Summary of Key Points:
Despite the stress in the banking system, including the second-largest bank failure in U.S. history (Silicon Valley Bank), global equity markets held up remarkably well in March and posted solid returns for the quarter.
The S&P 500 index was up 3.7% in March and gained 7.5% in the first quarter. Developed international stocks did a bit better, rising 8.5% for the quarter (and returned 2.5% in March). Emerging markets stocks gained 4% for the quarter and rose 3% in March.
Underneath the calm market surface, there was a wide dispersion in returns across sectors, market caps and styles. Large-cap growth stocks gained 14.4% in the quarter, while the large-cap value index returned 1%. The Nasdaq Composite surged 17%, while the Russell 2000 Small Cap Value Index dropped 0.7%. The Technology and Communications Services sectors gained 21.8% and 20.5%, respectively, while Financials and Energy lost 5.6% and 4.7%, respectively.
Fixed-income markets had a strong quarter as longer-term bond yields fell, generating price gains. Core investment-grade bonds (Bloomberg U.S. Aggregate Bond Index) returned 3%, as the 10-year Treasury yield fell to 3.5% from 3.9% at year-end. Riskier high-yield bonds outperformed core bonds gaining 3.7%. Municipal bonds gained 2.3%. Flexible/nontraditional bond funds gained around 3%.
Alternative strategies and nontraditional asset classes generally underperformed traditional stock and bond indexes for the quarter.
Quick Recap: The Silicon Valley Bank Failure – What Happened and Is This the Beginning of Another Great Financial Crisis?
By now, the story of the Silicon Valley Bank (SVB) failure is well known. But we think a quick recap is worthwhile as it sets the stage for our broader discussion of the macroeconomic backdrop and outlook below.
In a nutshell, SVB was a victim of a classic “bank run,” where depositors en masse seek to withdraw their money, but the bank doesn’t have the “liquidity” (the cash on hand) to meet their demands.
Importantly, SVB had unique characteristics that made it particularly susceptible to such a run. This is one reason why we and most economists/analysts do not see this as the beginning of a replay of the Great Financial Crisis (GFC) of 2008. But there clearly will be broader economic and financial market impacts, which we will discuss later in this commentary.
While SVB’s situation was unique, the seeds of the bank run, and the broader banking system stress now playing out, were planted with the Federal Reserve’s unprecedented monetary policy stimulus (quantitative easing and zero interest rates) in the years following the GFC and then turbocharged by the pandemic stimulus. The damage has come from the Fed embarking on its most aggressive monetary policy tightening in 50 years – hiking interest rates from 0% to 4.75% over the past 12 months.
As all bond investors painfully experienced last year, sharply rising interest rates caused sharp declines in core bond prices (the worst declines in U.S. bond market history). This includes Treasury bonds and government agency mortgage-backed securities (MBS) – where many banks invested some of their customers’ deposits.
All banks’ bond-holdings have been hurt by the sharp rise in rates/falling bond prices, but SVB was particularly exposed to this interest-rate risk (or bond “duration risk”) as the charts below show. SVB held an unusually large share of its assets in bonds, and those bonds had particularly long duration, i.e., they had a lot of duration risk, meaning their prices (values) were highly sensitive to changes in interest rates. As such, SVB faced extremely large unrealized losses on their bond portfolio, which the bank had purchased when interest rates were much lower/prices were much higher.
In addition to SVB’s exposure to unrealized losses in its bond holdings, it also had two other unique susceptibilities to a bank run: (1) a highly concentrated depositor base comprised of start-up tech, venture capital firms and the like; and (2) almost its entire depositor base was above the FDIC insurance coverage limit of $250,000 per account. As shown in the chart below, a whopping 90% of SVB’s total deposit base was FDIC uninsured at year-end 2022. (Note that Signature Bank of NY (SBNY), the other regional bank taken over by the FDIC, also had roughly 90% of uninsured deposits.
Combined, these characteristics of SVB caused some of their concentrated, large, uninsured depositors to start pulling their money from the bank, which in turn forced SVB to raise capital (liquidity) to meet the withdrawals, which meant SVB had to sell bonds at losses (and/or raise equity capital), turning the unrealized losses on their balance sheet into realized losses, raising the question of not only liquidity risk for the bank but solvency/bankruptcy risk, leading to even more depositor flight, etc., until the FDIC and Fed stepped in over the weekend of March 11 to take over the bank, guarantee all SVB deposits above $250,000, and set up a broad banking system liquidity backstop (the Bank Term Funding Program (BTFP)).
