Banking Aftershocks: 4 Areas Investors Should Watch Now

Mar 22, 2023

While the shudders from the recent turmoil in the banking sector appear to have been contained, the effects on key asset classes, lending and the broader economy are expected to linger.

Turmoil in the banking sector has eclipsed investors’ focus on macroeconomic pressures over the past weeks. The federal government’s swift move to backstop uninsured deposits and efforts to shore up failing institutions have helped lessen risk of spillover effects. However, the impacts to financial services firms, the economy, equities and venture capital, are expected to linger.


Here, Morgan Stanley Research offers perspective on the near- and long-terms effects in four key areas—and where investors should turn their attention now. 


1. Banks

“We clearly see rising risks in the banking industry, given the closures of three banks and significant deposit outflows at others,” says Betsy Graseck, Global Head of Banks and Diversified Finance Research. However, she notes that banks have ample access to additional cash if needed, in particular from government-sponsored lenders, the Fed discount window and the new Bank Term Funding Program (BTFP).


In terms of areas investors should watch, Graseck points out that banks are likely to see their funding costs rise as they diversify their debt and aim for a longer-term mix of funding sources. For customers, that could mean tougher standards for new loans, higher loan spreads and reduced lines of credit. Banks will also see higher interest expenses as the competition for deposits increases; as well as elevated non-interest expenses as banks expand products and improve customer experience to retain accounts. In turn, banks could ask for guaranteed holding periods or impose penalties for early withdrawals for uninsured balances.


“In the long term,” says Graseck, “sustained higher funding costs and operating expenses could bring about more industry consolidation.”



2. U.S. Equities 


The heightened risk of a credit crunch is real, says Mike Wilson Chief Investment Officer and Chief U.S. Equity Strategist, and investors shouldn’t expect additional liquidity to banks on loan from the Federal Reserve to show up as new money in the economy or the markets.


“None of the reserves will likely transmit to the economy, as bank deposits normally do,” says Wilson. “Instead, we believe the overall velocity of money in the banking system is likely to fall sharply and more than offset any increase in reserves, especially given the temporary nature of the Fed funds.” 


In fact, Wilson says a credit crunch may convince market participants that the equity risk premium (ERP)—or the extra return an investor can expect for investing in the stock market instead of risk-free 10-year Treasuries—is far too low. That realization could bring about a real buying opportunity as forecasts realign more closely to companies’ actual earnings prospects.  “Our conviction that earnings forecasts are 15% to 20% too high has increased. Given that, we believe the risk/reward in U.S. equities remains unattractive until the ERP is at least 350 to 400 basis points,” says Wilson. The S&P 500 ERP is currently 220 basis points.



3. The U.S. Economy 


Banks were already reining in lending standards in response to rising interest rates, and further increases to funding costs would likely slow economic growth and hiring, says Chief U.S. Economist Ellen Zentner. “Substantial tightening in credit conditions raises the risk that a soft landing will turn into a harder one.” 


Why? Tougher lending standards dent job creation, and smaller firms, which have been a key driver of labor market resilience in recent months, are especially sensitive to these dynamics. A quick drop-off in jobs gains could result. “Concerns are most acute around smaller banks, who will likely face more difficulty raising funds, and for the small businesses that rely on them,” Zentner says. 


Weekly lending and labor market data would be first to reflect signs of stress, but the readouts could take several weeks at least to fully reflect the pain. “Meanwhile, we still expect the Fed to follow through on a 25 basis point hike in response to persistent inflation and a very strong labor market. “That said, the Fed has little incentive to surprise markets in this volatile environment, and we think it will stand ready to adjust the rates and balance sheet paths should conditions warrant.”



4. Startup Funding 


With Silicon Valley the epicenter of recent banking challenges, the effects on venture capital activity and startup funding are in sharp focus. For now, government deposit guarantees have abated some concerns, namely that firms have access to their money to stay in business. 


But startups traditionally burn through a lot of cash. At present, startups valued at $1 billion or more need around $300 billion by year end just to exist, says Ed Stanley, Head of Thematic Research in Europe. Even with aggressive intervention to support these banking clients, he says, “a high proportion of start-ups could fold during the second half of the year, given the simple math on cash-burn rates.”


As new lines of credit and syndicated debt become harder to get, startups are returning to simpler equity raises, and with a greater sense of urgency. And while development and widespread adoption of new technologies may slow for a spell, the long-term trend of technology diffusion remains strong. “In the long term,” says Stanley, “venture markets are essential components for innovation, the diffusion of technology and creating megacap public equities,” says Stanley. “Strong private companies will continue to be funded, as they have in every prior downturn.” Software-as-a-service companies, supply chain automation and fintech firms, he notes, are best positioned to weather a tight funding environment.


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