INSIGHTS

On March 13, 2023

The Confidence Game

This morning, many have quipped that the scene at Silicon Valley Bank (SVB) reminded them of last night’s Oscar winner for best picture, “Everything, Everywhere, All at Once.” There is a better Oscar winner that is more reflective; in a scene akin to a modern-day version of the bank run in the holiday classic “It’s a Wonderful Life,” the rapid collapse of SVB last Friday was in many ways a symptom and casualty of the Fed’s 12-month campaign of rapid rate increases to combat inflation. The speed of the SVB collapse created concerns of further contagion across the banking sector. As that fear began to grow it translated into a broader selloff of bank stocks, which dragged the overall stock market down about 5% with a flight to quality to Treasuries, causing yields to drop a significant 50 bps (basis points) by week’s end. At Friday’s close, investors were still in the dark as to how it would play out.

The fact that this occurred on a Friday was probably a lucky break as it gave regulators, the Federal Deposit Insurance Corporation (FDIC) and potential suitors a bit of time to try and figure out the best way to prevent the fear of contagion from becoming a reality. We know now that the government has stepped in to ensure that all depositors at SVB and Signature Bank (a weekend casualty) will have access to all their funds whether they were insured or not. The Fed also announced a new facility, the Bank Term Funding Program (BTFP). This facility allows banks to tap one-year loans from the Fed while allowing the collateral banks post to be marked at original cost, as opposed to markets helping alleviate some of the strain of unrealized losses on those securities.

The event is being described as “idiosyncratic” as SVB had a business model concentrated on lending and taking deposits to and from venture capital businesses. Because the bank began to lose deposits as venture capital firms withdrew cash to cover cashflow burn at their own firms, SVB needed to sell some of its Treasury bonds to cover the shrinking deposit base. The problem was, they had to take a $1.8 billion loss on the sale as the bonds had dropped in price due to the Fed-induced rate increases over the last year. The reported loss induced further panic by depositors creating the run on the bank.

While idiosyncratic in many respects, the situation and speed of SVB’s fall jolted the market’s overall confidence in the banking sector.

With the recently installed Fed program and blanket SVB depositor guaranty, the market is still looking for its footing. Spreads widened by 12 bps on CDs which wasn’t a blowout (a positive sign), however, as we have been arguing for some time, we think spreads are still too tight in any event given our expectation that the Fed action would likely lead to a recession sometime later this year. The question now is, are these new actions enough to stop a contagion spreading to other banks? Depositors at other, smaller regional banks have yet to provide clear assurance that their uninsured deposits will be covered if contagion arises. That said, it is important to remember that the U.S. banking system is in much stronger shape then before the Great Financial Crisis (note Barron’s ran a positive article on the big banks this weekend).

Capital buffers, diversity of depositors and risk management are more robust, and the large banks run stress tests more severe than the situation that is playing out. So, it is indeed very much a confidence game at this point. Understanding this, President Biden did just state that, “We will do whatever it takes” (another throwback to the Great Financial Crisis uttered by then-European Central Bank Chief Mario Draghi). Has the government done enough to instill broad confidence throughout the system? We think this is still the question and that volatility will remain elevated until the market is sure the issue is put to bed. For now, the market is recovering but it would not be surprising to see further volatility and more assurances and programs put in place if volatility spikes further.

Taking a step back, our view of the bigger picture has not dramatically changed. The regime change brought about by sticky inflation that lingers for longer and a Fed that goes further and faster entered a new phase this year as the dramatic rate increases from 2022 begin to bite. The SVB situation likely causes a further headwind for bank lending as banks need to focus on their liquidity, risk management and figuring out how to manage the yield increases on deposits that are being forced into their income statements due to the death of “TINA.” Our not-too-pleasant thesis of a risk of the Fed tightening until something breaks is still real and the Fed is in a tough position. If they stop raising rates here the question is, “Will inflation remain even higher down the road (“stop and start” scenario)? If they keep going, do they risk more “breakage” and further unintended consequences? The market is unsure at this moment having now priced in better odds for no hike at the next meeting instead of the 50 bps that seemed like a sure thing a week ago. The market bet today is that the terminal rate will still reach about 5%, implying that the immediate issue will abate, the Fed will get to where it forecasted at thelast meeting. There still is a wide range of uncertainty but what is clear is that we should expect volatility to remain elevated for the balance of the cycle given the complex dynamics borne from the regime change we have been talking about for the past two years.

The three investment themes we created at the end of last year were meant to be a durable guide on how to position for this next phase of the regime change. We believe these themes remain germane, by design. And even though the market has given back much of its gains, it is still close to flat on the year providing an opportunity to act on repositioning portfolios toward resiliency throughout the next phases of the regime change.

As a reminder, our core three investment themes are:

• Mitigating an Era of Elevated Volatility
  • Expect continued volatility, muted returns
• Overcoming Persistent Inflation/Higher rates that “Linger for Longer”
  • Inflation remains sticky/Fed reaches terminal rate
• Mitigating the Impacts of a Slowing Economy
  • Fed tightening leads to an economic stall, U.S. dollar ultimately weakens

We believe the key focus to creating resiliency in portfolios is to emphasize quality, income generation and predictable sources of return, portfolio diversity and active management.

Last week’s event is a reminder that building a resilient portfolio is paramount given the new regime we are living in.

CRN: 2023-0313-10736 R