The BTFP allows banks to borrow from the Fed for up to a year, based on the issued face value (par value) of their Treasury bonds and agency MBS, rather than the current (lower) market value. This new facility, as well as the Fed’s decision to ease the lending terms on its existing “discount window” short-term (90-day) lending facility, enables banks to meet deposit withdrawals and other liquidity needs without having to sell currently underwater bonds at a loss. As the chart below shows, banks have taken the Fed up on its offer, and then some.
While the banking system is not out of the woods, and there may be smaller-bank takeovers, it seems these steps and subsequent actions from authorities have stemmed the risk of widespread bank-run contagion.
More broadly, as to why we don’t see this as likely the beginning of “GFC 2.0,” we’d highlight the following key differences between now and then:
1| The GFC was the result of a self-reinforcing negative spiral involving credit risk and counterparty risk. Banks and other financial institutions lent hugely to unqualified borrowers (e.g., NINJA mortgages to homeowners with no income/no job/no assets) and the systemic risk was multiplied by the pervasive creation of financial derivatives based on such shoddy loans. As housing prices fell, the value of these loans collapsed, and banks had insufficient capital to handle the declines. This led to a credit crunch, which further fed the housing price decline and economic downturn, leading to further losses on loan values, further bank insolvency, etc. etc.
This time, the problem is not caused by poor lending standards (credit risk), exploding derivatives and weak bank balance sheets (although poor management of the failed banks is a common theme), but instead interest rate duration risk from the banks’ Treasury and agency bond holdings, whose values plunged as interest rates soared. There is no risk of default – no credit risk – in Treasuries and government agency MBS.
Further, in the current situation, as core bond yields have subsequently fallen in response to risk aversion and macro fears caused by the SVB crisis, the value of banks’ high-quality bond holdings have increased (unrealized losses have lessened). So, this seems more of a self-limiting feedback loop, very different from the self-perpetuating adverse feedback loop of the GFC.
2| (2) U.S. consumers in aggregate are now less leveraged and lending standards were tightened, especially in the housing market where regulations since the GFC have reduced loan-to-deposit ratios and raised loan qualification standards.
3| Banks are better capitalized now, particularly the very largest “systemically important” banks, due to tighter regulations since the GFC.
4| Having lived through 2008, the authorities (Fed, FDIC, Treasury) have acted relatively quickly and forcefully to stem the systemic contagion risk.
In the sections below, we provide an update on the macroeconomic environment, followed by our assessment and outlook for the financial markets.
Macro Outlook for 2023: Recession increasingly likely over the next 12 months
We frame the macroeconomic backdrop and outlook across two dimensions: inflation and GDP growth.
The bottom line is this: (1) U.S. inflation remains too high but very likely to decline significantly over the year; (2) U.S. economic growth is well below trend and although positive in the first quarter is likely to tip negative later this year.
Although inflation peaked last year and has come down, it remains much too high for the Fed’s 2% long-term target. February’s year-over-year core CPI inflation rate was 5.5%, while core CPE inflation – the Fed’s preferred measure – clocked in at 4.6%.
As we noted at year-end, it is the services component of inflation that is the concern now; price hikes for consumer goods have dropped dramatically as supply and demand have come into balance after the pandemic-era dislocations.
There are good reasons to expect core CPI services inflation to recede as the year goes on. The largest component of the core services inflation basket is shelter, which includes housing rental prices. Given the slowdown in the housing market over the past year as well as real-time measures of rent declines, most economists expect shelter inflation to moderate over the course of the year.
As such, the Fed has continued its rate hiking campaign this year, although the magnitude of the rate hikes has diminished. At its March 22 FOMC meeting, the Fed hiked its federal funds policy rate by 25 basis points (0.25%) to a range of 4.75% to 5.0%. This was the consensus expectation, although a meaningful portion of market participants thought the Fed might not hike at all, given the upheaval in the banking sector. The Fed’s inflation concerns won out over worries about exacerbating the banking stress.
This was the Fed’s ninth consecutive hike since March 2022, representing a total tightening of 475bps (4.75 percentage points). As noted above, this is the most aggressive monetary policy tightening campaign since the Paul Volcker days in the early 1980s. It was inevitable something (in this case, SVB and other poorly managed banks) would “break” given the magnitude and speed of the hikes.
The Fed is still hoping they can land the economy softly without causing much more damage, let alone a recession. It’s not impossible, but the odds are low, and history is not on their side given the complexity of the task and the multitude of economic and behavioral variables outside of their control.
As of the March meeting, the median FOMC participant projects just one more 25bp rate hike this year to a range of 5.0% to 5.25%, and then 75bps of rate cuts in 2024. The FOMC median projects core PCE inflation falling to 3.6% this year and 2.6% by the end of 2024. If the Fed projections play out (a big if), that implies a real (inflation adjusted) fed funds rate of 1.5%, which the Fed would consider restrictive/tight. The Fed’s assumption for the long run “neutral” (neither loose nor tight) real fed funds rate is 0.5%, comprised of 2% core inflation and a 2.5% nominal fed funds rate.
