by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a discussion of the U.S. banking system, which has now seen the collapse of several sizable banks in the last week.  Over the weekend, federal regulators put a plan into place that appears to have removed the fear of massive bank runs, but that plan does nothing to shield bank stockholders and bondholders.  Bank shares and bonds remain under pressure so far today.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including the latest from the Chinese government’s “two sessions” meetings.

U.S. Banking System:  Following Friday’s collapse of Silicon Valley Bank (SVIB, $106.04) and its takeover by regulators, Signature Bank (SBNY, $70.00), a key depository institution for cryptocurrency firms, collapsed on Sunday and was taken over by regulators.  To avoid a widespread loss of faith in the nation’s banks and their deposit insurance backstop, the Treasury Department, the Federal Deposit Insurance Corporation, and the Federal Reserve declared the two institutions to be a systemic risk to the country’s financial system.  This gave the regulators special powers to guarantee the banks’ uninsured deposits and establish a broad “Bank Term Funding Program” of one-year, collateralized loans to help banks cover their customers’ withdrawals.  The regulators said Silicon Valley’s depositors will have access to all of their funds by Monday.

• The critical issue in this crisis is contagion. Anytime a bank fails, it raises the risk of a widespread run on banks.  Fortunately, Silicon Valley was unusual in that so many of its deposits were bigger than the $250,000 insured by the FDIC.  In addition, under the government’s rescue scheme, the FDIC will cover 100% of the deposits at Silicon Valley and Signature, rather than the standard $250,000.  Federal regulators said any losses to the FDIC would be recovered in a special assessment on banks, and that the U.S. taxpayers wouldn’t bear any losses.  The banks’ equity and bond holders will not be made whole.
• In a statement Sunday night, the Fed said it was closely monitoring conditions in the nation’s financial markets and would use its “full range of tools to support households and businesses” as appropriate.
• The regulators launched their rescue plan after failing to find a buyer for Silicon Valley over the weekend. If their plan is seen as credible, it could restore confidence in the banking system and prompt a rebound in stock prices today following the rout on Friday.  However, the crisis could also spark a reversal of the bank deregulation of recent years and, if it’s seen as a bailout at the public’s expense, it could also be a political black eye for the Fed and the Biden administration.
• We have long warned that the Fed’s aggressive interest-rate hikes had the potential to “break something” in the financial system, and it now appears that the “something” was medium-sized, technology-dependent banks. It was reassuring that last year’s many bankruptcies and financial shenanigans in the cryptocurrency industry appeared to have little impact on the broader financial system.  However, it now appears that the Fed’s rapid rate hikes dried up financial flows into venture capital funds and technology startups, forcing them to withdraw funds from tech-focused banks even as those banks faced falling values for their bond holdings.
  • Fortunately, it appears so far that Silicon Valley and Signature represent relatively rare special cases. Some other smaller, regionally focused banks are facing pressure this morning, but it appears that the regulators’ emergency program will be able to contain the crisis and prevent broader contagion.
    • Another asset class that could come under pressure in the near future is mortgage REITs.
    • If Silicon Valley has to dump large amounts of its $50-billion portfolio as it is cleaned up, then the mortgage-backed securities could face losses.
  • Going forward, the crisis could well prompt the Fed to slow its rate hikes to assess any further stress in the financial system.
  • Reflecting the chance for slower rate hikes, investors today are bidding up bonds, pushing their yields down. The yield on the benchmark 10-year Treasury note has fallen to 3.505% so far this morning.

Chinese Politics:  In the latest developments from the government’s “two sessions” over the last few days, the National People’s Congress (NPC) gave Xi Jinping a precedent-breaking third five-year term as president to go with his October success in garnering a third term as general secretary of the Communist Party of China (CPC).  The vote, which positions Xi to become president for life, was 2,952 to 0.  Xi was also named head of the Central Military Commission, which leads the People’s Liberation Army, for a third term.

• The NPC on Saturday also named Li Qiang as China’s premier, the government’s #2 official. As powerful as that sounds, the role has come to be seen mostly as that of an implementer of the president’s policies, especially in the economic sphere.
• The NPC yesterday also kept Yi Gang as the head of the People’s Bank of China and Liu Kun as finance minister, in an apparent effort to reassure investors by leaving familiar faces at the central bank and finance ministry. However, given that the legislature has also approved Xi’s steps to again give the CPC the lead in setting policy, leaving Yi and Liu in their positions does not necessarily mean policy continuity.

Chinese Mining Industry:  New analysis from a British cobalt trader estimates that China will account for 50% of global cobalt production within the next five years, up from approximately 44% currently.  The increase will come despite Western efforts to gain control over supply chains for critical minerals such as cobalt, lithium, and nickel, which are essential for making EV batteries.  We continue to believe that China and its evolving geopolitical bloc may crimp global supplies of the critical minerals they control as tensions with the West continue to worsen.

