Fabian Estevez

Following up on the agreement reached between President Joe Biden and House Speaker Kevin McCarthy on the debt ceiling, here is an update with the relevant points: 

• Over the weekend an agreement on the “Fiscal Responsibility Act”, which suspends the debt limit until next January 1^st, 2025, was announced. 
• The main source of budget savings in the agreement is a two-year cap on federal discretionary spending. Congress annually appropriates this segment of spending, which represents about 25% of the total federal spending, with just over half going to defense and the rest to domestic programs outside of major entitlement programs. These limits could reduce discretionary spending by $1.5 trillion over the next 10 years. Additionally, the agreed-upon adjustments could imply an annual reduction in spending in 2024 and 2025, on the order of 0.1 – 0.2% of GDP.
• Reaching an agreement eliminates the greater part of uncertainty concerning the looming debt deadline, however the bill still has to be approved in both Chambers. 

The home stretch of this process will be subject to the speed with which it can be approved by the legislators, before Monday, June 5^th (considered as “x” date). Under this context, the House of Representatives is scheduled to vote as soon as possible, while the Senate could vote on Friday, June 2^nd. 

Throughout this year, the US dollar’s dominant position as the largest global reserve currency has been questioned. This is not the first time this questioning has arisen, having as precedents: the birth of the euro in 1999, the great financial crisis in 2008 and the cryptocurrency boom. That said, the perspective that China’s yuan could eventually function as a replacement is now beginning to gain strength.  However, we bring to the table some points that allow us to think that this scenario remains far off, as the US dollar has strong arguments to maintain its hegemony.

• On the one hand, nearly 60% of the reserves held by the world’s central banks are denominated in US dollars (vs. 67% 20 years ago). This is followed by the Euro with 20%, while the Yuan barely represents 3%. Another factor to take into account is that foreign investors maintain an important appetite for U.S. financial assets, either through government instruments such as Treasury Notes and Bonds or through stock shares.
• On the other hand, the U.S. dollar maintains an important role in the performance of the global economy, facilitating and speeding up a large number of transactions, due to the fact that around 90% of commercial operations use it as a currency of exchange. Meanwhile, trade in Yuan accounted for less than 2% of world trade in 2022.
• With regard to the Yuan, let us recall that it is not a freely convertible currency or one that operates under a free-floating regime, meaning that its value is determined by market forces, without the direct intervention of the monetary authorities.

In the short term, we do not rule out that the dollar will continue to lose momentum, mainly because the FED may pause the interest rate hike cycle that started last year. These ups and downs do not mean that the role we described above for the U.S. dollar is nearing its end. Let’s remember that a currency, in order to be considered a reserve currency, must be stable and secure, work as a means of exchange, store value, and be widely accepted and trusted. All of these characteristics are covered by the U.S. dollar, noting that the U.S. is the global financial center as well as the world’s largest economy with a stable political environment.

AI has really taken off and it has become a very popular theme, especially since ChatGPT was launched last year. Before delving into some of the applications that this tool could provide to investment firms, it is relevant to put into context what is ChatGPT?  ChatGPT is a language model that has been trained with a great amount of text data so it can perform a great variety of tasks related to natural language. Its capacity to understand the context and intention behind the users’ questions and consults make it a very useful tool to develop chatbots and improve accuracy in systems that search for information. ChatGPT was developed by OpenAI, an artificial intelligence research organization founded in 2015 based in San Francisco, California. 

Some benefits that Chat GPT and other large language models (LLMs) could bring into the investment analysis processes are: 

Large Database Processing. Analysts are often overwhelmed by the great amount of material that must be processed to analyze a company, like quarterly reports, press releases, investor calls, generating an endless flow of information. This forces investment teams to focus on deep research, in a limited time frame to make investment decisions. Therefore, driven tools such as ChatGPT and LLMs, could perform time-consuming tasks for analysts that drain disproportionate resources on tasks that may end up not being relevant, or may end up not being done at all.

