“My biggest concern is that further tightening will test the fragilities of market plumbing.”
Scott Minerd, 1959 – 2022, CIO, Guggenheim Partners Global
THE FED’S TIGHTENING CYCLE HAS STARTED TO INFLICT DAMAGE
Originally, ‘The Story of the Three Bears’, as it was known then, was a celebrated nursery tale that was shared orally long before it was set to paper. Like most folk tales, the story went through several reworkings before its current adaption. British poet laureate Robert Southey was the first one to publish it in written form in his prose anthology ‘The Doctor’, in 1837. In early narratives, the main character was an intrusive old woman. Over the years, the character unfolded and evolved into the likeable but curious girl with golden tresses that’s now widely recognized as Goldilocks.
Goldilocks is known for her audacious trip to the three bears’ cottage where she samples their porridge and finds she prefers porridge that is neither too hot nor too cold, but what she describes as ‘just right’. Though a fairy tale, it offers a simple analogy about the concept of finding ‘just the right amount’ of something. It has become known as the Goldilocks principle, which states that something must fall within certain margins, as opposed to reaching extremes. The concept has been applied to a wide range of disciplines, including astronomy, biology, engineering, and certainly, economics.
David Shulman, the former Salomon Brothers analyst is generally considered the first to introduce the phrase Goldilocks economy in 1992 as part of a piece called "The Goldilocks Economy: Keeping the Bears at Bay". Much like the fairy tale, he described it as a period of time where economic conditions were ‘hot enough for profit growth, but cool enough to keep the Fed from hiking interest rates’.
After a very challenging 2022, when the global stock indexes dropped by a fifth and bonds saw their worst year on record, markets rebounded into 2023, delivering one of their best starts to a calendar year as cooling inflation and resilient economic growth drove investor hopes for a market-friendly Goldilocks ‘soft landing’ without a significant recession. A decline in Treasury market yields and a weakening U.S. dollar further aided market sentiment. After plumbing bear market lows in October, January delivered significant returns across nearly all asset classes.
Economic growth proved surprisingly resilient at the start of the year, with retail sales increasing 3% in January, the largest monthly gain in nearly two years. Job growth accelerated sharply in the first month of the year, with nonfarm payrolls up by 517,000 jobs and the unemployment rate dropping to a five-decade low of 3.4%. Yet despite the strong job gains, wage growth had cooled to a level close to the Fed's comfort zone.
Manufacturing output increased 1% in January after dropping in the final two months of the previous year, and high inflation also cooled slightly. In the blink of an eye, the economy’s most pressing problems seemed to have surprisingly gone away and the all-but-certain 2023 global recession was being called off.
How quickly things change! Those gains unraveled quickly as the stock market shifted into reverse in February amid a stream of hotter-than-expected economic releases, including the above-mentioned data on the labor market and consumer spending, that forced investors to raise their forecasts for how high the Fed will have to hike interest rates. In a sign of investors’ shifting interest rate expectations, Government bond yields, as measured by the benchmark 10-year Treasury note saw the largest one-month climb since September (bond yields move in the opposite direction of price).
Then, in just a matter of days, the financial world turned on its head and upended many of investors’ assumptions about how the rest of 2023 would play out. What began as a plight specific to one crypto-focused bank rapidly morphed into a crisis with economic, political and international repercussions. In early March, La Jolla-based Silvergate Bank, a central lender to the crypto industry that counted the now-bankrupt crypto exchange FTX among its biggest clients, announced that it was shutting down its operations and liquidating its assets after suffering heavy losses.
Then, just a few days later, the FDIC (Federal Deposit Insurance Corporation) stepped in to close Silicon Valley Bank (SVB), a three-decade-old firm that was a major lender in the tech world, serving as banking partner for nearly half of all venture-backed technology and healthcare companies in the U.S. The nation’s 16th-largest bank failed after depositors hurried to withdraw more than $42 billion in the span of a single day following the bank’s statement that it needed to raise $2.25 billion to shore up its balance sheet.
New York-based Signature Bank, which also had a strong crypto focus but was much larger than Silvergate, was seized two days later by banking regulators and became the third regional bank to collapse in a week. SVB and Signature represent the second- and third-largest bank failures in U.S. history after the collapse of Washington Mutual during the Great Financial Crisis in 2008.
Meanwhile, the nation’s 18th-largest bank, First Republic Bank, which specializes in private banking and servicing billionaires sought to reassure customers that their deposits were safe after securing additional liquidity from the Fed and a group of banks led by JP Morgan.
