April Investment Comments
The bill has seemingly come due for the Federal Reserve’s mistaken belief inflation was “transitory.” A late start in tightening policy to combat inflation led to the fastest rate hikes in forty years, and it should come as no huge surprise the stress from such a move might break something. The collapse of Silicon Valley Bank (“SVB”), the 16th largest bank in the U.S., was the headline casualty, but Signature Bank was also shut down by regulators and the impact was evident across the sector, notably regional banks where share prices declined sharply.
Given the potential for widespread market disruption, regulators stepped in with a package of emergency measures to calm fears among depositors and help prevent contagion. The actions taken brought back unwelcome memories of the financial crisis. The government announced the FDIC would guarantee all deposits held at SVB and Signature Bank, even those beyond the $250,000 limit, by invoking a “systemic risk exception.”
The Federal Reserve also put in place a lending facility, the Bank Term Funding Program, available to banks to ensure customer withdrawals could be met. The depth of concern was evident as shares of several regional banks remained under heavy selling pressure even after these steps were taken. There remains some concern the actions taken may not be enough, but further intervention seems likely if the need arises.
How did the banking system, and SVB specifically get here? Though SVB is a strange animal due to its customer base, this ultimately was a classic asset-liability mismatch. Concerns regarding the potential insolvency of SVB grew as the value of its securities portfolio declined with interest rates moving higher. The issue at SVB was exacerbated by its high percentage of deposits that were uninsured — approximately 96%, which is significantly higher than most other banks.
Deposit balances for banks in recent years have grown meaningfully. Per former hedge fund manager and blogger Marc Rubenstein, between the fourth quarter of 2019 and the first quarter of 2022, deposits at U.S. banks rose by $5.4 trillion. Over this same timeframe SVB’s deposit balances more than tripled to $198 billion. For banks generally, only about 15% was lent out due to weak loan demand with the remainder invested in securities portfolios or kept as cash. Bank securities portfolios increased to $6.3 trillion, up from approximately $4.0 trillion at the end of 2019. SVB followed a similar path, with the securities portfolio growing from $27.7 billion to $126 billion at its peak.
The securities portfolio at SVB was generally made up of very safe bonds – US Treasuries and agency mortgage-backed securities. However, while SVB’s securities had little credit risk, it had meaningful interest rate risk, a risk it apparently did not do enough to hedge. As rates went up, bond prices went down, and the securities portfolio lost significant value. Ultimately these losses became large enough to raise questions regarding solvency.
SVB had another issue, which was its client base, largely comprised of tech firms and venture capitalists. Deposits had been on a downward trajectory as customers moved funds to higher yielding assets. Furthermore, the availability of venture funding had slowed and many of SVB’s depositors were cash-burning startups. The high level of uninsured deposits meant that once fear started to spread, it spread quickly. As one SVB executive told the Financial Times, “it turned out that one of the biggest risks to our business model was catering to a very tightly knit group of investors who exhibit herd-like mentalities.” Depositors tried to withdraw $42 billion from the bank the day before it was seized by the FDIC, the equivalent of a quarter of its overall deposit base. To raise cash to pay depositors, SVB sold securities. However, the sale further highlighted the unrealized losses in its securities portfolio, in turn spooking the market and ultimately resulting in its collapse.
The banking turmoil has substantially changed expectations for the Federal Reserve’s path forward. Fed policy works with long and variable lags. The SVB situation demonstrates the impact of rapid rate increases is starting to bite. Rates have been volatile, but as of the time of writing, the 10-year Treasury has fallen from a peak of more than 4% in early March to approximately 3.4%. The two-year Treasury, following the failure of SVB experienced its biggest single-day rally since 1987, with yields falling below 4% from over 5%.
The stresses related to SVB, including an anticipated pullback in lending, are likely to crimp economic growth and settle the heated debate over whether the Federal Reserve will opt for a quarter or half percent move at its meeting March 21st-22nd in favor of a quarter percent increase. Fed Funds futures currently imply another anticipated quarter point increase in May, marking the expected peak at 5.0%-5.25%. From there, market expectations reflect 1% of rate cuts by the end of 2023 in response to an anticipated slowdown in the economy.
Currently, signs of a meaningful slowdown are hard to find as the economy continues to show momentum. The Atlanta Fed’s GDPNow projects 3.2% gross domestic product growth in Q1. The February jobs report was indicative of a still strong labor market. A 311,000 increase in nonfarm payrolls was once again well ahead of expectations, though the unemployment rate ticked up to 3.6% from 3.4%. However, this uptick was due to an increase in labor-force participation, a welcome development. Regardless, a slowing of the economy over the coming months looks almost certain. This is reflected with consensus estimated earnings growth of just 2% this year. Earnings will be closely scrutinized as margins come under greater pressure. The S&P 500 currently trades at approximately 17x forward earnings, generally in line with the 10-year average. It is worth noting that in the case of a recession, stocks tend to bottom several months before other indicators, like earnings, bottom.
While a recalibration in rate expectations on the back of an anticipated slowdown in growth is clear, this does not mean inflationary concerns have gone away. The consumer price index rose 6% in February from the prior year, a modest improvement from the 6.4% increase in January but still well ahead of the Fed’s 2% target. Core CPI excluding food and energy prices rose 5.5% versus a year ago, just a tick lower than January. The Fed’s preferred inflation measure, the personal-consumption expenditures price index rose 5.4% in January, the most recently available data, with core growth of 4.7%. Both were up slightly from December. Goods inflation has settled down, but services inflation remains stubbornly high. The Fed may be facing a situation where inflation remains a problem but if it continues to raise rates it also increases the risks to financial stability. That is not where the Fed wanted to end up, and it may be able to thread a needle, but increasingly it appears the Fed may have some difficult choices ahead.
James M. Skubik, CFA