Credit Musings: April 4, 2023

Apr 04, 2023

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Public Trust Credit Team

Shadow banking, CRE, and commercial banks. What does it all mean?

Over the past several weeks – a time defined by the recent banking fiasco – obscure financial terms and acronyms have been used liberally in the financial press. While investors may no longer be focused on deposit outflows and maturity mismatches, their attention has turned to “shadow banks” and “CRE lending.” Shadow banking refers to non-bank lending; these are loans offered by investors like private credit funds, hedge funds, or even pension funds. Shadow banks have claimed a larger share of the funding market post-2008 as commercial real estate (CRE) investors sought out new debt providers to fill the void left by the formerly large contribution of money center and super-regional banks. Large institutional investors and smaller commercial banks were the lenders that stepped up to facilitate these transactions.  

According to the Real Estate Roundtable, 50% of the $5.5 trillion CRE lending market is financed by commercial banks, and of that 50%, 70% is held by smaller community banks. Weakness in the U.S. regional banks and a string of high-profile bank failures have led to investor worries. They ask whether U.S. banks are over-exposed and whether the shadow banks can handle declining valuations of the commercial properties. Judging by the headlines and investor roundtable discussions, the market is broadly aware of the risk in the CRE market and the exposures these non-traditional lenders might have. The Public Trust Credit Team has been bearish on CRE lending since the onset of the COVID-19 pandemic and continually monitors our approved counterparties’ exposure to the asset class. We strive to carefully manage the risks involved in the CRE market and will continue to monitor the sector to identify cracks as they are exposed.  

Home prices are retreating, but only for half of us.

January marked the seventh consecutive month of a decrease in home prices with the S&P CoreLogic Case-Shiller National Home Price Index dropping 0.2%. This figure may be somewhat misleading. Despite the drop, the year-over-year figure climbed, signaling that market prices are still increasing overall. However, as in all real estate, location matters. The western half of the U.S. saw price declines, while the eastern half is still increasing. Drawing an imaginary line through Austin, Texas, the housing markets for the 12 most populous metro areas west of the line saw home prices slump in January. Conversely, the 37 most populous metro areas east of Colorado, excluding Austin, saw prices increase year-over-year. Many factors contributed to this divergence including affordability, supply, and the local job markets. This isn’t to say that it is cheaper to live on the west coast as seven of the 10 least affordable markets in January were located there. The eastern half of the U.S., particularly Florida, is experiencing emigration as companies relocate and bring employees with them. On the other hand, the established tech markets of the west are navigating large layoffs and the commensurate declines in home values. The uptick in interest rates is clearly not deterring eastern buyers, so we will need to wait a little longer to see how high interest rates will climb and if the U.S will return to seeing all its metropolitan cities move more in lockstep.

Core inflation continues to climb in the Eurozone.

Although Eurozone headline inflation has declined each month since October, when it peaked at 10.6% (to 6.9% in March 2023), core inflation in the Eurozone has continued climbing. Core inflation increased from 5.0% in October to a record-high of 5.7% in March 2023. Core inflation excludes food and energy prices which are typically more volatile and, as a result, tends to be a metric favored by central bankers as an indicator of whether recent interest rate increases are having the desired effect of curbing demand. Despite declines in headline inflation and recent financial sector strains, many analysts expect the European Central Bank (ECB) to continue increasing its key rate during its next meeting in May because of the climbing core inflation metric. The ECB’s decision about increasing rates could be made even easier if headline inflation were to climb over the coming months. One potential inflationary pressure is the recent announcement from a group of Saudi oil producers stating that they plan to cut their daily production by more than 1 million barrels beginning next month which could materially increase energy prices worldwide. In setting its key rate, ECB officials will be closely monitoring inflationary metrics as they must balance increasing recessionary fears with remaining diligent in their battle to rein in inflation. 

A dramatic policy shift in the world’s third largest economy could potentially send shockwaves through the global financial ecosystem.

The Bank of Japan is expected to reverse a decade-long policy of ultra-low interest rates following a momentous leadership change as new president Kazuo Ueda begins his term. This policy reversal is set to impact not only the economy of Japan, but a significant outflow of funds from Japanese investors and could cause ripple effects through almost every global market. During what was the world’s largest monetary easing program, Japanese funds have been invested largely overseas due to low rates in Japan relative to other countries such as the U.S. or the EU. So much so that Japanese investors are the largest foreign holders of U.S. bonds, having purchased 50.1 trillion Yen ($378 billion at today’s rate) of U.S. assets over the last decade. Japanese total international investments currently total $3.9 trillion, which is larger than most G20 economies. According to Bloomberg, the countries with the largest Japanese holdings by total market size are Australia and New Zealand at 13%, with the U.S. coming in at just over 6%. As rates begin to rise in Japan, many of these funds will begin to repatriate from global markets and return to Japanese soil as domestic investors will be able to obtain competitive rates and eliminate foreign currency exchange risks. A preview of the effects of this policy occurred last December when the Bank of Japan relaxed bond yields by a small fraction causing Japanese bonds to plunge, the Yen to skyrocket, and jolted everything from U.S. Treasuries to the Australian dollar within hours. Many analysts, however, do not expect this policy transition to cause an immediate shock to the markets, but rather a more gradual shift. It will likely take some time for Japanese rates to reach competitive levels, especially if the U.S. maintains its current course and keep rates elevated. 

All comments and discussion presented are purely based on opinion and assumptions, not fact. These assumptions may or may not be correct based on foreseen and unforeseen events. The information presented should not be used in making any investment decisions. This material is not a recommendation to buy, sell, implement, or change any securities or investment strategy, function, or process. Any financial and/or investment decision should be made only after considerable research, consideration, and involvement with an experienced professional engaged for the specific purpose. Past performance is not an indication of future performance. Any financial and/or investment decision may incur losses.

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