Hello All-
Happy Friday. It’s a pretty cloudy one here in Boston, but in the low 50’s, so I’ll take it. The longer days have already boosted spirits, as have these hardy tulips I splurged on this week at Whole Foods! Happy (almost) spring, y’all.
I will be spending most of this writing discussing market outlook in the context of current events, but before I get into that, I just want to take the opportunity to remind everyone of important
deadlines coming up:
March 31—End of Medicare General Enrollment Period
April 1—Required Beginning Date of RMDs
April 15—Deadline to contribute to an IRA or HSA for 2022
As a quick refresher on what happened this week at Silicon Valley Bank (SVB), in simple terms, SVB experienced massive deposit growth over the past few years. This was at least in part driven by a boom in venture capital. It invested a chunk of these deposits in long-dated bonds, at a time when yields were at generational lows. As interest rates rose, the prices of those long-dated bonds fell (bond prices move inversely to interest rates), creating substantial investment losses for SVB. After SVB announced that it had lost $1.8 billion in asset sales, the bank attempted to raise additional investment capital last week, but was unable to. Many customers then rapidly withdrew deposits, and finally the bank was seized by regulators last Friday.
To address the biggest question on everyone’s mind right now, which is “Could the events of the past week have the potential to escalate to a systemic event, such as a large-scale banking crisis?”—our answer is that this is highly unlikely. The US’s primary safeguard against bank runs is, of course, FDIC insurance. FDIC insurance covers up to $250,000 per depositor, per bank ownership category. While there was initially a lack of clarity over what might happen to SVB depositors holding more than that amount at the bank, the Fed, FDIC, and Treasury issued a joint statement over the weekend confirming that depositors would have access to all their money starting Monday. And they did.
Another weekend announcement from regulators was the creation of the Bank Term Funding Program, or BTFP, to serve as an additional backstop. The BTFP will lend money to banks that need cash to meet deposit withdrawals, and let banks use some types of bonds and debt assets as collateral for those loans (with the intention of helping to prevent repeat occurrences of what happened at SVB—so that banks don’t need to sell bonds at losses in order to meet withdrawals).
Now to the 2008 Comparison. Back then, the problem was far-reaching credit risk—junky mortgages on virtually every financial institution’s balance sheet (and the balance sheets of many non-financial institutions). Credit risk is not the problem this time, it is interest rate risk. Rising interest rates caused the value of the bonds on SVB’s balance sheet to lose value. Once those securities were marked to market, as is prescribed by accounting rules, SVB was no longer capitalized as well as it needed to be, prompting the FDIC to place the bank in receivership.
But that wasn’t the whole story. SVB’s niche customer base was another big problem. It’s emphasis on early-stage venture capital customers meant its deposit base was more concentrated and less sticky. Many of those start-up companies burned through a lot of cash recently, while funding options such as IPOs dried up.
One other unique element of this story is SVB’s mismanagement of its balance sheet. Its heavy exposure to interest rate sensitive Treasury and other government securities, with insufficient interest rate hedging activities, left the bank particularly vulnerable to a run. Once the bank was known to be facing solvency issues, word traveled fast through the venture capital community and the deposits fled as fast as these entrepreneurs could log into their online accounts.
As the dust settles around the SVB implosion, some questions have been answered, but many remain. A key outcome I now see as possible; regional banks are going to be forced into raising deposit rates they pay customers, which many banks have resisted doing for a long time. One article I read said that Bank of America has already experienced $15 billion of inflows to their bank accounts. This is likely only the beginning of a larger tidal wave of deposits ready to hit the shore of the big banks. It remains unclear whether big banks will “need to” raise deposit rates. My guess would be that if they do, it won’t be by much. The perceived safety of the larger banks will drive continued adoption of their platforms. I would expect large non-banks with premium brands such as Fidelity, may also be the beneficiaries. The question then becomes, what is the outcome of this? If small banks experience outflows, is there an equilibrium interest rate that will stem the outflows? If so, what is it? My guess is that it will be a rate high enough to severely hamper their ability to lend.
This is a big deal for the commercial real estate industry – which largely works vis a vis small banks (they do 33% of all CRE lending). All in all, I would say that this has probably raised the risk of a recession. Small banks not only are the lifeblood of small business creation, but in needing to raise their deposit rates, issuance of longer-term loans will be less profitable, since the business model of borrowing at (now higher) rates, will be called into question. In the case of regional banks, it could be a dual shot to their bottom line, since they are losing on volume (customers walking out the door), and price (interest rates they pay, going up). SVB is a prime example. They literally fund start-ups. Fifty percent of tech start-ups banked with SVB. Will this choke off the tech start-up industry? Not necessarily, but the risks are rising. And could a similar thing happen at other small banks? That risk is not off the table, and the farther down the path of financial tightening the Fed goes, the more pronounced that risk becomes.
