Weekly Comment

The Consumer Price Index (CPI) for January recorded an acceleration of 0.3%, surpassing expectations of 0.2%. This elevated the annual inflation rate to 3.1%, compared to the estimated 2.9% and the 3.4% recorded in December. On the other hand, core CPI inflation, which excludes food and energy, increased by 0.4%, exceeding the forecast of 0.3% and the December figure of 0.3%. In its twelve-month variation, it reached a rate of 3.9% (versus the expected 3.7% and the 3.9% in January).

In the report, the monthly performance of the food component advanced 0.4% (+2.6% annually), highlighted by a 0.5% monthly (+5.1% annually) rebound in food away from home. On the other hand, the energy index declined 0.9% on the month (-4.6% annually), mainly due to a decline in the gasoline component.

Surprisingly, after several months of moderation, the shelter index rebounded in January, registering an increase of 0.6% monthly (+6% annually). It is worth noting that this category contributed more than two-thirds of the monthly increase in the entire CPI. In detail, the rental index increased 0.4% on the month (+6.1% annually), while rent equivalent to owning a home rose 0.6% on the month (+6.2% annually). 

Considering the latest employment and inflation data, it could be thought that the Federal Reserve (FED) will not rush changes in monetary policy, as there is still room for improvement in terms of Core CPI. In this context and after Jerome Powell’s reaffirmation that there will be no cuts in March, conditions and consensus expectations suggest that the first adjustment to the reference rate could take place until the June 12 meeting. As we have previously expressed, with this combination of factors prevailing, it is anticipated that the talk of higher rates will remain until a more pronounced cooling in the economy and/or an improvement especially in the shelter index, which carries specific weight in the cost of living for Americans – is observed.

Change (%) in the last twelve months in CPI and Core CPI

Source: U.S. Bureau of Labor Statistics

CPI monthly change (%)

Source: U.S. Bureau of Labor Statistics

January is now history, leaving a positive impact on the markets. The S&P 500 closed the month with a 1.6% increase, while the Nasdaq registered a 1% advance. The first month of the year is always full of discussions about how the remaining months might evolve. That said, certain key themes will be on almost every investor’s mind throughout 2024. Here are some perspectives on these.

Can the Economy Continue to Grow at the Same Rate? 2023 was billed as the year of the recession that never came. So far, some signs suggest continued economic resilience. This has generated the possibility of thinking about a very optimistic “Goldilocks” scenario, implying solid growth and declining inflation. Fourth-quarter 2023 GDP data showed a 3.3% year-over-year increase, with the labor market remaining solid, as indicated by the most recent nonfarm payroll report. Looking ahead, it is not out of the question that the economy will experience a deceleration, allowing for a soft landing, meaning healthy employment generation and inflation slowing to the target range. This environment could allow the Federal Reserve (FED) to begin adjusting rates before the end of the first half of the year (the market is discounting a total cut of 100 basis points for the full year), after Jerome Powell made it clear that there would be no adjustment in March.

Will the Dominance of the Magnificent 7 Persist? While there is optimism around the tech sector and the “growth” style, it is unrealistic to assume that these tech giants will perpetually rise together. A high standard implies a small margin for error, as evidenced by the fall of Google and Tesla after reporting lower-than-expected numbers, while Meta and Microsoft presented solid reports. Now, these companies will have to excel in all aspects to please the markets. A key theme this year could be differentiation among the Magnificent 7, with some winners and some losers. It is easy to forget that these are seven very different companies. Therefore, the ability of each to monetize new revenue streams, such as artificial intelligence, could make the difference in staying on top or not.

Should Markets Be Concerned about Geopolitical Tensions? As unfortunate as it is that, in recent years, humanity has entered a new era of rising geopolitical tensions in various regions of the world, as a general rule, geopolitics is not a major driver of long-term returns. In fact, several analyses spanning the 30 major shocks since 1940 concluded that, yes, there is often short-term volatility in the day or two after the event occurs, but at three months, returns were positive 60% of the time. And at three years? That’s 90% of the time. For most investors, geopolitical events are disruptions, but they are generally not turning points. However, elevated geopolitical tensions suggest the need for some hedges, most notably gold and energy-related stocks, to protect against the risk of higher oil prices.

What Could an Electoral Rematch Mean for the Markets? So far, the Democratic and Republican primaries (Iowa, New Hampshire, and South Carolina) suggest a rematch between Joe Biden and former President Donald Trump. It is worth mentioning that these elections are of great relevance for domestic and foreign policy; however, statistics show somewhat scattered results, where the historical average return of the S&P 500 in an election year stands at 13.1% (excluding 2008, when the global financial crisis emerged). Therefore, investors should not base their investment decisions solely on this event but consider a broader analysis that encompasses other economic and financial factors.

