|Barclays US Agg Bond Index||2.96%|
Stocks started 2023 strong with the S&P 500 up over 7% and the Nasdaq up nearly 17%, its best quarter since 2020. Frothy stocks led the way but two factors poured cold water on the rally: hotter-than-expected inflation and trouble in the banking sector.
Despite losses last year, equity valuations remain at elevated levels. I think inflation will continue to come in hotter than expected unless we enter a recession. Sustained high inflation will force the Fed to hike rates higher and keep them there longer than is currently priced in the market. However, the recent bank failures and issues they’ve unearthed may be the canary in the coal mine signaling that the US economy is on the brink of a recession.
Either way, equities are in for pain. I believe that preserving capital and taking advantage of higher short-term rates is the best path forward. This allows an investor to earn a reasonable return while waiting for a better risk/reward environment in the future.
Many investors expected a rapid decline in inflation in 2023. For instance, commodity prices dropped significantly from their 2022 peak. The Bloomberg Commodity Index is down 20%:
Source: JP Morgan Asset Management
The drop was even more pronounced in the energy sector. Crude oil is down nearly 40% and natural gas is down more than 75% since last June. Even with commodities selling off, inflation has remained hot. February’s CPI inflation number came in at an annualized level of 6%. Core inflation, which excludes food and energy, came in at 5.5%.
As I stated in my last quarterly letter, there are technicalities in the way inflation is calculated that will prove sticky. For instance, the shelter component of CPI is virtually guaranteed to be a significant contributor to inflation in 2023. The following chart shows changes in yearly rent vs the shelter component of CPI:
The chart shows that in 2021 and 2022, as rents (blue line) were spiking, the shelter component of CPI (orange line) was drastically understating those increases. Shelter CPI is reported with a lag; thus, the shelter component of CPI is now higher than rent increases and is likely to remain a significant component of core inflation in the upcoming months. Shelter drove more than 70% of the CPI inflation in February.
The renewed jump in oil prices won’t help either. OPEC+ announced a significant production cut over the first weekend of April. That caused crude oil prices to jump over $80 per barrel, up from the mid $60s per barrel earlier in March.
Inflation remains the primary focus of the Fed. In late March, Jerome Powell said, “We have to bring inflation down to 2%. There are real costs to bringing it down to 2% but the costs of failing are much higher.” Hence, I continue to believe that rates will stay higher for longer than the market expects unless we enter a recession.
The US saw two large regional banks fail in March: Silicon Valley Bank (SVB) and Signature Bank (SBNY). Both banks were among the top 25 largest banks in terms of deposit size (although both were small compared to the 4 largest US banks). These failures caused anxiety on Wall Street and Main Street alike.
The steep interest rate hikes have had a serious impact on all banks. At first rising rates appeared to have a positive impact as banks reported improved profitability. The interest they were paying depositors was not going up as quickly as the yield they earned on their investments.
However, the rise in rates caused the value of the holdings of these banks to plummet. A large portion of those losses went unrealized as banks classify them as long-term held-to-maturity assets, meaning they don’t mark them to fair value. If banks could continue to pay low interest rates to depositors and allow their held-to-maturity assets to mature, there would be no issue. When depositors seek yield elsewhere, those unrealized losses have the potential to become problematic. Once depositors pull enough money from a bank, it is forced to sell their held-to-maturity assets and realize those previously hidden losses. That can leave a hole in the bank’s capital and damage the perception of the bank, in turn precipitating a bank run.
Unrealized losses are currently a problem for most banks to some degree, but the majority have hedged a large portion of that risk and still have some equity capital to cushion them. Not so with Silicon Valley Bank (SVB). The following chart shows what happens to banks’ tier 1 capital after adjusting for unrealized losses through the end of Q4’22:
As the chart shows, SVB’s capital cushion was wiped out when accounting for unrealized losses. Digging into their financials it is clear that, unlike virtually every other bank, SVB did not hedge its portfolio against rising interest rates at all. That’s a pretty stunning lack of risk management.
