Fabian Estevez

In the past two weeks, markets have experienced not seen volatility since the pandemic with the Silicon Valley Bank default, which subsequently led to the decline and purchase of Credit Suisse by UBS AG. 

During the weekend of March 18, UBS AG agreed to buy Credit Suisse for $3.2 billion (less than $0.8 per share) with considerable facilities and guarantees from the Swiss regulator, the Swiss Financial Market Supervisory Authority (FINMA). Although the market widely discussed the terms of this purchase, what generated the most controversy was FINMA’s treatment of Jr. subordinated bonds or Contingent Convertibles (CoCos). 

What are CoCos, and why are they relevant?

Contingent Convertibles (CoCos), also called Additional Tier 1 Bonds (AT1), are Jr. subordinated bonds that act as buffers if a bank’s regulatory capital levels fall below a certain threshold. If this happens, they can become capital or be canceled.

These instruments are part of the capital buffer regulators require banks to hold to support in times of market turbulence. In other words, banks are required to maintain a determined level of CoCos in their capital structure. And the essential point for this commentary is that CoCos rank higher than stocks in a bank’s capital structure. If a bank is in trouble, the bondholders will be ahead of the shareholders to get their money back. That’s why these bonds have more correlation with the movement of the bank’s action.

What happened to Credit Suisse’s CoCos?

During that weekend, FINMA decided to change the capital structure hierarchy, granting some recovery to Credit Suisse’s shareholders but canceling all the CoCos of this bank, which reached a value of $ 17 bn.

What reaction did the market and other regulators have?

The Monday following these events, the market entered a risk-off mode towards these bonds, as they considered that the precedent of this operation could be generalized to the other CoCos of other banks. On average, these fell between 10-15 percentage points on the same day, and credit risk premiums on the US treasury increased by about 200 basis points (bps). 

Given this, European regulators, such as the European Central Bank, the Bank of England, and the Federal Reserve in the United States, spoke out before the market. The regulators made it clear that FINMA’s procedure would not apply in these jurisdictions and that the hierarchy of the banks’ capital structure would be respected in case of non-viability of the banks, but that the financial system for these regions was solid and with sufficient liquidity. These announcements have helped to provide certainty to the market.

Can the case of Credit Suisse’s CoCos be generalized?

No, it is essential to consider that Switzerland is a different jurisdiction from the rest of Europe, such that the ECB cannot act or interfere in Switzerland and vice versa. In addition, in Europe, there are precedents that the hierarchy in the capital structure was respected during bank liquidations. First, in 2017, when Santander SA acquired Banco Popular, and recently, with the sale of Silicon Valley Bank UK to HSBC. In both cases, the first line of defense to absorb losses was common stock and later CoCos.

Another critical point is that triggers for CoCos are different in Switzerland compared to the ones issued in the rest of Europe. Swiss CoCos are canceled permanently once the capital ratio falls below the threshold. In contrast, CoCos of German, Spanish, and French banks are temporarily revoked until the bank’s capital ratio is again above the threshold. In the case of British CoCos, they are converted into shares once they exceed this threshold.

Our Committee has always recommended CoCos from banks with solid credit profiles and systemically important globally, in very manageable proportions, in the construction of portfolios. In addition, we recognize a somewhat irrational market reaction towards this sector, so we closely follow different metrics that help us react on time to relevant market events.

Capital structure for Banks under Basel III and American Banks

Source: UBS

The statement stressed that recent indicators point to moderate growth in spending and production. Job creation in recent months has been notable, allowing the unemployment rate to remain low, although inflation remains high. On the other hand, he stressed that the US banking system is solid and resilient. Consequently, recent events will probably result in tighter credit conditions for households and businesses, impacting economic activity and inflation. The magnitude of these effects is uncertain.

In this context, the Federal Open Market Committee (FOMC) increased the benchmark rate by 25bp to a range between 4.75% – 5.0%, which implied its highest level since the end of 2007. This decision was in line with expectations and was unanimous. He also anticipated that further policy tightening might be appropriate to achieve a monetary stance tight enough for inflation to return to 2% over time. As in previous releases, the FOMC announced that it would closely monitor incoming information and assess the implications for monetary policy. That said, he reiterated that he remains very attentive to the risks associated with inflation. Finally, he indicated that he would be prepared to adjust the stance of monetary policy as appropriate should risks arise that could prevent the achievement of objectives, considering the labor market situation, inflationary pressures, inflation expectations, and the development of events financial and international.

