The views expressed are those of the speaker(s) and are subject to change. Other teams may hold different views and make different investment decisions. For professional/institutional investors only. Your capital may be at risk.
Fixed Income Portfolio Manager Brij Khurana joins host Thomas Mucha to discuss today's bank liquidity crisis, recession risk, and how a hard landing could impact markets. Episode recorded on 3/27.
2:20 – Investing in a banking crisis
4:40 – Recession risk
6:15 – Consumer confidence
7:20 – Potential length and severity of recession
8:40 – Implications of a profit recession
11:30 – Interest rate hikes
13:50 – The hard landing playbook
17:10 – Geopolitics, oil markets, and the US dollar
BRIJ KHURANA: Those pandemic savings are still in the system, but those are being worked through very, very quickly, and I would imagine at least for most of the lower half of the income distribution, that will be gone in the next few months, and so we are talking about a world where savings rates are going to start rising, and that’ll have big economic implications as well.
THOMAS MUCHA: Once again, the world finds itself amid a banking crisis set off by a single entity, and then exacerbated by dramatic policy moves, and of course, nervous markets. The collapse of Silicon Valley Bank quickly cascaded to other regional US banks, and then it echoed across the Atlantic, with beleaguered Credit Suisse taken over by UBS. We continue to see ongoing volatility in the sector, as well as ongoing moves to help stabilize the system, including First Citizens acquiring much of failed SVB. Now, given the implications, Wellington’s banking sector experts, its macro analysts, its fixed income analysts, among many others at the firm, have been in constant communication about this situation from the start. Now, to help us sort out a few of the key medium-term impacts is Brij Khurana, a fixed income portfolio manager based in our Boston office. Brij, welcome to WellSaid.
BRIJ KHURANA: Thanks, Thomas, glad to be here.
THOMAS MUCHA: So, Brij, before we dive into your macro and your market views, I’d like to start here by asking what the past couple of weeks have been like as you’ve been navigating this situation for clients. Wellington, of course, has a highly collaborative investment culture, and, you know, times of crisis are when debate and unique perspectives are needed most. So, how has that collaboration held up during this spiraling crisis, and what’s jumped out to you in all of this drama and market volatility?
BRIJ KHURANA: Yeah, I do think that times like this really value being at a place like Wellington, because of the broad resources. We have analysts in US, in Europe, on the credit side as well as on the equity side, and so it’s really been helpful, combined with the macro team, to put together and connect more dots very easily. And I do say our finance team has really been ahead of the curve in a lot of ways. You know, they were talking about the deposit flight regional banks were experiencing about a month, month and a half ago, before this all broke.
THOMAS MUCHA: Yeah, so it didn’t come as a big surprise to us.
BRIJ KHURANA: Yeah, exactly, I mean, we were thinking some of the liquidity problems might take place in the third quarter of this year, so it happened a lot quicker than we thought, but at least we had thought through a lot of the implications beforehand, so at least felt somewhat prepared to react in real time.
THOMAS MUCHA: So, on the personal level, how do you do this, how do you manage through this extreme stress to keep focused on the long-term, and of course to make sound decisions for clients, I mean, do you have tricks, go-to books, meditation, exercise?
BRIJ KHURANA: I do change my routines a bit during these more stressful market environments, so I tend to wake up a lot earlier than I normally do, however --
THOMAS MUCHA: Is that wake up, or not being able to sleep? (laughs)
BRIJ KHURANA: Exactly, that’s part of it too. (laughs) But certainly wake up earlier, and, notably, I do not check my Bloomberg or my email first thing in the morning, so --
THOMAS MUCHA: Healthy.