Increased coverage of presentations, corporate reports and meeting summaries. Analysts typically cover dozens of companies in one or more sectors, while also monitoring competitors and potential investment candidates. During earnings season, it is impossible to participate in all the calls of the companies under coverage, as well as other related calls that may be of interest. In this sense, ChatGPT and LLMs can provide a solution, generating summaries with a high number of quality and accuracy. Also, these models make it possible to identify substantial changes in the text of corporate presentations, which could indicate a change in trend or strategy in the direction of the company and that will undoubtedly require further analysis. Furthermore, ChatGPT can condense Zoom transcripts and clean up raw notes into defined, easy-to-use formats, such as full sentences or key points. It can also be used to extract topics from longer, blurry text, which helps analysts instantly make sense of a rambling conversation.

Promote productivity. Beyond the technical issues, ChatGPT sets out a cultural challenge; where data science teams must actively promote its benefits and show tangible examples. Under this context, analysts need to figure out what they can automate, become familiar with the technology, and comprehend its limitations to obtain high-quality results. New LLM technologies provide easy access for anyone with basic programming knowledge. Then, once those logistics bottlenecks in the analysis processes have been identified, AI can be creatively implemented to create tangible efficiencies.

Finally, it has been speculated that all these new technological capabilities could eventually replace human capital. Nevertheless, we agree with the opinion of specialists in the sense that both variables of the equation are complementary. When combining the intellectual human power reflected in the experience to analyze companies and market trends with the ChatGPT processing power, we can increase the AI benefit, improve the efficiency of the analysis process, and ultimately, make better investment decisions.

Source: AB- AllianceBernstein

The consumer price index accelerated 0.4% monthly in April from 0.1% in March. This figure was in line with what the consensus was expecting, and at the same time allowed a slight reduction in inflation in annual terms, reaching a rate of 4.9% (vs. 5.0% in March and 5.0% expected). For its part, the index that excludes food and energy, that is, core inflation (core CPI) rose 0.4%, in line with what was expected by the consensus and in line with the variation registered in March. With this, the annual change was 5.5% (vs. 5.6% in March and 5.5% estimated). 

In detail, the shelter component advanced 0.4% in the month (+8.1% annually), which represented more than 60% of the total increase in all items excluding food and energy. Also notable was the 4.4% increase in the month (-6.6% annually) registered by used cars and trucks, as well as gasoline, with an increase in the month of 3% (-12.2% annually). As far as food is concerned, positively the food component remained unchanged during the month, as it was in March. In particular, food at home fell 0.2% in the month (+7.1% annually), while the component of food outside the home climbed 0.4% (+8.6% annually). Finally, air fares, new vehicles, transportation services, and medical services registered setbacks in the month.

On the other hand, in recent days the employment figures for April were published, which were positive in general terms. The nonfarm payroll registered the creation of 253,000 jobs and exceeded the expectation of 185,000. In addition, the unemployment rate descended to 3.4% and average hourly compensation increased 0.5% per month (+4.4% annually), which represented its steepest increase in just over a year.

After the 25bp increase that the Fed implemented at the beginning of the month and with this mix of results in inflation and employment, the market has begun to assign a greater probability of seeing a pause in the upward cycle as soon as June. Similarly, it begins to reflect the possibility of seeing cutbacks in the reference rate towards the end of the year of around 75bp. However, we notice that this scenario faces certain challenges, because the 2% inflation target still seems far away, in the midst of a robust labor market, with an unemployment rate at its lowest in the last 50 years. In addition, there are situations that could generate volatility, such as the crisis of the regional banks, and of very short-term, the negotiations on the debt ceiling. 

In line with what was expected by the market and unanimously, the FED increased the reference rate by 25bp to 5 – 5.25%. This movement represented the tenth increase since March 2022 and implied its highest level since September 2007. 

