Market Outlook: Q2 2023
April 20, 2023 Wealth management
Markets generally moved higher in 1Q23 as the S&P 500 gained 7% and global equity markets rose close to 3% (as measured by the MSCI World Index). Bond prices moved higher as the 10-year Treasury yield declined from around 4% to just below 3.5%. Commodities were mostly higher (especially precious metals) though oil prices fell about 2%. Currencies were mixed but finished the quarter generally little-changed. However, these moves masked significant volatility within the quarter. For instance, the S&P 500 traded upward to nearly 4,250 in early February before correcting below 3,900 in early March. The market then reversed course, closing above 4,100 on March 31.
This relatively contained trading range belies substantial economic volatility and liquidity concerns over the past few weeks. Central banks hoping to break the back of inflation and cool an overheating economy want risk-taking to be curtailed. But central banking is not an exact science, and during tightening cycles, things eventually start to break. We do not believe the failures of Silicon Valley Bank (SIVB) and Signature Bank are indicative of larger systemic risk, as the failures of Bear Stearns and Lehman Brothers were in the Global Financial Crisis (GFC). There is no liquidity crunch or deposit crisis at US regional banks. However, these bank failures are symptoms of a broad tightening of financial market liquidity that has far-reaching and ongoing effects, and will likely hasten the economy’s push towards recession.
No doubt you’ve all read about the failure of SIVB, but much of the media coverage on this topic misses some key points and lacks context. What happened and why? Ever since the GFC, central banks around the world have generally employed Zero Interest Rate Policies (ZIRP) or, at a minimum, very low interest rate policies. This has put banks in an enviable position: their funding costs have been very low, because they haven’t had to pay much, in anything, to their depositors. The wildly expansionary fiscal policies of 2020 paid workers to stay at home and paid businesses to retain those workers. As a result, a flood of savings (deposits) entered the banking system. These deposits had to go somewhere. Banks can either use them to make loans or to buy securities (i.e. bonds). And in a world where credit creation was anemic, many banks logically chose to plow these newly-created deposits into Treasury bonds and other forms of “duration” (meaning assets whose cash flows to investors are mostly (or entirely) far off in the future).
This state of affairs had worked pretty well over the past few years. Even in 2018, when the Fed was hiking rates, banks weren’t forced to raise deposit rates much above zero. Fed Fund rates weren’t that high (they never got much above 2%) and depositors had been conditioned from a decade of ZIRP to not expect much yield on a checking account. But that changed last year as Fed Funds rates moved north of 4%. Why accept less than 1% on a demand deposit account when you can earn close to 5% in a risk-free money market account? As a result, total bank deposits began to decline in mid-2022 and that trend accelerated in the wake of SIVB.
So began an intense competition for deposits, as banks across the country have battled to retain the funds they need to lend. For any bank in isolation, just like any company in any competitive industry, this can work. But in aggregate, it doesn’t. Between the shift from demand deposits to Treasury bills and money market funds, and the draining of liquidity as quantitative easing (QE) shifts to quantitative tightening (QT), the financial system and the banking system have been under pressure as the Fed has continued to hike rates. As a result, we’ve seen banks forced to do things like tap the Federal Home Loan Bank (FHLB) for funds.
Enter SIVB, a unique bank in that it catered/caters almost exclusively to the world of start-up tech firms (themselves under pressure over the past 18 months). This was a bank that was uniquely and terribly positioned on both the asset and liability sides of their balance sheet. SIVB took on huge amounts of deposits from a highly-concentrated group of volatile, high-growth companies and ultra-high-net-worth individuals. These deposits were not sticky, they weren’t diversified, and they were almost all too large to qualify for FDIC deposit insurance. SIVB then plowed those deposits largely into long-duration securities. So, as rates rose and deposits became scarcer, their liabilities were especially vulnerable to a bank run, and their assets were losing money on a mark-to-market basis. By last month, they were insolvent. No bank can survive a run, and certainly not one with the structural problems and poor risk management of SIVB. The Fed and FDIC stepped in and moved quickly to stop the panic and take systemic risk off the table. They protected depositors and created a special facility, the Bank Term Funding program (BTFP), to allow banks to borrow at par against securities trading at less than 100 cents on the dollar. Make no mistake: the Federal Reserve has the tools to stop a run on the banking system, and they have demonstrated their willingness to use them. It surely looks like the acute phase of this banking “crisis” is over. But as funding costs remain high, competition for deposits remains stiff, and regulations (and associated costs) are poised to move higher, banks will remain under stress.