Anxiety over contagion in the U.S. banking sector quickly spread to Europe, where regulators brokered a takeover by UBS of the troubled 167-year-old Swiss banking giant Credit Suisse. Shares in Deutsche Bank, Germany’s largest lender, plummeted sharply as its credit-default swaps - tradeable insurance against defaults on a bank’s debt - jumped to near-record levels.
While U.S regulators quickly stepped in to contain the crisis, shockwaves are still echoing through the economy, with investors and consumers having ongoing concerns about the health of the banking system and broader financial markets, where bank stocks big and small shed value at a remarkable rate. There’s heightened uncertainty that more shocks could be lurking, especially given the backdrop of the Fed’s aggressive rate hikes over the past year and the concern that other investment business models based on lower interest rate assumptions could emerge.
More than a decade of abnormally low interest rates has made it difficult for financial institutions to earn an adequate net interest margin (NIM), which is the difference between what banks pay for deposits and earn on loans. Expecting inflation and interest rates to stay low for years on end and looking for some kind of a return, some banks like SVB, for example, put a substantial amount of their customers’ deposits in traditionally safe long-dated Treasurys and mortgage-backed securities. In short, they took funds mainly on short-term deposit and tied them up in long-term investments, which created a classic asset-liability mismatch.
Easy financial conditions tend to lead to higher risk-taking and a complacency that long-established patterns will continue - until they don’t. As the Fed began raising interest rates at a record pace over the last year in an effort to curb inflation, the value of those previously issued bonds declined substantially because they pay lower interest rates than comparable bonds issued in today’s higher interest rate environment.
The investment losses that led to SVB’s failure are a problem, to some degree or another, across the U.S. banking system. As the chart above shows (source: FDIC), the industry ended last year with $620 billion of unrealized losses on its books from investments in low-yielding bonds. In comparison, during the 2008 financial crisis, they were less than $75 billion. Bonds held in investment books represented less than a quarter of the banking system’s $23.6 trillion of assets in December, and according to experts, the issue is manageable for most banks.
While the Fed has been steadily raising interest rates, the average national rate for bank savings accounts has remained stubbornly low. As a result, many depositors began to pull out large amounts of money in search of higher returns elsewhere, such as Treasury bills and money market funds. Since banks typically do not hold enough cash to cover all their clients’ deposits, they were forced to sell some of their longer-dated bonds at steep losses.
The banking system is, and has always been, built on confidence. When depositors lose confidence, it can lead to a sense of panic that feeds on itself and ultimately causes a classic ‘bank run’. SVB and Signature Bank failed with enormous speed - so quickly that they could be textbook cases of classic bank runs, conjuring up images of “It’s a Wonderful Life”, in which anxious customers, crammed shoulder to shoulder, desperately plead with a harried George Bailey to hand over their money. Except, this time few depositors lined up at a branch. Instead, they used bank apps and phone calls to access their money in what might well be the first bank run of the social media era. But just as Bailey explained, the money wasn’t there, it was invested elsewhere.
While regulators chose to make depositors at both banks whole by guaranteeing that all deposits would be honored, there’s no guarantee this will happen again. Bank failures are not a new development (see graph below) - they can and do fail, and we believe that it makes a lot of sense for depositors to proactively manage their bank cash reserves, particularly if they have an account near the FDIC-guaranteed $250,000 threshold. To quote Warren Buffett: “Only when the tide goes out do you learn who has been swimming naked,” meaning that companies that thrived on cheap loans might no longer be able to survive now that the economy has shifted and borrowing is more expensive.
The old Wall Street adage is that to quell inflation, central bankers must tighten monetary policy until something breaks. As we mentioned earlier, for much of the past year this cliché was easy to dismiss as consumers continued to spend and it seemed like the economy might re-accelerate. But things are breaking now. Several banks failed and fear about the unseen risks to the financial system rippled across the globe as investors scrambled to find someplace safe to park their money. Most noticeable was the frenzy in stocks of other banks, which investors worried may have similar vulnerabilities. Financial markets appear to have entered a new phase in which the Fed’s cycle of rate increases has started to inflict damage.
Even before the crisis, banks tightened underwriting standards on all manner of loans and were more cautious in their lending to households and businesses. Softer bank lending effectively amplifies the already dampening effect of higher rates on economic activity, functioning like an additional interest rate hike. Yet despite the ongoing bank turmoil, the Fed continued its attempt to balance out inflation risks with the threat of banking system instability and a potential credit crunch, raising rates for the ninth time by another 25 basis points (0.25%) and bringing the cumulative total over the last year to a staggering 4.75%. The combination of high interest rates and a potential credit crunch might weigh on households and businesses, lead to higher unemployment, and raise the odds that the U.S. economy, already widely seen as prone to recession, might actually tip into one.