As every three months, the Fed updated its outlook for the benchmark rate, predicting that it could end this year at 5.1%, unchanged from the December estimate. For 2024, the new assessment reflected a slight increase to 4.3% from 4.1%. However, the expectation of lower rates compared to 2023 (5.1% vs. 4.3%) remains. Regarding the economic outlook, the new estimate suggests the economy could grow by 0.4%, in line with the previous projection of 0.5%. For inflation (Personal Consumption Expenditures, PCE), the new estimate reflects a slight upward pressure considering a rate of 3.3% (vs. 3.1%). 

During his press conference, Jerome Powell reiterated that the banking system is robust and remains well capitalized while endorsing recommendations for greater sector regulation. On the other hand, he ruled out cuts to the reference rate for this year.

Fed Indicators Update (March vs. December)

Source: Federal Reserve

With the recent volatility unleashed due to the closure of Silicon Valley Bank (SVB) operations, we share a series of questions and answers with the information we have so far.  

What happened to SVB?

On March 8, SVB, based on the U.S. West Coast, announced the need to sell its US$21bn Available for Sale Securities (AFS) portfolio, which led it to acknowledge a loss of US$1.8bn. At the same time, the bank planned to raise US$2.25bn by issuing common shares and convertible preferred shares to improve its liquidity position within its balance sheet. After this statement, in hours, the bank suffered a bank run (massive withdrawal of deposits), so California regulators had to intervene in the bank. 

What is the market worried about?

Bank indices and shares of financial institutions worldwide have fallen sharply after the news of the closure of SVB, with uncertainty centering on whether this situation could be an idiosyncratic event from SVB or if there is a risk of relevant systematic transmission. At the moment, a couple of banks have been intervened, First Republic Bank and Signature Bank, also by bank runs since they maintained a high concentration in their depositors. At the time of writing, the information and the market do not point to a significant risk of contagion for this sector.

What did regulatory authorities announce over the weekend? 

At an emergency meeting, U.S. financial regulators (Treasury Department, the Fed, and the Federal Deposit Insurance Corporation) assured all depositors on Sunday that their money is safe after SVB bankruptcy. In this context, the authorities emphasized that the bank’s depositors will have access to all their money as of Monday, March 13. The statement noted that taxpayers would not be liable for any losses associated with SVB’s resolution. Similarly, the Fed announced implementing a loan program for financial institutions affected by the collapse of SVB.

How does SVB’s situation compare to other banks?

SVB had a high concentration in emerging growth companies (start-ups and venture capital) in specific niches, focusing on the technology and healthcare industries. The boom in technology fundraising and the large number of Initial Public Offerings (IPOs) in the wake of the pandemic substantially accelerated SVB deposits. As the operating conditions of these types of companies deteriorated over the past year, SVB began to experience a more pronounced than expected withdrawal in its deposits. Therefore, the deposit base that the bank had did not function like traditional commercial banking. Another factor that influenced SVB’s fall was its high exposure to low-yielding Treasury and mortgage agency securities, leaving SVB vulnerable to market losses due to the sharp increase in rates last year. 

Contrary to SVB, the largest capitalization banks that could pose greater systemic risk worldwide were subject to a broader review by their respective regulators in the wake of the pandemic and other regulatory changes over the past decade. Therefore, this type of bank has a healthy portfolio of deposits and diversification, distributed among retail, institutional, and wealth management deposits. This offers a relatively stable deposit base. They also hold significant positions in what is known as HQLA (High-quality liquid assets), usually in cash and short-lived government securities. Finally, under Basel III regulations, they operate with strict LCR (Liquidity coverage ratio). Banks must maintain this LCR ratio >100% (i.e., always have enough HQLA to fund money outflows in a 30-day stress period). 

What implications could it have on monetary policy? 