The Labor Market
The largest input cost for most businesses, and services businesses in particular, is wages. Wages in turn are partly a function of inflation expectations, which can feed into a self-reinforcing wage-price spiral — the Fed’s biggest fear.
While wage inflation appears to have peaked and has started to fall, February’s 6.1% year-over-year wage growth reading is still much too high to be consistent with the Fed’s 2% core inflation target.
Put differently, the labor market still is too tight (as Jerome Powell has repeatedly said); there is too much demand for workers relative to their supply. The ratio of Job Openings to Unemployed workers is one measure of labor demand (job openings) versus supply (unemployed workers). It remains near all-time highs, with 1.9 job openings per unemployed worker.
The Fed’s hope is that tighter monetary policy will reduce the number of job openings, relieving the pressure on wages without causing a big increase in actual layoffs and unemployment. That’s a possibility given the unprecedented number of job openings relative to very low unemployment. We’d also point out the Fed itself is projecting roughly a 1% increase in the unemployment rate this year. This is a significant increase and based on historical relationships would imply the economy falls into a recession.
A significant bright spot in the inflation picture continues to be the stability of medium- and longer-term inflation expectations, which, as shown in the chart below, have remained in the 2-3% range, right where the Fed wants them. Shorter-term inflation expectations, which are more volatile and highly sensitive to gasoline prices, have also dropped.
Inflation expectations are crucial because if they become un-anchored, they can feed into a self-reinforcing, inflationary wage-price spiral – where wage and price hikes feed into higher inflationary expectations, which feed into further wage and price hikes, etc. This was the inflationary regime that Fed Chair Paul Volcker had to break in the early 1980s with double-digit interest rates.
With above-normal inflation and the Fed sharply tightening, the short-term outlook for economic growth was already poor coming into the year. Add to that the negative impact from tighter credit conditions due to the recent banking stress, and the growth outlook has gotten worse. How much worse isn’t clear. But it definitely hasn’t improved the chance of avoiding a near-term recession.
The FOMC’s updated economic projections from March showed a further reduction in their GDP growth expectation for 2023, to just 0.4%. Given the first quarter’s GDP growth will likely be solidly positive, this implies negative GDP growth for the rest of the year.
The FOMC left its unemployment rate forecast roughly unchanged at 4.5% for this year. If that occurs, history strongly suggests a recession is likely. Since 1950, there has never been an instance where the U.S. unemployment rate increased by a half percentage point or more from its cyclical low without an accompanying recession. The unemployment rate bottomed out at 3.4% in January 2023 and was 3.6% in February.
In addition, two leading indicators with long track records continue to signal a recession is coming sooner than later. The Conference Board Leading Economic Index (LEI) has declined for 11 straight months and its rate of change is clearly in recessionary territory. As we’ve said before, no economic or market leading indicator is 100% predictive. But in terms of recession probabilities, based on the weight of the evidence, we believe the odds are tilted strongly in that direction.
The second recession indicator is the inverted Treasury yield curve – meaning short-term Treasury yields are above longer-term Treasury bond yields. An inverted yield curve is unusual and usually (but not always) a leading indicator of recession. Also, the timing from initial curve inversion to the onset of recession has been highly variable. But as with the LEI, the current degree of inversion has never occurred without a subsequent recession in the U.S.
With the banking system turmoil, we will add another historical recessionary indicator to our list: bank lending standards. Bank lending standards are a leading indicator of credit conditions, which in turn impact economic growth. The chart below shows the results of the Federal Reserve’s long-standing Senior Loan Officer Survey through January 2023. It shows there had been a sharp tightening in consumer lending standards even prior to the SVB collapse, to levels consistent with recession in previous instances.
There seems little doubt that bank lending standards and credit conditions will tighten further in the days and weeks ahead as most banks conserve capital and liquidity, boost deposit rates (to retain deposits fleeing to higher-yielding money market funds) and generally face higher overall funding costs.
That will weigh on business investment and consumer spending, i.e., overall economic growth. For example, Goldman Sachs’ economists estimate that tighter lending standards among small and midsize banks will cause a ¼ to ½ percentage point drag on U.S. GDP growth this year than would otherwise have been the case.
However, all is not gloom and doom for the economy. And, because the future is inherently uncertain, we always consider a range of scenarios when forming our investment views and constructing diversified investment portfolios.