The following chart from Michael Burry, famed investor from The Big Short, shows SVB and Signature Bank (SBNY) were risky outliers amongst banks. They had the highest percentage of uninsured depositors and the highest unrealized losses as a percentage of tier 1 capital.
In a nutshell, the banks at the top and the right of the chart were in the riskiest position. I find it noteworthy that the next bank in the upper right quadrant that hasn’t failed is FRC or First Republic Bank. First Republic Bank’s stock is down 90% year-to-date and has been struggling to stay alive as depositors flee the bank.
Systemic Risk or Idiosyncratic Examples of Poor Risk Management?
Most of what I’ve discussed so far suggests the problems in the banking sector have been limited to banks with poor risk management. The banking sector underwent massive overhauls following its issues during the great recession. The whole sector is much better capitalized than it was during 2008. By all accounts, lending standards have been substantially improved and loan portfolios have not had credit issues thus far.
However, the more I think about the implications of these bank failures, the more I worry about a broader slowdown in the economy. First, let’s consider other regional banks. As Warren Buffett said, “There’s never just one cockroach in the kitchen when you start looking around.” The BKW regional bank stock index just hit a new low on April 5th, falling below its prior March 23rd low. Despite the measures the Fed has taken to prop up other banks, this tells you investors still have serious concerns.
If you have significant excess savings at a bank, why wouldn’t you move it out of a low-yielding savings account into a treasury or money market account that yields 3.5-4%? Not only does the alternative yield more but you have no concerns over your bank’s health. With the advent of mobile banking, you can make that transfer in a few minutes from your couch. The data shows that consumers have begun doing exactly that:
Nearly all banks are seeing depositor outflows. In response, banks are tightening their lending standards. The following chart shows the huge spike in banks increasing their lending standards through the end of 2022:
That trend likely accelerated during the first quarter of 2023. Jerome Powell confirmed that the Fed expects the turmoil to impact the economy: “Events in the banking system over the past two weeks are likely to result in tighter credit conditions for households and businesses.”
Commercial real estate is expected to experience significant disruptions in this new environment. Roughly 50% of the $2.9 trillion commercial real estate mortgage market will have to be refinanced in the next 2 years. Regional banks made 70-80% of those loans. New lending rates are likely to be 350-450 basis points higher than the loans they’re replacing. The environment is so bad that even normally bullish Wall Street firms are expecting a major downturn. Morgan Stanley’s chief investment officer said they’re expecting a peak-to-trough decline of 40% in commercial real estate prices, a loss greater than the sector experienced during the great recession.
My north star guiding investment allocation is valuation. The US Stock market remains expensive, coming off the bubble levels it achieved in late 2021. It would defy history for the market to reach such an extreme without a more significant drawdown. On top of that, I’ve found very few individual opportunities in equities outside of selected emerging market values.
I think we’re at a crossroads with both paths leading to pain for investors. Down one road the economy remains resilient, employment remains strong, the consumer keeps spending, inflation remains elevated, and the Fed will be forced to keep rates higher for longer. That seems to be the path the Fed expects. Fed Bank of Cleveland President Loretta Mester said on April 4th that she expects the “fed funds rate moving above 5% and the real fed funds rate staying in positive territory for some time.” Sustained high inflation has not been a kind environment for equities in the past.
Down the other road lies a potentially ugly recession. Virtually every box you’d expect before a major recession is ticked: inverted yield curve, Conference Board Leading Economic Index down, slow down in residential housing construction/permits, manufacturing indices and new orders in negative territory, consumer confidence at lows, etc.
I continue to believe the only prudent approach in this environment is a conservative one. Keeping equity exposure low helps preserve capital to take advantage of better opportunities in the future. Fortunately, rate hikes have left short-term treasuries as a reasonable option to earn a return while waiting for better future opportunities.
Scott Caufield, CFA, CPA