The SVB situation represents a different complexity component for the Fed’s following announcement, reflecting other consequences of tightening monetary policy. Following the Fed chairman’s aggressive stance ahead of his most recent congressional appearance, markets began pricing in a higher probability of a 50bp hike at the next meeting in March. However, these expectations subsequently fell with the news of SVB’s closing of operations, again considering an increase of 25bp and in which the FOMC (Federal Open Market Committee) members would have to prioritize financial stability for the excellent functioning of the banking system and markets. 

Conclusion

While SVB implies the most significant failure of a U.S. bank in more than a decade, and events like this can trigger instability, the risk of a crisis may be limited, especially since large, systemically important banks do not share the same vulnerabilities of which SVB was subject. In addition, regulators have already taken measures to avoid further transmission, not to mention that the Fed may rethink its policy strategy in the coming months, prioritizing the smooth functioning of the financial system.

Banks’ LCR liquidity coverage ratios (%)

Source: Credit Suisse

SVB Deposit Mix at 3Q22

Source: Goldman Sachs

Quarterly reports are nearing completion, with 95% of S&P 500 companies releasing their numbers. Against this background, we summarize the key points the season has left us.

On the one hand, earnings per share (EPS) behavior was much weaker sequentially since, in 3Q22, a growth of 4.4% was observed year over year (YoY). At the same time, the final figure indicates that, in 4Q22, EPS decreased 3% YoY (at the beginning of January, analysts estimated a 2% YoY drop). Since 3Q20, S&P 500 companies have not reported a reduction in their EPS (-5.7% YoY).

On the other hand, 68% of the sample published an EPS that exceeded consensus expectations; this compares to the long-term average of 66.3% and the average of the last four prior quarters of 75.5%.

By sector:

Energy companies drove most of the results seen at the aggregate level (excluding this sector, S&P 500 EPS would have declined 7% YoY), with earnings growth of 55% YoY.

The industrial and consumer discretionary sectors also contributed positively, recording 40% and 21% YoY increases, respectively. 

On the other hand, the materials and communication services sectors led the negative performance with drops of 29% and 28% YoY.

Another point indicates that 105 companies in the S&P 500 have issued guidance or estimate of earnings growth for 1Q23.

Of these 105 companies, 77% shared a negative guidance, and the remaining 23% gave a positive expectation. This rate of 77% is above the 5-year average of 59% and the 10-year average of 67%; the information technology, manufacturing, and consumer discretionary sectors comprise the most significant number of companies with negative expectations.

With this data, analysts anticipate that S&P 500 earnings per share could decline by 4.5% in 1Q23, so the entire 2023 growth would average around 1.5%.

Finally, the season showed that sales performance was reasonable, with an increase of almost 6% year over year , in which 59% of the sample exceeded analysts’ expectations.

S&P 500 YoY Growth Rates

Source: I/B/E/S

The official February manufacturing activity (PMI) report in China advanced strongly and remained in the field, indicating expansion (+52.6 points*). This result was better than expected and represented its highest reading since April 2012. 

Among the report’s details, the notable rebound in the export orders component stood out, which is particularly interesting because there are concerns in the market about the possible strength of external demand. This external sector performance could have resulted from a more significant normalization of the supply chain. Similarly, the new orders component (considered an economic leading indicator) revealed significantly positive numbers, suggesting that activity could remain robust for the coming months. 

Regarding the activity of the services, the numbers were also favorable (+56.3 points), where recovery is maintained beyond the festive season of the Lunar New Year. In this sense, the non-manufacturing PMI touched its highest reading since March 2021 in February. With the mix of these figures, employment conditions could continue to improve, so there could be higher household income growth and higher domestic consumption. In this context, the consensus estimates that China’s economy could grow by 1.3% in 1Q23. 

From now on, markets will closely watch the development of China’s National People’s Congress, which begins on March 5, amid a government shakeup not seen in decades as Xi Jinping operates with greater control. In addition, the economic growth target for this year (5 – 6%) will be set, and national security issues will be addressed, including rising tensions with the United States.  

