Update on the Economy and Investment Markets 3-18-23

Welcome to the Stearns Financial Fireside Chat.

A wild card risk was dealt to the U.S. and global economies late last week. During the past week, the U.S. banking sector experienced the second and third largest failures in its history. The size of the failures of Silicon Valley Bank (approximately $209B in assets according to the Federal Deposit Insurance Corporation [“FDIC”]) and Signature Bank (approximately $110B in assets) has only been exceeded by Washington Mutual (approximately $307B in assets) in September of 2008. The bank run experienced by SVB was a 21^st century version of what was portrayed in the 1947 film It’s a Wonderful Life. Instead of a panic being spread by word of mouth and account holders physically lining up at the Bailey Brothers Building and Loan to retrieve deposits, concerns were raised and spread like wildfire on social media, especially Twitter, leading investors to withdraw money digitally from SVB and other banks without being physically present at the banks. The FAQ this week will provide more details on what led up to the failure of SVB. 

The U.S. government took action Sunday in an attempt to calm fears of further contagion and failures in the banking sector by essentially backstopping deposits at SVB and Signature – along with implying it would assist any other banks that fail. This action removed FDIC limits at SVB and Signature so that all deposits regardless of size could be accessed with no losses beginning Monday morning. There will be significant debate as to whether this should be referred to as a “bailout” when history evaluates this period, but it is important to understand that investors in these banks (equity and bond holders) have been wiped out, although some investors are holding out hope for some recovery if the company goes through the bankruptcy process. The government action only covers deposits held with the banks by individuals and businesses. 

While the concerns that arose late last week with the failures of SVB, along with another bank, Silvergate (pursuing voluntary liquidation in California without FDIC assistance at this time), contributed to pressure on the stock market along with Fed Chair Powell’s testimony, the broader market held up relatively well at the beginning of this week – despite the bank failures. Outside of the financial sector (which was hit hard, especially regional banks), the market traded mostly sideways through Wednesday, albeit with increased volatility. The government’s action at least temporarily eased fears that depositors would lose savings and working capital balances above FDIC limits held with banks. Some of the banks seen as most at-risk of failing have seen their stocks rally off their lows, despite the concern that there could be more dominos to fall (depending on government and Federal Reserve actions in the coming weeks). 

How we arrived here will be a topic extensively analyzed in research papers and books, but one reason that appears to be a contributing factor is the creation of a two-tiered banking system. The largest banks are considered systemically important and “too big to fail” and are also subject to stricter capital requirements and oversight, as a result of regulations coming out of the financial crisis. Some regional banks, depending on size, fell under some of these stricter regulations, including SVB. Under the previous administration, regulations were relaxed via a bill that could be described as bipartisan following lobbying from regional banks. While this may have contributed to a lack of strict oversight by regulators and lower capital requirements, on the surface the failures appear to be due to poor risk management. 

Where do we go from here? The risk and fear of contagion in the financial sector remain and have extended overseas, as European banks were hit hard on Wednesday. Credit Suisse was a victim of the selloff as concerns continue to be raised about its solvency. Wednesday night in Europe, the Swiss National Bank stepped in, announcing it would provide liquidity to Credit Suisse if needed. SVB (now doing business as Silicon Valley Bridge Bank), now appears to have essentially reopened for business for the time being, with any deposits being fully covered regardless of size. In a statement from their new CEO: “If you, your portfolio companies, or your firm moved funds within the past week, please consider moving some of them back as part of a secure deposit diversification strategy. We are also open for business for any new customers. We are actively opening new accounts of all sizes and making new loans.” Will this lead the FDIC to remove the arbitrary limits that exist for insurance at all other banks, or is this temporary during this crisis? One concern is that if this occurs, those who are not breaching the current limits (due to more limited income) will bear the brunt of the change, as banks may pass on the increase in insurance expense they pay to FDIC to their own customers.  (Note:  As we go to press, a rescue package for First Republic Bank, another bank with liquidity/solvency concerns and approximately $200 billion in assets, was arranged on Thursday by Treasury Secretary Janet Yellen and JPMorgan.  The agreement called for 11 of the largest banks to deposit $30 billion with the struggling bank to stabilize it.)

Prior to the markets being consumed with a banking crisis, Fed Chair Powell gave hawkish remarks during his semiannual monetary policy report to Congress. During his speech he stated: “The latest economic data have come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated.” This initially sent rates higher, stocks lower and increased the odds of a 0.50% increase in the Fed Funds Rate at the next meeting on March 21-22. However, following the failure of SVB and Signature Bank, the yield on the two-year treasury note dropped over 1% from over 5% to below 4% – the largest three-day decline since October 1987. The yield on the 10-year treasury note has retreated to 3.4% from just over 4% during the same period. At the same time, it is now expected that the Fed will keep rates the same or raise at most only 0.25%. Additionally, the market is now expecting rate cuts during the next twelve months, a significant change from expectations earlier this month.

Inflation Update

The latest inflation data this week continued a downward trend in headline numbers with February CPI coming in at 6% and core inflation at 5.5%, driven by shelter costs on a trailing 12-month basis. On the surface, this is positive and the lowest CPI reading since September 2021. However, month-over-month inflation remains stubbornly high. Month-over-month CPI was 0.4%, while core inflation came in at 0.5%. While the data was mostly in line with expectations, investors are mixed on what this means for the Fed decision next week. It is likely that the banking crisis will take center stage at the Fed meeting and weigh heavily on decisions made. The crisis does provide the Fed with cover to do nothing if it chooses. (Note: despite concerns in its own banking system, the European Central Bank went ahead with a 0.50% increase in its key interest rate on Thursday.) 