BRIJ KHURANA: -- I like to, you know, get a cup of coffee and think through the plan for the day, before even turning on any of the systems, and I think that’s really important, because you can just so easily be influenced by what was going on in the news that morning, so when the market’s bullish you feel bullish, and same thing, when things are going badly, everything looks like the sky’s falling. So, I think separating that time is really helpful for me. You know, a lot of people turn off their Bloombergs during the day and just think, you know, for me, I can’t do that. I feel like the market’s giving you these opportunities, if you can think clear-headed, so I like to be in front of the screens for most of the day, but once again, at the end of the day, either exercise or just shut off the computer, I definitely do not look at how things are trading in the Asian markets, because, as you say, that’ll ruin my sleep, and then I won’t get any sleep. (laughter)
THOMAS MUCHA: All right, well let’s move onto probably the biggest question on people’s minds, which is recession. And you know, you’ve been bearish even before the events of the past couple of weeks, so where are you right now in terms of the probability of an economic slowdown here?
BRIJ KHURANA: I would say it’s very likely at this point. You know, even before this tightening in credit conditions that are likely going to materialize as a result of the SVB failure, the shadow Fed Funds Rate, which is what we look at, it’s basically the effect of the Fed Funds rising, but also the impact that quantitative tightening has. That’s risen almost 7% since early last year, which is really puts it on par with the hikes we saw in the 70s and the 80s.
THOMAS MUCHA: Yeah, that’s a huge number.
BRIJ KHURANA: Yeah, exactly, and so you were already seeing that impact the interest rate-sensitive parts of the economy, so over the last three quarters, housing has subtracted almost 1% from real GDP, home affordability has deteriorated to 2006 levels, and then also the other interest rate-sensitive part of the economy, the industrial side, you’re starting to see that slow with inventory-to-sales ratio rising. So, what has been the bright spot of the economy has been the consumer, and quite frankly, the consumer has stayed very strong with household balance sheets that look very good, low levels of debt to net worth. But I would point out that the labor market really is the most lagging of the variables, and we are actually even starting to see high-frequency job openings data start to turn. So, I do think small businesses have held up really well, however, they employ about 50% of the workforce in the US, and the cost of credit just has to rise as deposit rates rise for regional banks, which is where they get their funding from, so I do think the jobs outlook and the unemployment rate can rise a lot more than economists think right now and even the Fed.
THOMAS MUCHA: What about Animal Spirits? I mean an attack on the banking system can’t do much for consumer confidence.
BRIJ KHURANA: I agree, and I think consumers are already figuring that out, so if you look at the difference between consumer expectations versus their present situation, that gap is pretty much the largest it’s been, and consistent with other recessions. And I think one thing that everyone’s been excited about, the consumer, is that excess savings have just been so large, those pandemic savings are still in the system. But those are being worked through very, very quickly, and I would imagine at least for most of the lower half of the income distribution, that will be gone in the next few months, and so we are talking about a world where savings rates are going to start rising, and that’ll have big economic implications as well. However, it really depends on the country, I would say. So, as negative as I have been on US growth, Chinese growth should accelerate this year, Japanese growth as well. There’s still a potential for reopening to really boost those economies, and also the countries that have those trade linkages, you know, a lot of southeast Asia for example, should benefit from tourist flows.
THOMAS MUCHA: So what does all this mean, then, for the length and severity of a potential recession?
BRIJ KHURANA: I think markets are pricing in a very mild recession right now, and that’s consistent with what we’ve experienced over the last 30, 40 years, outside of the GFC, really. And so, that begs the question, why have recessions been short, and not too big of downturns? And the reality is I think that inflation just hasn’t been a problem for the economy for the last 30 to 40 years, and so the Fed could ease very aggressively into downturns. Typically, you’d expect the Fed to cut policy rates 400 to 600 basis points, and you know, we have this expression that policy rates take the escalator up and the elevator down. It could be the opposite this time around with inflation this high, where policy rates took the elevator up, and now they might take the escalator down, so the Fed might be necessarily behind the curve this time on the slowing environment. And then the second aspect to it is that fiscal is just unlikely going to be there with a split congress. You know, debt levels are very high, and many, in my view, correctly blame the inflationary experience on the aggressive spending we got by fiscal authorities during the pandemic. So, we should expect recessions to look a lot more like the 70s and early 80s, which were longer recessions, much shorter cycles.
THOMAS MUCHA: Let’s dig into this a little bit, and you’ve been maintaining that this pullback will be different. That we’re facing a profit recession as opposed to the balance sheet recession. What do you mean by that, and what does that suggest for the trajectory of the global economy here?