Not all regional banks are going to be hit the same. Regionals that are larger, and derive more of their money outside of pure lending activities, may not be hit. An example of this would be KeyCorp. While Key does derive the majority of its income from loan income, it also generates a significant amount from “non-interest income.” This would encompass wealth management services, investment banking, sell-side research, credit cards, life insurance, mortgage servicing, and a host of other services that full-service banks participate in. While they derive substantially more income from their interest-bearing loans, it stands to reason that they nonetheless could survive a more prolonged credit crunch (at least much better than an undiversified bank such as SVB.) Furthermore, to the degree they have a substantial book of loans issued at lower rates, they may still be making money on some of these legacy loans.
Nonetheless, the situation in the economy remains fluid. We will attempt to thread the needle between the economy, and the stock market. It is said that monetary policy trickles into the economy with “long and variable lags.” So there is a lag between the policy and the economy. There is also a disjointed timeline between the economy, and the stock market, with the market often leading the economy.
Monetary Policy.
One common definition of money is called M2. Before COVID hit, there was about $15 trillion of M2 percolating in the system. Since then, M2 has reached a maximum peak of $21.7 trillion dollars, and has come down slightly through monetary policy tightening. Banks have benefited, as much of this money wound up on their balance sheets, in the form of deposits. For three years, banks have benefited by not having to pay much in terms of interest they pay to depositors. As monetary policy has tightened, we are getting a bit of this moment that Warren Buffett has described as “when the tide goes out, you’ll see who’s been swimming naked.” This is happening both because higher interest rates on treasury bonds are luring investors away from bank deposits, and also because many of the reckless risks that were the byproduct of the post Great Financial Crisis (GFC) era of ultra-stimulative monetary policy are coming to the fore. At the tip of the spear was cryptocurrency. It is odd to see Bitcoin going up through this debacle. Right behind crypto in terms of riskiness was profitless tech (many of whom used SVB as bankers.) As the Fed has kept raising interest rates, it has done several things, all of which have had adverse consequences on profitless tech. Profitless tech as an asset class if a so-called “long-duration” asset, because its profits are very far out into the future. When the so-called risk free interest rate rises, it raises the cost of capital for everyone in the economy. This effect is most pronounced on profitless tech. Many of these companies with no cash flow will have a harder time getting access to funding. Many will go bankrupt. I’m not saying it is good or bad, I’m stating the obvious.
The environment of free money from 2009-2021 is over. Monetary policy, it is safe to assume, is now well into restrictive territory (neutral interest rate is generally around 2.5%), meaning the risk-free fed funds rate is above the neutral interest rate (the hypothetical interest rate in the economy that is neither stimulative nor destructive to the economy.) The longer we stay at this interest rate, the more damage will be done to the economy. The next up on the chopping block after profitless tech, are companies that are barely profitable, and start-up like. By staying restrictive, the Fed is acknowledging that there were too many excesses in the last cycle that need to be “washed out.” They may not be saying that explicitly, but it is what they are doing, that really matters.
The Economy.
As monetary policy tightens, it greatly affects all businesses. Many businesses rely on borrowing in order to fund their payroll. Think of the letter written by the Silicon Valley tech entrepreneurs, who said that there could be 100,000 jobs lost if SVB were not rescued. Now multiply this number by the many hundreds of regional banks that exist out there. We quickly come around to the realization that if this thing turns systemic as a credit crunch, many millions of hardworking Americans could be laid off. That is what would trigger a clear-cut recession. It is not a done deal yet. Again, much will depend on the Fed’s reaction function. It basically faces two choices.
A) acknowledge that although the current inflation rate of 6% is higher than they would like it to be, that inflation number is dis-inflating to the point where it could be 3-4% by year’s end. They could be forgiven for taking a wait and see approach – i.e. not raising interest rates any more, or doing one more nominal 25 bps rate hike, before pausing to see what happens (i.e. does more “stuff break”, or do they pull off the so-called immaculate disinflation.) I personally believe pausing here would be the optimal approach. Nowhere in the Fed mandate does it say there is a timeline for getting inflation under control. It is getting under control by the nature of the fact that we are in restrictive territory. Just look at all the layoffs happening in the tech sector; are these accidental? Most likely not. These will eventually bring down wage growth and inflation.