On the positive side, as we noted above, the U.S. and other major global economies appear to have grown in the first quarter of the year. The Purchasing Managers Indexes (PMI) improved in February and March, indicating the U.S., Europe, Japan and China are all currently in expansionary territory (PMIs above 50). The Economic Surprise indexes for these regions are also in strongly positive territory, indicating recent economic data points in aggregate have been much better than the consensus expected. Household and business balance sheets remain healthy and supportive of continued spending. U.S. households are still sitting on an estimated $1.4 trillion in pandemic-era savings. Employment remains robust, with a stronger than expected 311,000 new jobs (nonfarm payrolls) in February, following the shockingly strong 504,000 jump in January. Real disposable income is rising as wage growth is now stronger than CPI inflation. Even if a recession plays out, these are all reasons to believe it may be relatively mild (although that is little solace to anyone who loses their job as a result).
Macro bottom line
A U.S. recession this year is not a certainty. But weighing the evidence, a recessionary path has become more likely with the banking system stress of the past few weeks.
Financial Markets Outlook
In an economic recession, it is almost certain corporate earnings will decline, i.e., an “earnings recession.” S&P 500 index earnings typically decline around 15% to 20% (peak-to-trough) during economic recessions as both sales growth and profit margins compress. In a mild recession, the earnings decline might be closer to 10% to 15%. Yet, the current consensus earnings expectations for 2023 do not reflect that magnitude of decline.
As such, from a 12-month perspective, we are once again quite cautious of global equities following their recent recovery. We do not believe the S&P 500 is adequately discounting the likelihood and severity of an oncoming earnings recession.
We still see U.S. stocks likely to generate mid-single digit annualized returns over the longer-term. This is a decent but not great expected return for U.S. stocks given their risks. It may also prove to be inferior to developed international and emerging markets (EM) equities of high single to low double-digit annual average returns.
Foreign Equities Absolute Valuations Remain Attractive and at a Deep Discount to U.S. Stocks
When the U.S. stock market declines to levels that offer more compelling medium-term returns and adequately discount shorter-term risks, we will look to add back exposure by selling more-defensive assets (bonds). This typically happens during a recession when investor pessimism and fear are widespread. Eventually, stocks bottom out and then start to rebound as investors anticipate an earnings growth recovery. And the next cycle and bull market begins.
Fixed Income/Core Bonds
The relative valuation/attractiveness of U.S. stocks versus core bonds (known as the “equity risk premium”) continues to favor bonds slightly relative to historical averages, as shown in the first chart below. To revert to a more normal, i.e., higher, equity risk premium will require either a decline in equity valuations, lower bond yields, or some combination of the two.
As the Fed has continued to raise short-term interest rates, the yield premium between stocks and “cash” (short-term Treasury bills) has shrunk even further since year-end, as the second chart below shows. It’s possible that if we tactically reduce our stock exposure, we’d put the proceeds into cash.
In addition to our core bond exposure, we continue to have a meaningful allocation to higher yielding, actively managed, flexible bond funds run by experienced teams with broad investment opportunity sets. There are many fixed-income sectors outside of traditional core bonds that offer attractive risk-return potential, and we want to access them via our active managers.
In general, we see the events of March not just as a reminder of risks but rather as a necessary and expected by-product of the current monetary tightening cycle. Higher rates eventually tend to leave real wounds in the financial system. However, tighter financial conditions are essential for getting inflation under control.
Overall, our allocations remain neutral among equity and fixed income. Following historically speedy and aggressive monetary tightening, it was only a matter of time until we might see something along the lines of the recent banking sector turmoil. We expect major central banks, led by the Fed and the ECB, to await firm evidence of inflationary pressures easing before contemplating any interest rate cuts. While accidents can never be fully ruled out at such delicate turning points, we continue to think that a full-blown credit crunch is very unlikely. There will be a tightening of lending standards, which looks set to be both painful – and necessary.
A lot still depends on the Fed and how much further they tighten (raise rates). If the Fed pauses their hiking campaign sooner than later, equities may positively respond (at least over the short-term), as lower interest rates imply higher P/E multiples. But there are numerous other key variables for the economy and financial markets that are beyond the Fed’s or any policymaker’s control. A recession may be pushed out to 2024, but we doubt it’s been rescinded.
Fixed-income assets and high-quality bonds are also now attractively priced with mid-single digit or better expected returns, depending on duration and credit quality. Core bonds will also provide valuable portfolio ballast in the event of a recessionary bear market. Our investments in alternative strategies should provide further resilience to our portfolios.
Certain material in this work is proprietary to and copyrighted by Litman Gregory Analytics and is used by Argent Financial Group with permission. Reproduction or distribution of this material is prohibited, and all rights are reserved. Argent Financial Group is the parent company of Argent Trust, Heritage Trust and AmeriTrust.