Newcrest Mining

Newcrest Mining is on the cusp of breaking technical resistance at roughly $25.50, with the stock carving out a short-term uptrend. A break of that level could open a rally to the 200-week moving average at $26.50 while support is at roughly $23.30 per share.

Newcrest Mining weekly chart

• Evolution Mining

Despite the broad upswing in gold stocks, Evolution Mining has lagged the pack. The stock remains in a structural downtrend with momentum skewed to the downside.

Evolution Mining weekly chart