So, where does this leave the banking system? In a world where banks had to fund their assets at the current Fed Funds or Treasury bill rate, or anywhere near it, net internet margins (bank profit margins) would collapse. We aren’t moving to that scenario tomorrow, but these stresses are by definition deflationary, as they lead to incrementally less credit creation in the economy.
For financial markets, this banking system stress creates offsetting impulses. On the one hand, weak loan growth that pushes the economy into recession is deflationary, implying that the Fed will have to cut rates. As a result, markets are now pricing an above 50% chance of no rate hike at the May FOMC meeting. In this scenario, with the Fed pivoting from hawkish to dovish policy, it has historically paid to buy bonds. But, as discussed above, banks (including the Fed) have been the biggest buyers of bonds over the past decade. At the same time, Federal budget deficits are set to grow. So, you have the biggest buyer of bonds stepping away from the market, and the biggest seller of bonds issuing more. Who will step in to buy these long-term bonds, and at what price? Moreover, the Fed is constrained in how quickly they can cut rates given their commitment to fighting inflation. The labor market remains tight, with historically high levels of job openings and wage inflation.
Source: Atlanta Fed
As a result, markets are now pricing that the banking stress will be enough to cause the Fed to ease by June (see below). We think expectations of this dovish pivot is likely misplaced due to the inflation pressures on wages. As such, the future clearing price for US 10-year government debt in this scenario is likely higher than the current sub-3.5% rate.
Source: Bridgewater
The other important fall-out from SIVB has been depositors fleeing small banks to move their deposits towards the “too-big-to-fail” banks (if a 2% decline in the deposit base of regional banks can really be considered “fleeing,” deposit declines have actually been larger at the big banks, see below).
Why does this matter? Small banks provide the lifeblood of the economy. They supply credit to small businesses, small projects, the real economy; they don’t engage in financial engineering or investment banking. In a phrase, they lend to Main Street, not Wall Street. Small banks create 35% of the credit in the US economy, and they provide an even higher percentage of commercial real estate lending. Small banks create credit that accounts for nearly 3% of total US GDP. If small (regional and community) banks pull back from risk-taking on the margin, it will prove a drag on the economy. Of course, lending will not go to zero, and only a small percentage of that 3% will come out of the economy, and it will not occur all at once. But the “short and shallow” recession we have been calling for since last year will likely happen sooner as a result of that decline in credit creation. As you can see below, bank credit creation began slowing last year and that slowdown has accelerated in the wake of SIVB, reflecting the broad decline in the money supply.
Source: Board of Governors of the Federal Reserve System
Against this backdrop of declining credit creation and a hawkish Fed, the mantra of diversification and risk mitigation we have been repeating for over a year continues to make sense. There are pockets of value in equity markets, but overall stocks are fairly valued trading at approximately 20 times 2023 earnings. Bonds provide more yield than they have in the past, but face both fundamental (rising short rates, sticky inflation) and technical (banks paring back on buying duration) headwinds. Alternative investments such as private credit and hedge funds continue to provide valuable diversification but are not without risks. Selective quality growth investing with a long-term timeframe continues to be our starting point. Inflation hedges like natural resource companies make sense right now as well, given the risk of ongoing 4%+ inflation. We complement this with value-oriented, tactical fixed income exposures and (where appropriate) diversifying alternatives. In many cases, above-target cash levels also make sense, given the 4.5%+ yield on money market funds. Uncertainty remains high, but we continue to believe that our focus on quality growth companies and prudent asset class diversification will continue to generate reasonable returns with reasonable risk across a variety of market environments.
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