An Evolving U.S. Financial Landscape

Transcript

This week, I’d like to discuss the future of finance, one mega force we see shaping returns now and in the future – and how it’s playing out in the U.S. financial sector.

1) Cash on the move

Higher interest rates have brought back competition for bank deposits. The rate U.S. banks pay on deposits has lagged other parts of the financial system, such as money market funds.

Savers have moved cash there as a result.

2) The impact on banks

In a more competitive market, we expect to see banks paying higher interest rates to savers. That likely means higher interest rates on bank loans, which would crimp loan demand.

Less lending and paying more for deposits will squeeze bank profitability.

3) Diversification of funding

Reduced bank lending is bolstering a longer-term trend in the U.S. financial landscape.

Companies have been diversifying funding towards non-bank sources. And we think that trend will persist.

Private credit, in particular, could be appealing for smaller firms that face high barriers of entry in public markets.

Greater diversification of funding is good for borrowers and higher rates benefit savers, in our view.

The higher interest rate environment also has broadened out the potential ways of making income – and we see opportunities in alternative funding sources like private credit.

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The future of finance is one global mega force we see affecting returns. It includes a changing U.S. corporate funding landscape, with less reliance on bank lending. That long-term trend has been bolstered by higher interest rates: Interest paid on bank deposits has lagged rate hikes, igniting competition for deposits. These shifts are good for savers, we believe. A more diversified funding pool makes the financial system safer and benefits borrowers overall, even if it means higher funding costs.

Follow the money

Notes: The chart shows the change since 2020 in U.S. Federal Reserve securities holdings, “excess deposits” (the difference between deposits and loans outstanding in the overall banking system, and money market fund assets.

Higher interest rates are a key tenet of the new regime of greater macro and market volatility, in our view. The end of zero interest rates has brought back competition for bank deposits. The interest rate U.S. banks pay on deposits has lagged Fed rate hikes since 2022. By contrast, other parts of the financial system, such as U.S. money market funds, have quickly offered higher rates. Savers have moved cash from banks to money market funds as a result: The Fed has injected $4 trillion into the economy since 2020 (orange line in chart), yet the banking system only has an additional $2 trillion of deposits over and above the loans it has made (yellow line) – still a comfortable buffer for now, but likely to run down as the Fed’s quantitative tightening progresses. The rest is in rising U.S. money market fund holdings (green line). We think higher rates are here to stay as the Fed keeps policy tight to fight inflation – likely to be confirmed at the Fed’s policy meeting on Wednesday.

The flight of deposits from banks sped up after the collapse of three U.S. regional banks in March, but this shift was already in motion. With more competition, banks can no longer cheaply fund loans by paying depositors rates well below the Fed policy rate as that would mean losing more depositors. We expect to see U.S. banks paying higher interest rates to savers as a result. Smaller banks have already started doing that this year. That, in turn, likely means higher interest rates on bank loans, which could crimp demand. Banks could choose not to pass on the extra cost of their deposits to borrowers. That would hurt their profit margins and reduce the profitability of lending, potentially discouraging them from lending as much. We see banks consolidating to reduce the need to support loans on their balance sheets. Overall, we expect a reduction in lending activity on bank balance sheets. U.S. regulatory proposals – partly in response to the U.S. bank turmoil – could reinforce the process.

The combined pressure on bank profitability from lending less and paying higher deposit rates is already visible in the net interest margins of small banks. They have fallen by more than those of large banks this year, according to September 2023 data from the Federal Deposit Insurance Corp. Small to mid-sized banks are also feeling more earnings pressure, with Q3 results reported so far showing declines versus both last quarter and last year. Bigger banks are holding up better so far.

Non-banks stepping in

The higher rate regime is catalyzing longer-run changes in the U.S. financial landscape – like the expanding role of non-bank credit providers. Bank loans now account for around one-fifth of non-financial corporate borrowing, according to Fed data. That is about half their share in the early 1970s. We think companies will keep diversifying their funding towards non-bank sources. Take private credit: It could appeal to small to mid-sized firms who face high barriers of entry to accessing public markets. Private credit lending spreads have widened over the past 12-18 months, and we find them attractive. Plus, private credit loans tend to have floating interest rates, insulating their returns from being eroded by higher policy rates. We are overweight on a strategic horizon of five years and beyond. But private markets are complex and not suitable for all investors. We think private credit requires selectivity and a focus on how much of the opportunity and risks are already in the price.

Bottom line

Greater diversification is good for borrowers, higher rates benefit savers, and such shifts create a more stable system – even as financing costs rise, in our view. Savers are benefiting from the higher returns in U.S. money market funds and regulatory reforms that made them more resilient. The higher interest rate environment has also broadened the potential ways of making income in the new regime. We see investment opportunities in alternative funding sources like private credit.

Market backdrop

U.S. stocks hit five-month lows and 10-year Treasury yields reached 16-year highs above 5%. Tech stocks underperformed on some disappointing earnings, while regional bank shares broadly hit new lows for the year. U.S. core PCE data, the Fed’s preferred inflation gauge, slowed further in September on falling goods prices. Strong consumer spending drove a stronger-than-expected rise in Q3 GDP. Yet, we don’t see that as sustainable as consumers exhaust their savings.

The Fed takes center stage this week. We see the Fed holding policy tight as inflationary pressures persist, with an aging workforces keeping the labor market tight. U.S. payrolls are also in focus. We think the demographic shift in the labor force means the economy will soon only be able to sustain a fraction of recent job growth without stoking further wage pressure.