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Are we in the calm before the storm?

Past performance does not predict future returns. You may get back less than you originally invested. Reference to specific securities is not intended as a recommendation to purchase or sell any investment.

We spent much of March trying to figure out what are the medium to long-term effects of the problems in the US bank system. After trying to stick with a relatively optimistic view, we have come to the conclusion there are significant downside risks. As a result, we are likely to be in the calm before the storm.

The unrealised losses issue at US banks is probably manageable. The Fed has done enough to calm investors on that front by creating the Bank Term Funding Program (BTFP). In addition, the side effects of the Fed’s emergency liquidity provision to the banks, via both the BTFP and Discount Window, has been a surge in its balance sheet, which jumped $391 billion from 8 March, unwinding nearly two-thirds of the last year’s Quantitative Tightening (QT) in just three weeks.

This has clearly supported stock markets. This is the good news. However, in the background, there is a slow burn of deposit flight at US regional banks due to the wide gap between deposit rates and money market rates, which will likely lead to higher funding costs for banks, lower bank profits, tighter lending conditions and a credit crunch for SMEs (small and medium-sized enterprises). This could put marked downward pressure on US GDP.

This funding squeeze at banks will take time to play out. In the meantime, the stock market could well drift higher in the absence of any further bad news. In fact, the early signs of the credit crunch hitting in terms of weaker employment and inflation data could be interpreted as positive, as it would lead to an easier Fed. The impact of tighter credit conditions may not really be fully felt until H2 2023.

A key question over the last year has been what, if any, side effects there would be from the Fed tightening cycle and QT. Now we seem to have at least a preliminary answer: a funding squeeze on small and medium-sized US banks. Small and medium-sized can be a misleading moniker as these banks represent a chunky 40% of US lending.

In broad terms, this is an example of how the rubber finally meets the road in terms of how Fed monetary policy tightening practically affects the economy. It seems the main medium-term ramification of all this will be continued switching of money from low-yielding deposits at banks to higher yielding money market funds. This causes two major problems:

1) It will force regional banks in the US to reprice their deposits, likely hitting profits, which in turn will lead to tighter lending standards and a credit crunch for US SMEs.

2) Bank deposits effectively fund growth in the real economy. If a customer puts money on deposit at a regional or community bank in the US that deposit is likely recycled into a loan for a SME. In contrast, if a customer puts money on deposit at a money market fund, 80% of that goes into the Treasury market to fund the US Government, which can easily fund itself anyway. The Fed by definition does not need other people’s money, it can print its own.

In simple terms, bank deposits are ‘live’ money that help grow the economy. Money market funds represent ‘dead’ money just sitting in the financial system. Clearly, it makes no sense from an economy-wide perspective for money to be channelled out of banks into money market funds. Eventually, policymakers will figure it out and find ways to reduce the attractions of money market funds, alleviating pressure on banks and the impending credit crunch.

Until then, it seems likely pressure on profits in US regional banks will build and a credit crunch looms for SMEs. This adds downside risk to US real GDP growth and reduces the probability of a soft landing for the economy.

The risk of a credit crunch for SMEs in the US looks high particularly in Commercial Real Estate (CRE). In CRE, $400 billion of loans come due in 2024 (and the same amount in 2025 and 2026). It could be difficult to refinance this, and most likely at a much higher cost, which will force more delinquencies and in turn hit profits. Virtually all the growth in CRE lending has been driven by smaller US banks.

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KEY RISKS

Past performance is not a guide to future performance. The value of an investment and the income generated from it can fall as well as rise and is not guaranteed. You may get back less than you originally invested. The issue of units/shares in Liontrust Funds may be subject to an initial charge, which will have an impact on the realisable value of the investment, particularly in the short term. Investments should always be considered as long term. Investment in funds managed by the Global Fundamental Team may involve investment in smaller companies. These stocks may be less liquid and the price swings greater than those in, for example, larger companies. Some of the funds may hold a concentrated portfolio of stocks, meaning that if the price of one of these stocks should move significantly, this may have a notable effect on the value of that portfolio. Investment in the funds may involve foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. Some of the funds may invest in emerging markets/soft currencies and in financial derivative instruments, both of which may have the effect of increasing volatility.

DISCLAIMER

This is a marketing communication. Before making an investment, you should read the relevant Prospectus and the Key Investor Information Document (KIID), which provide full product details including investment charges and risks. These documents can be obtained, free of charge, from www.liontrust.co.uk or direct from Liontrust. Always research your own investments. If you are not a professional investor please consult a regulated financial adviser regarding the suitability of such an investment for you and your personal circumstances.

This should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Examples of stocks are provided for general information only to demonstrate our investment philosophy. The investment being promoted is for units in a fund, not directly in the underlying assets. It contains information and analysis that is believed to be accurate at the time of publication, but is subject to change without notice. Whilst care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Liontrust as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. It should not be copied, forwarded, reproduced, divulged or otherwise distributed in any form whether by way of fax, email, oral or otherwise, in whole or in part without the express and prior written consent of Liontrust.

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