Highlights:
· The signature events of the first quarter were the sudden collapse and seizure of Silicon Valley Bank, followed in short order by Signature Bank, and Credit Suisse’s forced sale to UBS.
· The widespread deposit flight in response to these bank failures may have the propensity to slow economic growth via reduced bank lending.
· Ironically, this may help the Federal Reserve’s fight against inflation, but at the expense of heighted recession risk.
· China reported strong first quarter economic growth due to its departure from stringent Covid-19 controls, but inflation eased likely because of its high unemployment rate.
Commentary:
“If you were an adult in 2000 you probably had at least some vision of what the future would look like. Maybe even a vague vision of the next 20 years. But everyone was blind to 9/11, the 2008 financial crisis, and Covid-19 – the three risks that were both massive and unpredictable.
-Morgan Housel, The Psychology of Money
The intent of our suggested investment policy is to prepare portfolios so that they can handle anything that happens. As the quote above illustrates, the 21st century has so far been nothing if not full of surprises. As we have mentioned numerous times in past reports, we consider crystal balls notoriously unreliable in the long term, which is why we decline to employ them. We firmly believe that no one can accurately predict – with any consistency – what, how, and when events will influence the markets. That was on full display this past quarter with the collapse of several mid-tier banks, most notable of which was Silicon Valley Bank (“SVB”), along with the government-forced sale of Swiss bank Credit Suisse to UBS. As details have emerged over the last several weeks, the consensus seems to be that the failures of these banks was avoidable and due to mismanagement of what most finance professionals would deem basic bond duration risk management. There has also been no evidence to date that there is a material risk of contagion given that banks have generally become better-capitalized since the Great Financial Crisis (GFC).
During the GFC, banks literally had billions of dollars of worthless assets on their books due to the subprime mortgage crisis and high level of derivatives tied to these nonperforming loans. This time around, the primary culprit was long-dated U.S. Treasury and mortgage-backed agency bonds of the very highest credit quality. These bonds are still highly rated and will eventually payout. The problem the failed banks experienced was that the market value of these bonds declined on a mark-to-market basis due to the rapid rise in interest rates over the last year. The inverse relationship between bond prices and interest rates, as well as avoiding duration mismatches between assets and liabilities, are both “Banking 101” topics. For a bank to be rendered insolvent in this way is the equivalent of drowning in a puddle.
Confidence in banks is what keeps them solvent. The Treasury, Federal Reserve, and FDIC know this all too well and immediately made a joint statement following the failures of SVB and Signature Bank, effectively saying that all depositors for SVB and Signature Bank would be made whole. In addition, they announced that a new facility, the Bank Term Funding Program, would be created to provide liquidity for firms under stress so that they are able to obtain liquidity without incurring losses from selling Treasuries and agency mortgage-backed securities. "No losses associated with the resolution of Silicon Valley Bank will be borne by the taxpayer," policymakers made clear. Thus, while it is possible that additional banks will fail, depositors should not be impacted.
In the aftermath of these bank failures, it is likely that the regulatory environment will tighten for small and mid-tier banks, requiring them to hold more capital. Another consequence is that corporate treasurers may rethink or diversify their banking relationships and result in depositor money flowing out of regional and local banks into large money center banks where customers feels safer. This would be ironic because the Dodd-Frank Act, which was enacted as result of the GFC, was meant to reduce the concentration of assets in the big banks.
Whether or not SVB and Signature Bank are the proverbial canaries in the coal mine for the U.S. banking system, it is reasonable to conclude that we can chalk up much of the current turmoil to the departure from the easy-money era that began following the GFC in 2008. Historically, Fed policy tightening cycles have ended with accidents. The savings and loan crisis in the early 1990s, the dot com bubble bursting in the early 2000s, and the housing crisis in 2008 each began following a series of Fed interest rate hikes designed to fight inflation. This is why the market has been so focused on inflation for the past year and is the origin of the Wall Street adage, “The Fed tightens until something breaks.”