Within the statement, it stood out that the Federal Open Market Committee (FOMC) reiterated that it “will closely monitor incoming information and evaluate the implications for the monetary policy.” This phrase contrasted with the words expressed in the statement in March, because it omitted a line that mentioned that the Committee “anticipates that it may be appropriate to reaffirm some additional policies (meaning, more increases in the reference rate).” This message in a certain way could insinuate a possible pause in the most aggressive cycle of interest rate rise since 1980. Under this context, the Committee expressed that it remains very attentive to inflation risks, for which reason it is committed to returning it to its 2 percent goal.

Additionally, the statement pointed towards a stance which is more dependent on emerging data, stating that “in assessing the appropriate stance for monetary policy, the Committee will continue to monitor the implications of incoming information for the economic outlook.” Therefore, it would be prepared to adjust the monetary policy stance accordingly if risks arise that could prevent achieving the goals. The assessments will take into account a wide range of information, including the readings about labor market conditions, inflationary pressures and inflation expectations, and local and international financial developments.

Finally, in the middle of the turbulence that the banking system is experiencing, the statement once again highlighted that the sector is solid and resilient, although tighter credit conditions are likely to weigh on economic activity, employment, and inflation, where the extent of these effects remains uncertain.

The markets took the statement positively, as well as Jerome Powell’s statements during his press conference, emphasizing that his forecast is for modest growth and not for a recession. Also, he confirmed that the process of reducing inflation has a long way to go and that the banking conditions have “greatly improved” since March.

Over the last few months, several macroeconomic and financial events have impacted the various sectors of the economy, and the real estate market has not been immune to these movements. With that arose the debate about how much risk there is in investments focused on real assets, whether through equity or debt. Additionally, the Silicon Valley Bank (SVB) debacle exposed the risk that banks currently have within their portfolios to debt focused on commercial real estate, adding uncertainty to investors.

Now, how is the real estate sector classified? The traditional classification consists of 4 subsectors: housing (for rent and purchase), industrial and logistics, offices, and retail. This classification is essential since, in each sector, there is a particular dynamic; in the first place, the housing sector is in the process of a slowdown in the buying and selling market, driven mainly by the increase in reference rates, impacting the cost of acquisition of properties. However, this slowdown allows potential buyers to migrate to the rental market. According to data from CBRE, in 2022, the level of rents increased by 9.2%, a positive sign of a growing market. Although valuations may decline, the need for housing and rising rents will provide a hedge in this segment. The industrial and logistics sector is in a clear upward trajectory; on the one hand, the change of consumer trends towards digital commerce, and on the other, the reconfiguration of different dynamics in international trade has exacerbated the demand for industrial assets in different cities, with occupancy levels at historical highs, stable valuations, and increasing level in rents.

Although the previous sectors have a more defensive outlook, the office and retail sectors are more uncertain. Fundamentals in the office sector are weak; according to information from JP Morgan, vacancy and availability rates reached 12.5% and 16%, respectively, maximum levels since the global financial crisis; In addition, national income growth continues to decelerate, at 1.1% in nominal terms and -5% in real terms. Given the negative dynamic in these sectors, one of the main risks focuses on the debt issued. According to information from Trepp, there is a total of $ 4.4tn of loans payable, of which 38% has banks as counterparties. If we do not consider the multifamily housing sector, the amount owed is $ 2.5tn, of which 44% is in the hands of banks.

According to JP Morgan, applying an 8.6% loss rate on total exposure, potential losses for banks could be up to $38bn and $16bn for insurers. In conclusion, the dynamics of the real estate sector show mixed expectations. On the one hand, the rental housing and industrial and logistics sectors have positive fundamentals that will allow them to navigate a potential economic slowdown with more stability. In contrast, the office and retail sectors have begun to show negative dynamics, with lower levels of occupancy, increased vacancy rates, and depreciation in pricing. Finally, the financial sector could be affected in an adverse scenario as it is the leading lender of real asset investments.

Headline inflation slowed in March after registering a monthly increase of 0.1% in the consumer price index (CPI), with a rise of 0.4% observed in February and contrasting positively with the consensus expectation of 0.2%. In this context, annual inflation reached a rate of 5.0% (vs. 6.0% in February and 5.1% estimated).