The latest financial upheavals have led many to question whether they were harbingers of yet another 2008 global financial crisis. Although the far-reaching implications of the recent events will take time to truly understand, this seems like a very different situation than the Global Financial Crisis. Back in 2008, cheap credit and lax lending standards in the housing market fueled excessive risk taking by financial institutions. When the housing bubble burst, defaults on subprime mortgages shot up and many of those institutions suffered massive losses. This time around, the root problem isn’t bad loans. The banks that are in trouble today had concentrated deposit bases and poor interest rate risk management, not necessarily bad loans.
Post-financial crisis regulations required the largest financial institutions to be much less levered, better capitalized, more transparent and more liquid. This included raising capital requirements, annual stress tests and rules to make sure banking establishments had well-diversified revenue streams. As a result, the largest banks are in a much stronger position now than they were in 2008.
By the same token, Federal regulators moved quickly to launch emergency measures aimed at shoring up confidence in the banking system and prevent contagion at other regional banks in the wake of SVB’s sudden failure. The Treasury, Fed and FDIC jointly announced that the FDIC will cover all deposit accounts at both banks, SVB and Signature Bank, including those in excess of the $250,000 FDIC deposit insurance limit. The Fed also instituted a new Bank Term Funding Program that is designed to alleviate the pressure that banks face from unrealized losses on their portfolios of high-quality Treasury, agency, and mortgage-backed debt securities.
For now, the swift actions by regulators appear to have stabilized the U.S. banking system and partially restored calm to the financial markets. But even if market volatility subsides in the coming weeks and months, the recent banking crisis has raised the likelihood that lending standards will become drastically more restrictive, further tightening credit for U.S. households and businesses and likely curtailing economic growth and inflation. This might allow the Fed to forego further interest rate hikes, but it also risks tipping the economy into a recession.
One of the oldest sayings on Wall Street is ‘don’t fight the Fed’. We would wholeheartedly agree and note that Goldilocks is most certainly missing in action despite the strong start to the year.
A read of last month’s headlines could lead investors to think that the stock market crumbled under the weight of a worldwide financial sector catastrophe, but instead they are pleasantly surprised to see gains in both, their stock and bond holdings.
After being whipsawed by strains in the banking system, as well as shifting outlooks for inflation and interest rates, equity markets displayed a remarkable resilience, with the benchmark S&P 500 Index showing a 3.5% gain in March and a 7% year-to-date return. It was the best quarter since 2020 for the tech-heavy Nasdaq, which rose 16.8% in the January through March period. While pressure on global bank stocks continued, investors seemed to coalesce around the fact that the bank turmoil was specific to issues at certain financial institutions and not a systemic risk event.
Anxiety about bank runs and financial stability sparked the biggest one-day and three-day rally in short-term U.S. government bonds since the days that followed the 1987 stock market crash. After topping 5% for the first time since 2007 just a week before, the yield on the 2-year Treasury note tumbled to 4% - a full percentage point – the day after SVB failed.
Uncertainty and market volatility are always uncomfortable and we will continue to monitor this situation closely for both additional risks and potential opportunities. Our client portfolios are generally well diversified and have little direct exposure to the financial sector. As a result, we believe that investors with a properly diversified portfolio should stay focused on their long-term goals and not let short-term swings in the market derail them from their financial goals. The most challenging periods in the market often sow the seeds for the best opportunities. As the graph above from JP Morgan highlights, a 50/50 portfolio of stocks and bonds has never delivered a negative total return over a five-year time horizon. As always, past performance is no guarantee of future returns.
Happenings at Telos
It is with great pleasure that we announce the addition of Serena Smith as Client Service & Operations Specialist to our Telos family. Serena will initially work part-time until she graduates from SDSU with a BA degree in Economics and Quantitative Analysis and a Minor in Marketing/Interdisciplinary Studies in May. She will support our office operations with administrative tasks and help us ensure that all client service needs are handled in a timely, accurate, and professional manner. Serena has several years of client service and office experience in the real estate and retail industries. As our firm continues to grow, we are pleased to provide our clients with top-notch talent and service.
We are also excited to announce that in order to accommodate the needs of our growing workforce, we’ll relocate to our new and expanded office in the Sabre Springs neighborhood of San Diego on May 22nd. If you want more information about our change of address click here to see our blog post. Our telephone numbers and email addresses will remain the same. We look forward to serving your financial needs from our new office!