BRIJ KHURANA: Yeah, the GFC was a very uniquely bad type of recession called a balance sheet recession, and what you can think of it as is one large sector of the economy, the household sector, was technically insolvent, and that leads to very bad system-wide deleveraging. The way to solve that problem is to have a coordinated monetary and fiscal policy as, you know, the increased spending and the monetization of that debt prevents this debt spiral from cascading, and that’s what we got after the GFC, largely. The problem is that monetary and fiscal authorities use the same playbook after COVID, and COVID was not a balance sheet recession. Households were fine, the balance sheets looked very healthy. Same thing on the corporate side. And so, it was an income statement recession, and in my view, one of the reasons that we’ve had this inflation problem today. So, what does that mean going forward? Well, we tend to think about a profits recession as likely, and profits you can think of in a macroeconomic way as well as a microeconomic way, and there’s this famous equation called the Kalecki Levy Profits Equation, which is a manipulation of the GDP formula, but basically it says that any spending you get today relative to savings boosts profits, and it doesn’t matter where that spending comes from. Could be the government spending, it could be companies investing or buying back shares, it could be households saving less, but all that current consumption means higher profits today. And if you look at it from this lens, you can see why COVID was such a boon for profits, even though it was such a large economic disruption. From 2020 to 2021, you had massive fiscal stimulus that more than offset any savings from the consumer, and then over the last two to three years, we’ve really been living in those excess savings from the consumer, but when I think about the go forward, all of that is reversing. Consumers are increasing their savings rates pretty substantially, because we have worked through a large part of that excess savings. Government spending is unlikely to be there with a split congress, and companies are pulling back on not only CapEx, but they’re also increasingly, you know, with this higher rate environment, less likely to do share buybacks. And so, typical in a profit recession, you could see profits fall 20% to 35%, and I think what I would say is that investors have really been piling into tech recently, focused on the lower treasury yields, which means lower discount rates, and personally, I think that’s the wrong call, as the profit outlook for these companies is going to look very different six to twelve months from now.
THOMAS MUCHA: Now, Brij, given those shifts that you just highlighted, on the corporate side, on the fiscal side, on the consumer side, you know, what do you make of the Fed’s recent decision to raise interest rates by 25 basis points, which of course followed a hike by the ECB, proceeded one by the Bank of England. Do you think central banks are trying to signal to investors that, “Hey, everything’s going to be fine, nothing to see here?”
BRIJ KHURANA: At least for the Fed, I think history will remember this hike similar to Trichet’s ECB hiking in July 2008. First off, I want to say I really do hope the bank run stops. You know, people are very nervous, and it’s really bad for the global economy. And I do think we are seeing some tentative signs that at least deposit outflows have slowed, so I hope that continues, and that is a good thing. I don’t think we’re out of the woods yet. We are entering tax season, and in tax season, money goes away from deposits at the banks and make their way to the treasury. And so, this is a time when we need those deposits in those small banks, so I don’t think we’re completely out of the woods yet, but that is something I’m watching. Over the medium term, after the dept ceiling hopefully passes, treasury will have to build back their reserves, and so that’s another liquidity drain on the economy, and so I’m hopeful that the bank run stops, but regardless of if and when that happens, the regional banks are still in the position that they really need to raise deposit rates tremendously. The cost of credit is going to go up substantially, and I think that has big implications for the Fed’s dual mandate. You know, small businesses make up almost half the employment of the US, it’s very hard to see them not cutting back, if their cost of funding is going up. And similarly, lending growth is going to fall dramatically, and that really matters historically for the velocity of money, which is of course inflation. So I’m a long-term bull, thinking that inflation is going to be higher than we saw it after the financial crisis, but I wouldn’t be surprised if inflation actually surprises to the downside over the next 12 months. And so, I don’t think the Fed should have hiked, in my view. I think the Fed should end quantitative tightening immediately. The Fed still seems to be operating in this idea of an excess reserve regime, and that might be true for the system as a whole, there might be plenty of reserves in the system, but the distribution also matters, and it’s clear to me at least that the small banks do not have excess reserves at this moment.