Overall, “shelter” costs (+0.6% monthly and +8.6% annually) were the most significant contributor to the index’s monthly increase. This category makes up about a third of the CPI, thus representing an essential factor for the Fed. That offset the drop in the energy index, with a shrink of 3.5% month-on-month and 6.4% year-on-year. Also positively surprising was that the food index was unchanged in March, with the food for home subcategory falling 0.3% in its monthly variation (+8.4% year-on-year). It is the first drop recorded by this subcategory since September 2020.

On the other hand, the index that excludes food and energy, that is, core inflation (core CPI), rose 0.4% in March, which represented a slight decrease from the advance of 0.5% in February. With this, the annual variation stood at 5.6% (vs. 5.5% in February and 5.6% estimated). In addition to the increase in shelter costs mentioned above, there were advances in motor vehicle insurance costs, airfares, furniture, household equipment, and new vehicles. On the other hand, healthcare costs, cars, and trucks saw drops during the month.

In a certain way, these figures corroborate that the disinflation process continues. However, there is still a way to go, mainly in those categories considered “sticky”, such as shelter, transport services, recreational activities, and clothing, due to the lag with which their prices are adjusted. Considering this mix of factors and the strength in the employment data for March (+236k jobs vs. 230k expected), the prospect of the Fed raising the benchmark rate by 25bp in May remains latent. As of today, consensus assumes a 65% probability for this event

The corporate reporting season is about to begin. In this context, the consensus considers that the companies of the S&P 500 would have recorded a contraction of 5% per year in their profits in 1Q23 (excluding the energy sector, the contraction of profit would be 6.6% YoY). This would represent the most significant drop in reported earnings since 2Q20 and would mark the second straight quarter that earnings have contracted.

Only 4 sectors of the 11 that compose the index showed a positive performance. In this sense, the consumer discretionary sector registered the highest growth rate in the quarter (+36.4% annual) due to the strong performance of the sub-industries of retail, hotels, resorts, and cruise lines. Next, the industrial, energy, and financial sectors show increases of +17.9% per year, +13.7% per year, and +5.2% per year, respectively. On the other hand, the materials sector would have registered the weakest performance, with a 33.5% annual drop in profits, given the weakness of activities related to basic chemicals and copper mining.

About sales, the consensus expects growth of 1.6% per year (the lowest value since 3Q20) for the companies in the index. The financial sector experienced the highest growth rate in the quarter (+9.1% annually) due to the positive performance of consumer finance, financial services, and banking activities. Once again, the materials sector appears to be the weakest, with a drop in sales of 8.3% annually.

JP Morgan will give the starting signal on April 14, along with the reports of other central US banks, so that the market will be attentive to their respective announcements amid recent events related to the banking system.

In the past two weeks, markets have experienced not seen volatility since the pandemic with the Silicon Valley Bank default, which subsequently led to the decline and purchase of Credit Suisse by UBS AG. 

During the weekend of March 18, UBS AG agreed to buy Credit Suisse for $3.2 billion (less than $0.8 per share) with considerable facilities and guarantees from the Swiss regulator, the Swiss Financial Market Supervisory Authority (FINMA). Although the market widely discussed the terms of this purchase, what generated the most controversy was FINMA’s treatment of Jr. subordinated bonds or Contingent Convertibles (CoCos). 

What are CoCos, and why are they relevant?

Contingent Convertibles (CoCos), also called Additional Tier 1 Bonds (AT1), are Jr. subordinated bonds that act as buffers if a bank’s regulatory capital levels fall below a certain threshold. If this happens, they can become capital or be canceled.

These instruments are part of the capital buffer regulators require banks to hold to support in times of market turbulence. In other words, banks are required to maintain a determined level of CoCos in their capital structure. And the essential point for this commentary is that CoCos rank higher than stocks in a bank’s capital structure. If a bank is in trouble, the bondholders will be ahead of the shareholders to get their money back. That’s why these bonds have more correlation with the movement of the bank’s action.