What remains unknown at this time is whether banks and other lenders will react to current conditions by tightening their credit standards in an effort to buy themselves time to shore up their balance sheets due to losses from declines in long-dated assets. Fed rate hikes had already been cooling the economy, and a behavioral change in the banking sector poses a legitimate risk to an economy that relies on credit. If that were to occur, the economy would likely experience the opposite of what has transpired over the last ten-plus years, in that credit would become scarce and financial institutions would not be stretching for yield. If banks have a reduced capacity or desire to lend, credit is sucked out of the economy, the cost of financing everything from cars to real estate to factories would rise, and businesses that are clients of these banks may be forced to cut back on hiring and investment.
Just days before SVB collapsed, Fed Chair Jerome Powell told the Senate banking committee that “if the totality of the (job and inflation) data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes.” By the following week, the Fed recognized that something was breaking. “We’re looking at what’s happening among the banks and asking is there going to be some tightening in credit conditions. In a way, that substitutes for rate hikes,” Powell said.
Thus, if there is an unseen benefit here, it is that the aggressive interest rate increases that began last year might be ending, at least for now, by the end of this year. The recent bank failures should also serve as a reminder of the time lag between policy implementation and the real impact on the economy. The Fed is likely to end its tightening cycle soon, but the effects have just started to make their way into the system.
The Fed now faces the dual challenge of raising interest rates to cool inflation while reaching into its toolbox to prevent a full-blown banking crisis from erupting. While the U.S. inflation rate has dropped from 9.06% in June 2022 to 4.98% as of March 2023, it is still not coming down as fast as some people would like and has not come down enough to fully appease the Fed. Most economists believe that an inflation rate that remains near 4 percent for an extended period cuts into buying power and leads to a mindset among consumers that inflation may stay high for years. In such an environment, workers are more likely to ask their employers for higher wages to compensate for the higher cost of living, which can potentially cause a vicious spiral in which companies increase their prices to pay for these raises and inflation drifts even higher. Warren Buffet said in his annual letter that was released during the quarter that “inflation is a constant threat to a country. There comes a point when it gets out of control, and it screws everything up. It’s not good for society.”
Thus, although it appears we are past peak inflation, the economy still seems to be running hotter than is supportable and more action is needed to get price increases down to sustainable levels. The big question facing the economy right now is whether policymakers can continue to bring down inflation without driving up unemployment and putting millions of people out of work. To this point, the job market has proved remarkably resilient despite high-profile layoffs in tech and a few other sectors. Recent data has shown the job market is slowing enough to cool wages off, but not enough to roil unemployment. Thus, there is still a pathway for the U.S. to avoid entering a recession, but the path has likely narrowed due to the turmoil in the banking sector. “You don’t have a recession when you have 500,000 jobs and the lowest unemployment in more than 50 years,” said Treasury Secretary Janet Yellen. “What I see is a path in which inflation is declining significantly and the economy is remaining strong.”
Some degree of inflation could very well be here to stay. The question is - how much? Fed officials have repeatedly argued that it will be hard for inflation to fall back to their long-term goal of 2 percent as long as wages keep rising at a rate of 5 percent or more a year, as they have been since the middle of 2021. However, despite rapidly rising wages, workers, on average, have seen their standard of living decline over the last couple of years. Ultimately, what matters for workers and their families is wage growth in relation to inflation. An economy with 3% wage growth and 2% inflation is better for workers than one with 5% wage growth and 7% inflation.
In a positive development, for the first time in two years, pay raises of 6.1% exceeded average inflation of 5.8% in the first quarter of 2023. If this becomes a trend, it would very likely bode well for consumer spending and economic growth. The challenge the Fed faces is to lower both of these figures on an absolute basis, but maintain the relative advantage that wage growth has over inflation. The 50-year average wage growth is 4% so it stands to reason this is a reasonable target for the Fed, so long as they can reduce the inflation rate to a 2-3% range.
Elsewhere, the Bank of England (BOE) recently signaled that it might be getting ready to pause interest rate increases in response to an economy that seems to be faltering. Specifically, the BOE said they would likely only increase rates further if inflation threatens to be high for longer than it currently expects it to be. Investors interpreted this guidance to mean that inflation would have to accelerate to require more rate increases.