Following the inflation data reported on Tuesday, the latest Producer Price Inflation (PPI) was released on Wednesday. PPI dropped 0.1% month-over-month versus an expected gain of 0.3%. A drop in food prices, especially eggs which declined 36%, was the main driver of the decline.

Note that the Federal Reserve prefers the Personal Consumption Expenditures Price Index to gauge inflation, largely for two reasons: it has a broader scope, and better reflects how consumers change what they buy to account for rising prices. The next PCE Price Index reading is due March 31.

Geopolitics

While the banking crisis has captured headlines, there was a major development in Middle East relations as China brokered a deal between Saudi Arabia and Iran to renew diplomatic ties. This is another example of the ongoing tug-of-war between the two global economic powers (the U.S. and China) and their relationships with countries throughout the world. While peaceful relations between Saudi Arabia and Iran are welcomed, it is further evidence of China and Xi Jinping’s growing footprint on the world stage. Another example is China’s peace plan for Ukraine and Xi’s potential upcoming separate discussions with Putin and Zelensky. This would be the first time Xi has spoken with Zelensky since the war broke out in Ukraine over a year ago.

Key Points to Consider

• Retail Sales in the U.S. fell by 0.4% month-over-month in February, slightly more than the market forecast of a 0.3% decline. This followed a sharp rise in January; however, retail sales have declined five out of the past eight months.
• According to Reuters, balances in U.S. money market funds have hit an all-time high of $4.9 trillion this year. Money market funds have attracted assets from bank deposits, given the higher rates and the more explicit assets backing the funds compared to deposit balances above FDIC limits. This is a contributing factor to the outflow of deposits from regional banks.
• Latest Consumer Sentiment reading dropped for the first time in four months to 63.4 in March representing a drop from 67 in February and below expectations of 67.  Persistently high prices continue to weigh on consumers.  According to the University of Michigan which conducts the survey, “This month’s decrease was already fully realized prior to the failure of Silicon Valley Bank, at which time about 85% of our interviews for this preliminary release had been completed.”

Frequently Asked Questions

Q:   What was Silicon Valley Bank and why did it fail?

A:   There will be research papers and books written and maybe a movie about what happened at Silicon Valley Bank. The demise of SVB, along with Signature Bank, looks different than the bank failures during the financial crisis. At this time, there is no evidence that the bank took on risky assets that turned toxic – such as subprime mortgages that became worthless.

Instead, SVB was a victim of rising interest rates, poor risk management and timing. Tech sector deposits surged during the pandemic, and SVB loaded up on long-term government securities a few years ago when interest rates were near zero. With rates rising sharply over the past year, these securities developed unrealized losses, since debt declines in value as interest rates rise. These unrealized losses would not have been an issue if SVB could have held the debt to maturity, but the rise in interest rates coincided with a slowdown in funding for many startup companies. As customers began to withdraw large sums of cash, the bank was forced to take losses on these bonds as they were sold for liquidity. To prevent this from going on for too long, the FDIC stepped in to shut down the bank. 

CLICK HERE for an article from NPR which provides a high-level summary of what happened and what SVB represented to the tech world.

SFG’s Take: While banking stocks and stocks like Charles Schwab [Note: This is not advice to either buy or sell this company] suffered panic selling initially after the SVB collapse took place, they have already begun to recover, reflecting easing fears and helped by the U.S. government (FDIC in particular) making depositors whole even if they exceeded the $250k insurance limit. Any losses will be absorbed by the FDIC fees to member banks and will not be borne by taxpayers.

Our own cash reserves appear very solid – nevertheless, SFG remains on heightened alert, watching cash and money market safety, impacts on various stock sectors, impacts on venture capital and private equity, plus other downstream waves that could result from SVB’s demise.

Summary

Many factors still indicate a slower growth scenario for the U.S. and global economy, but some key areas have seen recent improvement. We still have mixed data on whether a U.S. recession is likely in 2023, but it is increasingly likely that any recession, if present, will be mild. Given the recent government intervention to backstop depositors at failed banks, it is less likely these events by themselves will trigger a recession. Certain sectors of the economy, like housing, are dealing with rolling recessions of varying magnitude around the country. 

SFG believes 2023 will be markedly different from 2022 in terms of investment performance. While we expect positive returns in most asset classes (contrary to last year), we believe some areas will experience only modest growth. Many of our alternative assets still have favorable return potential over inflation, along with risk mitigation benefits. 

Wildcard risks (low probability, high possible impact), one of which we witnessed over the past week, discussed in this and previous Chats remain and suggest some caution. Included among these risks are Putin’s future actions.

SFG is balancing numerous opportunities and threats in portfolios, customized to our clients’ unique circumstances.

In growth portfolios, we are leaning into a variety of short- and intermediate-term asset classes and trends we believe have favorable forward-looking risk/reward relationships.

In more conservative growth and income portfolios, we continue to maintain good diversification while striving for positive real returns over inflation.

Our “Sailing in Uncharted Waters” investing approach can be summed up by six themes:

• Diversification with a balance of offensive and defensive measures, depending on the desired risk tolerance of our clients,
• Underweighting, or avoiding areas of higher future concern,
• A focus on higher-quality investment themes,
• Identifying and implementing buying opportunities that may be appropriate for more growth-oriented portfolios,
• A more defensive stance using different portfolio tools for more conservative growth and income portfolios, and,
• Utilizing select alternatives to traditional bonds and stocks.

~ Dax, Dennis, Glenn, Jason, John and PJ
(The SFG Investment Committee)