Consensus expects sales of the Magnificent 7 to grow at a rate 4x (times) higher than that of the S&P 493.

*CAGR: Refers to compound annual growth rate.

Source:  Goldman Sachs

After December inflation accelerated to 3.4% annually, where shelter costs, which have a significant weight, continue to look at a very gradual pace; and after knowing the first revision of the 4Q23 GDP, which showed a robust annualized growth of 3. 3% (beating expectations of 2%), the Federal Reserve (FED) made the unanimous and widely anticipated market decision to again leave the target range for the federal funds rate unchanged (for the fourth consecutive occasion) at 5.25% – 5.50% (the highest level in the last 22 years).

In this context, the statement noted that recent indicators suggest that economic activity has been expanding at a solid pace, with employment prevailing strong, while inflation, although it has declined over the past year, still remains elevated. Therefore, and as part of a modification from previous statements, the Committee emphasized that it believes the risks to achieving its employment and inflation targets are moving toward a better balance.

Another important change in the statement was that it modified the following wording: “to determine the degree of additional monetary policy tightening that might be appropriate to eventually return inflation to 2%”, replacing it with “in considering any adjustment to the target range for the federal funds rate”. This could be interpreted to mean that the hiking cycle may have come to an end, while the Committee will continue to take into consideration all incoming information, the developing environment and the balance of risks when making future decisions.

Finally, among other changes in language, and no less relevant, is the Committee’s strong message that it is in no hurry to start reducing the federal funds rate range, stating that “the Committee does not expect it to be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2%”.

In his press conference, Jerome Powell considered that rates are at the peak of this tightening cycle and did not rule out the possibility that they could remain elevated if necessary. The overall message focused on the FED needing further evidence that inflation is consistently heading towards its target, and he was positive about the results achieved over the last year, reaffirming the importance of carefully assessing economic developments before making future decisions.

Expectation for Federal Funds Rate

Source: AllianceBernstein

In recent days, Taiwan concluded its presidential election, with Vice President Lai Ching-Te emerging as the winner, securing another four years for the Democratic Progressive Party (DPP). Notably, this marks the first time in Taiwan’s electoral history that a ruling party has clinched a presidential election for a third term. Lai’s inauguration is scheduled for May 20th, 2024.

The elections witnessed a high turnout of around 70%, and it’s worth mentioning that Lai’s 40% share of the presidential vote was lower than his predecessor Tsai Ing-wen’s 57% in the 2020 election. Additionally, the DPP lost its absolute majority in the Legislative Assembly, decreasing its share from 54% in 2020 to 45.1%. Both opposition parties increased their share of seats: the Kuomintang (KMT) from 33.6% to 46%, and the Taiwan People’s Party (TPP) from 4.4% to 7.1%. Consequently, no party holds a majority position. Historically, the KMT has been considered more open to the idea of closer relations with mainland China.

It’s important to note that this scenario aligns with market expectations and, generally, is not anticipated to alter the current course of events in the region. While the outcome is considered unlikely to significantly impact Taiwan’s economic growth in 2024, there will be a continuity of policies implemented by previous DPP-led governments. Regarding relations with mainland China, Lai expressed his interest in maintaining “healthy and orderly” exchanges, reiterating his openness to talks based on more equitable terms.

In conclusion, the positive outcome of this event may bring some calm to the geopolitical sphere in Asia and the world in the short term. However, it’s challenging to rule out the possibility of continued tension in relations with mainland China in the coming years, especially given the close interaction between Taiwan and the United States in the evolving economic landscape, heavily influenced by the semiconductor supercycle and Artificial Intelligence (AI) development.

Global semiconductor wafer capacity installed by region (market share).

In electronics, a wafer refers to a thin, circular slice of semiconductor material from which microchips/semiconductors are produced.

Source:  UBS

The December consumer price index (CPI) accelerated by 0.3%, slightly higher than expected, bringing the annual rate of inflation to 3.4% from 3.1% in November. Also, core CPI inflation, which excludes food and energy, increased by 0.3%, although in line with expectations. However, in its annual variation, it decelerated to 3.9% (versus 4.0% in November and October). Therefore, the overall trend shows that core CPI continues to moderate gradually. According to these data, analysts believe that the FED’s preferred price index, known as the “Core Personal Consumption Expenditures Price Index (Core PCE)”, would have increased by 0.2% last month, which would bring the annual variation from 3.2% to 3.0% (vs. 2.4% expected for the end of this year).

Within the report, the monthly performance in the energy component came as a surprise, higher than expected, with an increase of 0.4% (-2% annually), driven by a 1.3% increase in electricity prices (+3.3% annually). Meanwhile, food CPI rose 0.2% (+2.7% annually), in line with recent increases. Food away from home increased 0.3% (+5.2%), which implied a slight improvement over what was seen in previous months.