THOMAS MUCHA: Clearly, it’s not a fun time to be a central banker.
BRIJ KHURANA: Exactly.
THOMAS MUCHA: So, let’s talk about the investor hard landing playbook here. So, Brij, if you’re right, and we do end up in a recession, what are the key market implications? I mean, which asset classes are likely to suffer, or maybe somewhat insulated? You know, who are the winners, who are the losers, from a market perspective?
BRIJ KHURANA: Yeah, the typical recessionary playbook is you buy US duration, and particularly the back end of the curve, if you’re an unlevered investor. You stay away from emerging markets, you definitely stay away from inflation-linked bonds. And so, I do have relatively negative view on the US, which is hard for me, because I’m typically a pretty bullish person, but you know, right now, that’s just not the spot we are in. But I do think besides my view on the US, global growth could certainly surprise to the upside, so we still have China reopening ongoing, and likely to accelerate throughout the year. Europe also looks promising, real incomes are improving because the commodity shock is abating, fiscal spending is supportive, and I am of the belief that the Credit Suisse situation was one-off, and the banking sector overall profitability does look good on a go-forward basis. So, with that in mind, I think emerging market local debt is one of the most attractive places to be in fixed income. Emerging market countries really did the right things after COVID, which, you know, had very orthodox policy response, so as the dollar depreciated throughout 2020, they accumulated a ton of reserves, they hiked rates substantially, in many cases, double-digit levels. You know, just as an example, Mexican inflation right now is less than Europe’s, and their policy rate is almost eight and a half percent higher, so, we think that’s also besides rates having room to materially move lower, the currencies should benefit from the China reopening, and we think that that’s one of the most attractive sources of carry in the world right now is emerging market local debt. In terms of government bonds, I do think that you have to be careful where you want to own them. So, as I said, the historical view was go buy long-end duration at the back end of the curve, but I think we are moving from this environment where there was a surplus of demand for fixed income to much more of a deficit, and we see that because the Bank of Japan’s going to normalize policy rates this year, we’re seeing a lot less excess savings in capital from Europe, which flowed into US investment grade and long-end treasuries, and so I do think that flows as Europe spends on itself are going to change those capital dynamics. And so we tend to be focused more on the front end of yield curves where we think the market has incorrectly, and central banks have already done too much, given the health of their consumers, and so countries with high levels of consumer debt, floating rate mortgage markets like Australia and New Zealand, Korea, Sweden, Canada, countries where they’re likely to feel the bite of higher interest rates much quicker than we will in the US.
THOMAS MUCHA: So there’s a lot of differentiation out there among markets.
BRIJ KHURANA: Absolutely, and I think that is kind of a big change from after the GFC, you know, bond markets really just traded with one factor, which was global QE for many years, and even after even last year everything sold off pretty much and spreads between different countries didn’t really matter, but we’re seeing so much more different inflation regimes, different correlations, so it’s a very exciting time to be a bond investor. More grey hairs, but an exciting time.
THOMAS MUCHA: Now, Brij, I know you’ll be shocked that I want to talk about the geopolitical angles involved here. So let’s start with Russia, given all the developments in Ukraine, you mentioned the energy implications for Europe, there’s a lot going on here, obviously. Now, you know, no one senses opportunity from crisis like Putin. So, do you think he’ll sense an opening later this year to exert some pressure on the oil markets?
BRIJ KHURANA: It is one of my chief concerns. The risk is that perhaps I’m right about the US cycle, and growth materially slows down, inflation even comes down, which the Fed would be very excited about, and then, you know, sometime mid this year, the unemployment rate’s rising, and then suddenly Russia wants to cut production further, and you know, the Saudis agree, because they want higher prices as well, you know, I think they’d prefer $100 oil to over $70s where it’s currently around today, and that would create a very stagflationary world for the US and force the Fed to choose inflation or unemployment. Now, this is the same choice they faced in the 70s, I still think they would likely choose unemployment, if they think it is commodity driven. So, if it’s just because oil prices are higher, I think they will rely more on the unemployment side of their mandate. Now, if that happens, the dollar, in my view, would probably be the biggest loser in that environment. And then for multi-asset investors, my personal view is oil is a pretty good hedge to that scenario, given that the stagflationary world is so poor for most asset classes, given how much oil’s come down it seems to me a regional hedge for portfolios. But, I’m certainly not the expert on geopolitics, so curious to hear your thoughts on it.