China Manufacturing PMI

Note: **A reading below 50 points is considered contraction in the sector.Source: CNBC – National Bureau of Statistics of China

The debate in the US Congress on extending the government’s debt ceiling will be the main fiscal issue on the markets’ radar this year. On January 19, the government reached its legal debt limit of US$31.4 trillion (an all-time maximum). Therefore, we share some points that could influence the negotiations throughout this process:

•    Date “X”: The Treasury has not set a deadline. However, it is estimated that the actual date when the government would lack the necessary resources to pay all its obligations would be between July and September (this was expressed recently by the Congressional Budget Office, CBO). The determination of the “X” date will depend mainly on the income received via taxes during April. 

•    The Republican Party has a slight majority in Congress: Republicans do not have much bargaining power because the party has its lowest majority in the House since 2001-2003.

•    Tax revenues could decline: The government continually receives income through tax collection, although the pace and magnitude of those revenues depend more on the economy. Under this context, the market assumes that the economy could grow 0.6% this year. 

•    Restrictive financial environment: With interest rates rising rapidly, financing conditions have become more challenging. Therefore, future government spending could experience a significant impact (currently, interest payments represent 8% of tax revenue).

With the prospect that the Treasury may have exhausted its resources by the summer, the most likely scenario points to an agreement among lawmakers to raise the debt limit, where possible episodes of political controversy are not ruled out. In this sense, the Republicans will not increase the debt limit in exchange for spending cuts. At the same time, the Democrats would defend an increase in the limit so as not to fall into default and avoid increased tensions such as those experienced in 2011, when the S&P cut the government’s rating from AA to AA.  

Net interest Relative to other mandatory expenses 

Source: Raymond James 

The Consumer Price Index (CPI) advanced 0.5% in January, from the 0.1% increase seen in December (the monthly figure for December was revised slightly upwards). As a result, annual inflation stood at 6.4% (vs. +6.5% in December and +6.2% estimated). Core inflation, which excludes the most volatile categories such as food and energy, accelerated by 0.4%, causing its annual variation to register a rate of 5.6% (vs. 5.7% in December and +5.5% estimated).

In detail, the shelter index was the most significant contributor to the monthly increase of all items, representing almost half of the monthly increase. This category participates in more than a third of the index, rising 0.7% monthly and 7.9% in its annual comparison. Another relevant component, food (~14% within the index), increased by 0.5% in the month (+10.1% year-on-year). The food-at-home subcategory increased by 0.4% per month and 11.3% per year, respectively. In turn, the energy component surprised (~7% of the index) by rising 2% in the month (vs. -3.1% in December), with its annual figure reaching a rate of 8.7%. Within the main subcategories, the one referring to energy commodities advanced 1.9% monthly (+2.8% annually), while energy services rose 2.1% monthly (+15.6% annually). In particular, electricity rose 0.5% monthly (+11.9% annually). On the other hand, on a positive note, medical services (~7% of the index) fell 0.7% in the month (+3% annually), airfares (~1% of the index) fell 2.1% monthly (+25.6% YoY), and used cars and trucks (~3% of the index) were down 1.9% monthly (-11.6% annually).

In this context, we believe that this inflation report produces mixed results since, on the one hand, it continues to be phrased that the disinflation process continues its course, but at a slow and gradual pace, in which significant pressures on food products and those “sticky” components like shelter. This mix of factors influencing the behavior of inflation somewhat justifies the tone and hawkish stance that Jerome Powell has expressed, as well as various members of the Fed in different spaces since the beginning of the year, including the most recent FOMC statement for February.

12-month percentage change in CPI

Source: U.S. Bureau of Labor Statistics

The official January jobs report showed the non-farm payroll increased by 517,000 jobs, well above consensus expectations of 190,000. In addition, the unemployment rate stood at 3.4%, the lowest since the late 1960s, while average weekly hours worked jumped from 34.4 to 34.7 in December. Finally, the JOLTS (job openings) also surprised to the upside, rising to 11 million in December (vs. +10.4 million in November) and jobless claims that remain low, despite recent announcements of layoffs by significant companies.

In this context, the hopes of a change of direction in the Fed’s policy have started to lose strength since the Central Bank cleared that it wants to see a better balance between supply and demand. In his press conference following the February FOMC meeting, Fed Chairman Jerome Powell described the labor market situation as extremely tight. Therefore, it will be necessary to have more evidence that this balance is being reached (debe ser has been) before considering stopping the rise in interest rates.