China-Saudi Arabia-Iran:  Over the weekend, additional details came out regarding the Friday deal, brokered by China, in which Saudi Arabia and Iran agreed to reestablish diplomatic relations.  Besides Saudi Arabia and Iran agreeing to reopen each other’s embassy and restart normal diplomatic operations within two months, key elements of the deal and interests for the three participants are as follows:

• Saudi Arabia agreed to tone down the critical coverage of Iran by Iran International, a Farsi-language satellite news channel funded by Saudi businesspeople. Iranian officials believe Iran International has been instrumental in encouraging the recent popular protests against Iran’s government.
• In return, Iran agreed to stop encouraging cross-border attacks on Saudi Arabia from Yemen by Iranian-backed Houthi rebels.
• By brokering the deal, China gained the ability to present itself as an independent, influential power broker in the Middle East. China was also able to leverage its growing economic heft and its position as a key buyer of Middle Eastern oil.  For example, it appears that China has promised to help Iran deal with its current currency crisis and other economic woes so long as Iran improves its behavior vis a vis other Chinese friends in the region.  China probably also offered economic incentives to Saudi Arabia to come to a deal.  In any case, the agreement helps deter Saudi Arabia, which we assess to be in the developing “lean-China” geopolitical bloc, from getting too close to Israel and the rest of the U.S. bloc as it seeks protection from Iran’s expansionist policies in the region.  Indeed, it may be that China pushed through the Saudi-Iranian deal to scuttle a potential Saudi-Israeli normalization deal that the U.S. has been pushing.
  • As Israel becomes increasingly alarmed about Iran’s rapidly advancing nuclear program, the deal will probably constrain any plans it may have for a surprise military strike on the country.
  • Such a strike would probably require cooperation from Saudi Arabia, such as allowing Israeli jets to use its airspace. After working with China to reestablish ties with Iran, Saudi Arabia now would probably be more reluctant to allow that.

China-Russia-Ukraine:  In a sign that China may be trying to build on its recent diplomatic successes, the Wall Street Journal has scooped that Chinese President Xi will finally speak with Ukrainian President Zelensky for the first time since Russia’s invasion of Ukraine.  Xi’s call to Zelensky is expected to come after Xi visits Moscow next week to meet with Russian President Vladimir Putin.  It wouldn’t be surprising if Xi fleshes out his recent peace proposal for the Russia-Ukraine conflict, which was widely panned as nothing more than general principles.

Japan:  Investors are complaining that upcoming revisions to the rules Japan applies to companies’ anti-takeover defenses could deter domestic takeover bids, foreign buyers, and shareholder activists.  If so, it would exacerbate Japan’s longstanding reputation as a country where companies don’t prioritize investors and shareholder value.

United Kingdom:  The country continues to deal with continuing waves of strikes by transportation and public-sector workers.  Today, junior doctors in England’s National Health Service will begin a three-day walkout for higher pay.  This week will also bring additional strikes by teachers and other public employees seeking higher wages.

U.S. Military Power:  The nation’s newest aircraft carrier, the USS Gerald R. Ford (CVN 78), has embarked on her first deployment with a full air wing.  The vessel is the lead ship in the Navy’s new Ford class of carriers, incorporating multiple improvements over the previous Nimitz class.  After the Ford’s short deployment last year with a partial complement of aircraft, the current deployment is designed to refine how her crew and the rest of her task group will operate with her new technologies.  Once that is completed, the ship can finally be certified for a regular deployment, some six years after she was commissioned in 2017.

• Among their new features, the Ford-class ships utilize powerful electromagnetic catapults to get aircraft airborne, rather than the older steam-catapult technology. The ships also have advanced new elevators to move aircraft and armaments between the deck and hangers below.  Compared with Nimitz-class carriers, Ford-class vessels have their “islands,” i.e., control towers, farther aft to free up deck space and make deck operations more efficient.
• The six-year period between the Ford’s commissioning and first regular deployment illustrates some of the challenges faced by the U.S. defense industry as the West ramps up its defense spending to push back against authoritarian aggressor states like China and Russia. Part of Ford’s delay came from mechanical problems associated with her new technologies.  Even excluding that issue, however, current Western military procurement processes can be extremely slow and inefficient.

U.S. Fiscal Policy:  Late last week, President Biden released his proposed federal budget for the fiscal year starting October 1.  The proposal envisions total outlays of $6.883 trillion, or 25.3% of forecasted gross domestic product, compared with the current fiscal year’s projected outlays of $6.372 billion, or 24.2% of GDP.  Receipts would total $5.036 trillion, or 18.5% of GDP, compared with this year’s $4.802 trillion, or 18.2% of GDP.  That would leave the coming year’s federal deficit at $1.846 trillion, equal to 6.8% of GDP.  The proposal calls for cutting the deficit in future years by hiking taxes on corporations and individuals with very high incomes.  However, since the Republicans control the House of Representatives, the proposal is unlikely to pass and whatever budget emerges is likely to look far different.

U.S. Environmental Policy:  As the Biden administration prepares to approve the big “Willow” oil-drilling project in the Alaskan Arctic and anger environmentalists, he is also preparing to offer them a sop in the form of a ban on future oil and gas leasing in U.S. Arctic waters.  The ban would make about 2.8 million acres in the Arctic’s Beaufort Sea off limits to future oil and gas leasing indefinitely.

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