THOMAS MUCHA: Well, sure, Brij, I’ll add a couple of things from my geopolitical perspective on SVB and what’s happening more broadly. First of course, is the short answer, it depends on where these banking issues go from here, and I think if we get a relatively quick resolution without too much systemic, financial market, economic, and political disruption, I think the geopolitical implications will be relatively minor. I think the world can then move onto the next obsession or the next crisis. But if it drags on, or if it worsens dramatically, and as you say, we’re not out of the woods yet, I think then we’ve got another story, including some important longer-term implications for the dollar’s reserve currency status, as global investors seek stability elsewhere in this increasingly multipolar world. So, as this progresses, my lens on this crisis remains great power competition and how Russia and especially China will use these lingering banking problems to further their own arguments against the west. I think we should expect that in this long-running geopolitical competition, in my view, one that’s going to last years or longer, I think countries will use every opportunity to make their cases to domestic political constituencies and anyone else that will listen that their political systems are superior. So, in that sense, I think it’s logical for a crisis like this to be used for political purposes, it’s normal. But in a stricter and more fundamental sense, I think financial instability isn’t good for any country. It’s unpredictable, it’s potentially devastating to economic performance, it can set off all kinds of unintended social and political consequences for leaders, regardless of where they sit geopolitically. There’s another big potential negative here, in that potential financial and capital market instability in such a critical sector like technology, you know, where SVB was fully centered. Technology is on the front lines of great power competition. That won’t be good for emerging national economic strategies, or ongoing national security planning around the importance of this industry. And you know, Chinese tech companies did a lot of business with SVB. They will feel the impact of this too, so again, I think political leaders of all stripes should be careful with their domestic messaging, even if they believe there may be some short-term domestic or even geopolitical advantages to press if this situation drags on. So yes, I think this situation is complex and it’s certainly something that this already-complex geopolitical backdrop didn’t need.
BRIJ KHURANA: Yeah, I share some of your concerns about the US dollar, given the heightened geopolitical environment. Certainly, in my lifetime, I don’t expect the dollar to be replaced. You know, it has the exorbitant privilege, and other competitor currencies do not have the large financial markets and open capital accounts that the US does. However, the US has put itself in a relatively tricky place. There’s something called the Net International Investment Position, which represents how much assets are owned abroad. That right now is sitting at about 70% of GDP, so 70% of market value of exposure is held abroad, and that makes us very dependent on other countries not selling their assets, and that’s what happened in March 2020, people needed US cash and they would sell their assets, and that’s how it infected US financial markets, and so we are starting to see China reduce its holdings of treasuries, obviously, and replace some of that with gold as well. So, I know there’s a lot of talk about Saudi Arabia also potentially denominating oil in other currencies outside of the dollar, so these are certainly fringe risks, but things that could have material economic impacts, and so something we certainly pay attention to.
THOMAS MUCHA: Yeah, it’s certainly something I follow closely from the geopolitical perspective, that exorbitant privilege is a very powerful geopolitical tool that the US has enjoyed almost silently for decades, and so, Brij, thanks for all your ongoing insights as the global banking industry, and this one single bank, SVB, reverberates through all of our discussions here. I know your insights are valuable to my research and my own thinking about this backdrop. So, thanks for being here on WellSaid.
BRIJ KHURANA: Thanks for having me.
THOMAS MUCHA: Once again, Brij Khurana, Fixed Income Portfolio Manager with Wellington here in Boston.
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Views expressed are those of the speaker(s) and are subject to change. Other teams may hold different views and make different investment decisions. For professional/institutional investors only. Your capital may be at risk. Podcast produced April 2023.
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