What happened to Credit Suisse’s CoCos?

During that weekend, FINMA decided to change the capital structure hierarchy, granting some recovery to Credit Suisse’s shareholders but canceling all the CoCos of this bank, which reached a value of $ 17 bn.

What reaction did the market and other regulators have?

The Monday following these events, the market entered a risk-off mode towards these bonds, as they considered that the precedent of this operation could be generalized to the other CoCos of other banks. On average, these fell between 10-15 percentage points on the same day, and credit risk premiums on the US treasury increased by about 200 basis points (bps). 

Given this, European regulators, such as the European Central Bank, the Bank of England, and the Federal Reserve in the United States, spoke out before the market. The regulators made it clear that FINMA’s procedure would not apply in these jurisdictions and that the hierarchy of the banks’ capital structure would be respected in case of non-viability of the banks, but that the financial system for these regions was solid and with sufficient liquidity. These announcements have helped to provide certainty to the market.

Can the case of Credit Suisse’s CoCos be generalized?

No, it is essential to consider that Switzerland is a different jurisdiction from the rest of Europe, such that the ECB cannot act or interfere in Switzerland and vice versa. In addition, in Europe, there are precedents that the hierarchy in the capital structure was respected during bank liquidations. First, in 2017, when Santander SA acquired Banco Popular, and recently, with the sale of Silicon Valley Bank UK to HSBC. In both cases, the first line of defense to absorb losses was common stock and later CoCos.

Another critical point is that triggers for CoCos are different in Switzerland compared to the ones issued in the rest of Europe. Swiss CoCos are canceled permanently once the capital ratio falls below the threshold. In contrast, CoCos of German, Spanish, and French banks are temporarily revoked until the bank’s capital ratio is again above the threshold. In the case of British CoCos, they are converted into shares once they exceed this threshold.

Our Committee has always recommended CoCos from banks with solid credit profiles and systemically important globally, in very manageable proportions, in the construction of portfolios. In addition, we recognize a somewhat irrational market reaction towards this sector, so we closely follow different metrics that help us react on time to relevant market events.

The statement stressed that recent indicators point to moderate growth in spending and production. Job creation in recent months has been notable, allowing the unemployment rate to remain low, although inflation remains high. On the other hand, he stressed that the US banking system is solid and resilient. Consequently, recent events will probably result in tighter credit conditions for households and businesses, impacting economic activity and inflation. The magnitude of these effects is uncertain.

In this context, the Federal Open Market Committee (FOMC) increased the benchmark rate by 25bp to a range between 4.75% – 5.0%, which implied its highest level since the end of 2007. This decision was in line with expectations and was unanimous. He also anticipated that further policy tightening might be appropriate to achieve a monetary stance tight enough for inflation to return to 2% over time. As in previous releases, the FOMC announced that it would closely monitor incoming information and assess the implications for monetary policy. That said, he reiterated that he remains very attentive to the risks associated with inflation. Finally, he indicated that he would be prepared to adjust the stance of monetary policy as appropriate should risks arise that could prevent the achievement of objectives, considering the labor market situation, inflationary pressures, inflation expectations, and the development of events financial and international.

As every three months, the Fed updated its outlook for the benchmark rate, predicting that it could end this year at 5.1%, unchanged from the December estimate. For 2024, the new assessment reflected a slight increase to 4.3% from 4.1%. However, the expectation of lower rates compared to 2023 (5.1% vs. 4.3%) remains. Regarding the economic outlook, the new estimate suggests the economy could grow by 0.4%, in line with the previous projection of 0.5%. For inflation (Personal Consumption Expenditures, PCE), the new estimate reflects a slight upward pressure considering a rate of 3.3% (vs. 3.1%). 

During his press conference, Jerome Powell reiterated that the banking system is robust and remains well capitalized while endorsing recommendations for greater sector regulation. On the other hand, he ruled out cuts to the reference rate for this year.