B) the other choice is to cave into the inflation hawks such as Mohamed El-Erian, Bullard of the St. Louis Fed, Larry Summers, and the army of hawkish-narrative types who it seems would like to cause more suffering in the US economy. Powell has been giving in to these voices up until as recently as last week. They have been unanimously calling for 50 basis points ‘bps’ of rate hikes, which undoubtedly would “break more stuff,” and cause more economic hardship. In spite of all this happening under the surface of the market, Powell has not said anything. Janet Yellen has said “no bailouts” even though they did bail out all depositors including the uninsured (paid for by FDIC) and basically brought back the Fed Put by way of a $25 billion borrowing facility to prevent regional banks from needing to sell their bonds at a loss.
Nonetheless, the size of this facility leaves much to be desired (SVB alone sold tens of billions of dollars of bonds; and this facility alone will not stem the tide of many more bank runs if the Fed keeps raising rates farther into restrictive territory. Overall, I’ve heard it eloquently expressed that “it would be pretty dumb” if the Fed kept raising interest rates, but also wanted to engineer the bailouts, which of course will be caused by further rate increases. My gut feeling is we will get 25 bps of rate hikes, and that will be enough. Goldman believes no more rate hikes, so does Nomura. If they hike another 25 bps, more stuff might break, and I guess we all have to live with those repercussions.
The (Stock and Bond) Market.
The silver lining in here could be that, even though things look crazy, and potentially bad, the market has been discounting much of this pain for the better part of 2022. As the Fed embarked on its hiking cycle in early 2022, they were about a year late to increase rates. They had to raise fast, and hard. At each consecutive rate hike, the market took another leg down, for both stocks and bonds. Bonds got hit hard, but stocks even harder, as the market discounted not only rising rates, but also compressing profit margins. Margins did compress by a smidge in 2023 (only about 1%). But yet the market has still rallied this year. The Nasdaq is up close to 9% year to date. The S&P 500 is just barely in positive territory, and the Dow Jones is down. This may not seem like coherent information, but it is actually telling us a lot. The Dow last year outperformed by a lot – cyclical stocks in the value index tend to do better in a strong economy. The fact that they are now going down by quite a bit, means the market may be starting to price in a recession. Growth stocks have been outperforming, which is also emblematic of investor expectations that there could be a recession. Typically, when economic growth is weak, and growth in general is scarce, investors flock into safe haven growth stocks whose earnings can outperform and grow even when GDP is shrinking. That is what the market could be telling us now. The market also tends to bottom out before the economy bottoms out and goes into a recession. Therefore, as the market went down last year, it could merely have been pricing in the probability that these rate hikes would be precisely the cause of a future credit crunch, and recession, which now could be playing out.
Given GDP growth (as measured by GDPNow) is showing the economy humming along at 2.6%, the US economy is in a strong position. Much will depend on how the Fed decides to play its next hand. If I were Jerome Powell, it has got to look bad that even though inflation is coming own, I am determined to increase the pace of rate hikes once again (in essence, compounding his error of being late to hike rates with another error of being late to stop rate hikes – the proverbial Make-up call you see in the sports match.) For what it’s worth, third years of presidential cycles tend to be the best from a stock market perspective. Presidents and their admin’s know that only the six months leading up to an election really matters, so they act accordingly (of course it helps if you have an accommodative Fed who is decreasing interest rates.) Will that happen this time? Your guess is as good as mine, but I don’t think Jay Powell is dumb. Overall, it seems likely that unless this credit event will spill over and become a wide-ranging disaster, I would still defer to the ideology that the stock market lows are already set in behind us in 2022. If the Fed acts as we would expect any good Fed to act in a “situation like this one,” then it could be the Fed to the rescue, and an economy that narrowly averts a bad recession.
In the meantime, we believe it is wise to continue avoiding the regional banking space. The risk does not seem to be bleeding meaningfully into large cap banks. Going back to my comments about BofA, many large banks will eventually win market share from this. Large cap tech is also acting as if it is safe. (I.e. outperforming.) This actually makes sense, given that tech took it on the chin last year, and like it or not, given how profitable mega cap tech is, they have the most “levers to pull” in terms of the many ways management could cut costs, going forward. Healthcare could go on to be a beneficiary if the market resumes a risk-off tone. Certain real-estate companies (which we hold very low exposure to at this point) may be hurt if funding becomes difficult to get. Bonds are back to being the optimal risk hedge.
So, in short, what should investors do? Some caution is warranted as sentiment around the banking system remains fragile. But conditions will improve before long, in our view, especially as inflation continues to decline. For longer-term, strategic investors with well-balanced allocations, we would not make any changes at this point. If you’re holding excess cash that could/should be invested for the long-term, we recommend not agonizing over where the ‘bottom’ might/might not be, and instead put the funds to work in the market while we know we are still trading in a very favorable range of relative value. High yield savings accounts may be earning 4%, but that’s not enough to meet long-term goals, especially given inflation of 6%.
As always, we are here to help address any questions or concerns you may have. Please feel free to reach out.
Charlie & John