In other categories of interest, new vehicle prices advanced 0.3% in the month (+1% annually), while used vehicle prices climbed 0.5% (-1.3% annually), although used vehicle prices are expected to moderate again in the coming months. Basic services prices (excluding energy services) advanced 0.4% last month (+5.3% annually). That said, shelter-related increases, which have a significant weight, continue to moderate at a very gradual pace. In this sense, rents increased 0.5% (+6.2% annually), a similar performance to the previous month. Finally, prices for health care services rebounded 0.7% last month (-0.5% annually), pressured by another increase in the cost of insurance.

With all key data now available (inflation and employment), we believe that the Fed would not be in a hurry to accelerate cutbacks to the reference rate, as there is still room for improvements, especially concerning Core CPI. Moreover, it is challenging to think that the upcoming FOMC meeting at the end of January can provide further clues about how the Fed might act in the very near term. What can be anticipated is that the talk of higher rates for a while should prevail until a more pronounced cooling within the economy is observed. Finally, it is worth noting that, despite all of the above, the consensus assigns a 69% probability of seeing a 25-basis point (bp) cutback at the subsequent meeting on March 20th.

Change (%) in the last twelve months in CPI and Core CPI

Source: U.S. Bureau of Labor Statistics

The quarterly earnings results season is set to begin this week. In this regard, consensus forecasts anticipate an annual earnings growth for the S&P 500 of 1.3% (YoY) for the fourth quarter of last year. If this number is confirmed, it could mark the second consecutive quarter of YoY earnings growth for the index. However, this result represents a lower growth rate compared to third-quarter results, which showed an advance of 4.9% YoY. It is noteworthy that analysts considerably reduced their estimates (-6.8%), given that at the beginning of the quarter, they had expected an increase of 8% YoY. This decrease is higher than the 5-year historical average (-3.5%) and the 10-year historical average (-3.3%) for a quarter.

Five of the eleven sectors are projected to report YoY earnings growth, led by the communication services, utilities, and consumer discretionary sectors. On the other hand, the consensus estimates that six sectors will report YoY declines in earnings, led by the energy, healthcare, and materials sectors.

On the sales front, the consensus anticipates a YoY increase of 3.1% (compared to the 3.9% expectation at the beginning of the quarter), which could represent the twelfth consecutive quarter of sales growth if this number is confirmed at the end of the season.

With this combination of factors, the net income margin would be 11%, lower than the 12.2% of the immediately preceding quarter, as well as last year’s 11.2%. Finally, in terms of perspective, analysts expect YoY earnings growth of 6.0% for 1Q24 and 11.8% for the full year 2024.

JP Morgan will kick off on January 12; therefore, investors will be especially attentive to the development of the season due to the rally that took place at the end of 2023, with the resilience in earnings performance, to some extent, as support, along with the perspective that interest rate cutbacks could occur throughout this year.

S&P 500: expected earnings growth for the 4Q23

Source: FacSet

During their mid-December meeting, FED officials maintained the reference rate within the range of 5.25% to 5.5%. It was observed that the new projections hinted at the possibility of a series of cutbacks totaling three-quarters of a percentage point (75 bps) throughout the year.

Within this context, the meeting minutes unveiled that nearly all participants expressed the notion that, reflecting improvements in their inflation outlooks, it would be appropriate to establish a lower target range for the federal funds rate by the end of 2024. Emphasis was placed on the progress made in reducing inflation and in balancing the labor market, albeit with recognition that these tasks remain ongoing.

However, the minutes also indicated a degree of uncertainty about how or if this would occur, as “members considered that the reference rate is likely to be at or near its peak for this adjustment cycle. Nevertheless, the path of monetary policy will depend on how the economy evolves.” Specifically, some members mentioned the possibility of maintaining the reference rate at an elevated level if inflation does not continue its downward trajectory. Other officials left open the possibility of additional increases contingent on evolving conditions. Participants underscored the importance of maintaining a careful, data-dependent approach in making future decisions. They reaffirmed that it would be appropriate for the policy stance to remain on a tightening path for some time, until inflation is clearly declining sustainably toward the Committee’s 2% long-term objective.

In line with this cautious perspective, the President of the Federal Reserve Bank of Richmond, Thomas Barkin, recently expressed caution about monetary policy, highlighting the inherent risks in attempting to guide the economy toward a “soft landing.”

The FED will make its first announcement of the year on January 31st, with widespread anticipation that the reference rate will remain unchanged.

Expectations for the Federal Funds Rate

Source: JP Morgan

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