The collapse of three US banks – SVB, Silvergate and Signature Bank – and the crisis in the European Bank Credit Suisse triggered a risk-off in equity markets globally. News of high levels of unrealized losses in banks’ balance sheets and fears of contagion in the banking and financial system, rattled stock markets. The usual doomsayers didn’t miss the opportunity to feed the social media with stories of an imminent collapse of the financial system and crash in stock markets.

How should investors respond to the turbulence in markets?

The global financial system is facing challenges

The root cause of the current turbulence can be traced to the ultra-loose monetary policy followed by Fed and other central banks like ECB following the Global Financial Crisis of 2008. The developed world financial system got addicted to low interest regime. The fact that this loose monetary policy didn’t trigger inflation enabled the central banks to continue with the low-interest regime.

The Fed started raising rates by 2018; but then the pandemic broke out in 2020 forcing the Fed to go back to the low interest regime. The global recession of 2020 necessitated an ultraloose monetary policy, and the Fed cut the funds rate to 0 to 0.25%. The sudden spike in inflation, the consequent aggressive monetary tightening by the Fed, crash in bond prices and huge losses in bond investments of banks completely queered the pitch for banks and financial markets.

Weak financial system co-existing with a resilient US economy

Usually, financial stress emanates from a weak economy: a sharp decline in growth, deflation, highly leveraged private sector, and weakness in the corporate sector. But interestingly, this time, weakness in the financial system has surfaced in a resilient US economy. A tight labour market - the US economy created more than eight lakh jobs in the last two months - and strong aggregate demand have kept the economy resilient. Meanwhile, the supply-side disruptions caused by the Chinese lockdown and the Ukraine war caused elevated inflation pushing the CPI inflation to near double digits. The Fed was slow to act claiming that ‘inflation is transitory.’ But when faced with stubborn core inflation, the Fed resorted to massive rate hike of 450 bp in 2022.

This rapid rate hike in one year – the severest in the last four decades – led to sharp fall in bond prices and spurt in bond yields. The mid-sized regional banks in the US, especially those with lax risk-management, were hit by huge losses in their investment portfolio. The loosening of Dodd-Frank regulation in 2018 for mid-sized banks also contributed to the vulnerability and crisis in regional banks like Silicon Valley Bank.

The crisis in the European bank Credit Suisse triggered the fear that the contagion is spreading to Europe. But Credit Suisse has been plagued by scandals and problems for many quarters now. The fact is that rest of the European banks are strong. But fears of contagion and flight to safety led to sharp falls in the stock prices of strong European banks, too.

Where do we go from here?

Uncertainty looms large, and challenges and risks remain. But there is a strong positive. Learning from the Global Financial Crisis of 2008, authorities have acted quickly to contain the contagion. The US treasury, the Fed and the Federal Deposit Insurance Corporation acted quickly to calm the markets. The declaration that all deposits in SVB will be safe calmed the markets. In Europe, the Swiss government and the Swiss National Bank acted quickly to merge the crisis-ridden Credit Suisse with UBS in a commercial deal of $ 3 billion.

There may be more bad news coming from the US financial sector, but there is a very high probability that panic, and contagion will be avoided.

India’s underperformance

The underperformance of India, so far in 2023, is in striking contrast to our outperformance in 2022. In 2022, India outperformed with Nifty gaining 4.3 percent when developed markets and many emerging markets delivered between 10 to 20 percent negative returns. In sharp contrast to this outperformance, Nifty has delivered around – six percent returns so far this year, as on 21^st March. Sustained FII selling, high valuations and negative news flows impacted sentiments.

Don’t panic, wait for normalcy to return

Investors need not panic. Don’t make aggressive buys. Investors with investment time horizon of three to five years can start nibbling high quality stocks. With Nifty around 17000, valuations are reasonable now. It is important to continue with Systematic Investment Plans.

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