The European Central Bank (ECB) remains way behind the Fed and BOE in raising interest rates. ECB President Christine Lagarde said during the quarter that the ECB would “stay the course” and stressed that its job was “not done.” This suggests that the ECB will raise rates more aggressively than the Fed and BOE over the coming months. “We know that there is an element of catch-up...we know that we have ground to cover,” Ms. Lagarde said.
In a positive, if not surprising development, the Eurozone economy has proved remarkably resilient to Russia’s invasion of Ukraine to this point, despite initially higher energy prices that led to declines in business and consumer confidence. A mild European winter and high gas-storage levels have brought down energy prices in Europe over the last several months. Global supply bottlenecks have also eased, and the euro has surged to $1.10 as of the writing of this commentary, from less than $1 in October 2022. A stronger euro helps reduce the price of imported goods, including energy, for their residents.
China reported strong first quarter economic growth that was a direct result of Beijing lifting its heavy-handed Covid-19 policies. Investors are hopeful that a revival in China’s economic growth will buoy the global economy as the U.S. and Eurozone economies slow. Much of the first quarter growth was driven by Chinese consumers, who began shopping, eating out, and traveling again after almost three years of stringent restrictions on daily life. China’s economy also benefited from government investment in infrastructure and a surprise pickup in exports.
Somewhat surprisingly, inflation in China eased for the second straight month in March despite the aforementioned signs of a pickup in its economy. This gave investors pause as to the strength and sustainability of the country’s economic recovery as it emerges from nearly three years of strict Covid-19 controls. This is because the lackluster inflation reading suggests the lifting of Covid controls in China is not generating the kind of price pressures that drove inflation sharply higher in the U.S., Europe and other major economies where growth accelerated after the worst of the pandemic passed. Weakness in China’s labor market, which tends to limit price growth, likely explains a lot of the lackluster inflation. Unemployment in China, especially among young people, remains stubbornly high.
So, as usual, the world is fraught with uncertainty. Nothing new on that front. Long time readers of this commentary will not be surprised to hear that, despite today’s uncertainty, we remain cautiously optimistic that the long-term growth trajectory is up and to the right, but equally confident that the road between now and then will be filled with landmines.
You will recall that we began this commentary by stating that the intent of our investment policy is to prepare your portfolio so that it can handle anything that happens. We believe this policy helps you to avoid the pitfalls many investors fall into, the biggest culprit of which is attempting to time the markets. Another benefit of this policy that we do not talk enough about, and perhaps we should, is that it is meant to give you peace of mind so you can enjoy the process of accumulating wealth, spend your hard-earned money, and/or share it with your loved ones and/or important causes. Our financial-planning-driven investment policy is envisioned to serve as a framework for developing an asset allocation, as well as to allow you to spend your money guilt-free within the confines of a financial plan that is inherently conservative in its underlying assumptions. At the end of the day, the only promises we can make are that markets are inherently volatile and life is short. If our investment policy helps you enjoy the ride just a little bit more, we take comfort in knowing that we are doing our jobs.
Urban Financial Advisory Corporation – April 2023
Disclaimer:
Although we believe our sources to be reliable and accurate, we assume no responsibility for the accuracy of such third‐party data and the impact, financial or otherwise, it may have upon any client’s conclusions. Urban Financial Advisory Corporation has not audited or otherwise verified this information and accepts no liability for loss arising from the use of this material. The information contained in this document is current as of the date indicated. Urban Financial Advisory Corporation undertakes no obligation to update such information as of a more recent date. Any opinions expressed are our current opinions only. Nothing herein should be construed as investment, legal, tax or ERISA advice. You should consult with your independent lawyer, accountant or other advisors as to investment, legal, tax, ERISA and related matters to which it may be subject under the laws of the country of residence or domicile concerning the acquisition, holding or disposition of any investment in the account. Past performance is not indicative of future results. All investments involve risk including the loss of principal.