Reaffirming the previous idea, Jerome Powell expressed again before the Economic Club of Washington that if the job market reports remain strong or if there is a possible acceleration of inflation (referring to this point, he positively highlighted that there is a notorious reduction), “it may well be the case that more needs to be done and rates increased more than the market has anticipated.”

The Fed will exhaust all its options to bring inflation to its long-term target of 2%. However, futures for the federal funds rate continue to reflect that the peak will be reached in June, with a rate of 5% (in line with the view that was held before the end of 2022), which may be maintained, depending on economic conditions.

Unemployed workers and vacancies (figures in millions)

Source: UBS

In its first release of the year and in line with expectations, the Fed increased the reference rate by 25bp to a range between 4.5-4.75% (the decision was unanimous), its highest level since October 2007. This decision represented a minor movement compared to the 50bp advance last December and the 4 increases of 75bp implemented throughout 2022.

The Committee anticipates continued increases in the target range will be appropriate to achieve a monetary policy stance tight enough to return inflation to 2% over time. In this sense, the Committee will consider the cumulative tightening that has been implemented (8 consecutive increases in the reference rate), the delays with which monetary policy impacts economic activity, inflation, and the evolution of financial conditions. Also, the Fed will continue to reduce its holdings of Treasury and agency debt and agency mortgage-backed securities (as described in previous communications).

On the other hand, the announcement highlighted that the latest indicators point to moderate growth in spending and production; meanwhile, the labor market’s performance has been robust in recent months, with an unemployment rate that has remained low. In terms of inflation, it highlighted that even though it has slowed down a bit, current levels remain high.

In his conference, Jerome Powell ratified that it is necessary to maintain a restrictive position for a while to restore stability in inflation. At the same time, he emphasized that the labor market operates under highly tight conditions. Finally, he communicated that it is gratifying to see a disinflationary process underway.

Expectations for the Reference rate

Source: Goldman Sachs

Against a backdrop of rapidly rising US interest rates and mounting recession fears, most currencies weakened significantly against the US dollar in 2022. However, the Mexican peso was one of the outliers, appreciating 5% in 2022 and now trading below 19 per US dollar, a level not seen since February 2020, with a 3.6% gain this year.

What can explain this appreciation? The peso was highly exposed to global risk sentiment and liquidity conditions in 2022, but according to analysts, four idiosyncratic factors more than offset this reality. As we enter 2023, these factors will continue supporting the peso, particularly during the year’s first half.

 1. Interest rate differentials: Banxico began raising the reference rate in June 2021 to cushion the impact of the Fed’s rate hike. After a 650 bps (6.5 pp) rise, it is expected that Banxico is close to the end of the hiking cycle. However, the rate differential is expected to hold.

2. Positive impact of a relatively resilient US economy: The strength of the US economy in 2022 increased demand for manufacturing exports and boosted remittances from the US to Mexico to record levels. The slowdown of the ‘northern neighbor’ that we expect in 2023 should moderate remittances and the growth of manufacturing exports from very high levels.

3. Stable fiscal position and robust institutional framework relative to peers: Mexico’s credit outlook compares favorably with most of its Latin American peers, given its fiscal stance. Mexico faces several medium-term fiscal challenges, although these will likely be on investors’ minds this year, as its fiscal accounts remain strong relative to most emerging countries.

4. Constructive narrative of nearshoring: Mexico benefits from nearshoring as US companies try bringing production closer to home. According to estimates by the Inter-American Development Bank, Mexico could generate US$35bn per year in additional revenue from exports of goods through nearshoring in the coming years. While it may be too soon to assess the impact of this phenomenon on Mexico’s long-term growth, we believe it offers a positive narrative in investors’ minds.

As for the risks it faces, the possible consequences of a trade dispute with the United States and Canada stand out in the context of alleged violations of the USMCA in energy matters, which must be monitored. Also, a deterioration in investor confidence in the face of a larger-than-expected US recession could significantly damage the Mexican economy.

Reference rate trajectory (%) in Mexico and the United States post-pandemic

Source: Bloomberg