The first quarter of 2023 was an interesting one to say the least. While the rapid collapse of Silicon Valley Bank and the shock to the regional banking sector were surprises, the fact that something in the financial markets broke as a result of the unprecedented Fed tightening should NOT be a surprise. Over the prior two decades, monetary policy had been conducted with an eye toward the Fed’s “dual mandate” of price stability and full employment. Without any material threats to price stability from inflation during that time, the employment component of the Fed’s mandate drove much of the policymaking, and market participants became ever more reliant on the Fed’s implicit support. First called the “Greenspan put” and then just the “Fed put,” the easing program following the burst of the dot-com bubble, the quantitative easing and rate decreases executed during the Financial Crisis and the unprecedented support during the Covid-19 pandemic provided a pretty reliable pattern for a generation of market participants.
The highest levels of US inflation since the 1980s has changed those priorities dramatically, and we are now beginning to see some of the impacts of that sharp turn. While Silicon Valley Bank was an outlier in the size and industry concentration of its uninsured depositor base, the larger problem facing them – and all banks – is that they own loans and other assets paying them low-yields, while pressure on their funding costs (deposits primarily) has risen dramatically. Banks in general face a very difficult choice: either raise deposit rates dramatically and potentially become unprofitable or maintain low deposit rates and hope (which is never a good strategy) that customers simply accept low-yields. In Silicon Valley Bank’s case, the depositors were using their cash balances to fund operations for longer time periods without the ability to replenish those deposits through IPOs or other liquidity events. In other cases, deposits left banks in search of higher yields in money market funds or T-Bills. In both cases, banks have been left with portfolios of lower-yielding assets that incur losses, when sold to meet withdrawals, from deposit outflows.
Fortunately, the Fed recognized the need to stabilize the U.S. banking system, and it intervened in several ways to mitigate the risk of contagion spreading across the banking sector. While the Fed has provided the necessary liquidity to the banking system to meet any withdrawals and has assured depositors that their money is safe, the story is not over. Regional bank stocks remain under pressure, as investors work to ascertain which institutions will emerge intact and independent, and which will not. Most likely, stronger competitors will acquire the weakened players in part, as was the case with Silicon Valley and Signature Bank, or in whole through acquisition. The digitization of the banking systems facilitated rapid deposit withdrawals and has advanced far quicker than regulation can adapt. These changes will need to be addressed to ensure staying power in the regional banking system.
Despite early and frequent reports of its demise, the U.S. economy continues to chug along, showing more signs of strength than one would expect given the Fed’s aggressive posture. The labor market is confoundingly strong and stable, personal income and industrial production are still growing and consumer confidence has been relatively unchanged over the last year. Simultaneously, 60-65% of economists still believe the United States is headed for a recession. They have noted that the shape of the U.S. Treasury yield curve is inverted to an extent that has almost always predicted a recession. Consumers drive the majority of U.S. economic activity, so until their spending patterns change materially (they haven’t yet), they lose their jobs (tech jobs primarily impacted) or they are overleveraged and concerned (not at this point). The catalyst for a real economic contraction is not obvious. The upcoming corporate earnings cycle will shed more light on early 2023 sector-by-sector consumer and industrial activity. However, the impact of the SVB collapse and significantly tighter lending conditions is too fresh to gauge. The regional and community banking sector hit the hardest by the SVB collapse is the sector that lends to small businesses. As small businesses (less than 500 employees) employ nearly 50% of the U.S. workforce, the impact on this sector from substantially tighter financial conditions (both higher rates and constrained lending) will be an important factor in the next several months.
Although 2023 has been volatile, the S&P 500 is near its high for the year and has not been negative for the year since January 5, even during the depths of the Silicon Valley Bank collapse. Stubbornly positive U.S. economic performance (stubborn for those who called for recession already), very limited earnings downgrades and – most importantly – market expectations of an end to the Fed’s tightening program have allowed equity valuations to remain elevated. This is the quandary. The Fed has indicated that tightening will cease when they see a clear trajectory back to 2% core inflation, which, given how far we are from that level, arguably requires a contraction in the U.S. economy, which should be bad for stocks and consumers in general. Forward price-earnings multiples ended the quarter around 18x, based on what we believe to be elevated earnings expectations. The valuation and elevated earnings expectations do not reflect tighter financial conditions and/or recession risk. Thus, we continue to believe that patience is warranted and that there will be a more attractive entry point sometime during 2023 for investors looking to add equity exposure.
The bond market and its volatility were the headline acts in Q1. The two-year U.S. Treasury rose to 5.06% from 4.37% in the first two months, as the market’s Fed view became increasingly hawkish and then crashed to a low of 3.77% following the SVB collapse in late March before recovering to 4.06% to close the quarter. To put the volatility in a historical perspective, the three-day decline in that yield post-SVB collapse was the largest move over that time period since the stock market crash of 1987.
Somewhat remarkably, credit spreads saw only limited movement as a result of the SVB collapse and ensuing volatility in the regional bank sector. Credit spreads in both investment grade and high-yield bonds remain near their long-term medians, which reinforces our concern that there is more downside than upside in taking credit risk at today’s valuations.
Volatility aside, current pricing in the bond market implies that the Fed will begin to ease rates later in 2023 and continue to ease in 2024. That does not exactly align with what the Fed has been saying, though, so investors are left with another quandary. Financial conditions are considerably tighter today than they were prior to the SVB crash, as an accelerated contraction in lending has added to the already tight conditions created by higher rates and the Fed’s quantitative tightening program. The Fed will likely need more concrete data that demonstrates declining inflation before it can credibly change its hawkish tone. Even with the decline in short-term yields post-SVB, T-Bills and T-Notes maturing in the next three years continue to present an opportunity for investors. They have the potential to generate a low-risk return on cash, while waiting for an attractive entry point in equities or to use as a “holding tank” for future obligations such as private fund capital calls.
Some of the strongest vintage years for private funds are in periods coming out of crisis or significant weakness. Valuations have contracted dramatically over the last year, and we continue to believe that entry pricing for the equity and debt of good businesses and projects will create a strong opportunity set for skilled managers. At the same time, existing funds are suffering mark-to-market adjustments and extending their hold periods, as exit opportunities have narrowed. One key advantage of the private markets is patience, so skilled teams will focus on continuing to grow the values of their holdings and wait for a more favorable environment for their exits. Within private markets, real estate is an area under particular scrutiny, as the math of cap rates and financing have changed with increased interest rates, and the structural shift to remote work has dramatically changed intra-sector relationships. Overall, the country has too much dense urban office space and too little housing, which creates both risks and opportunities in the marketplace. We continue to believe that skilled teams with a strategic focus and responsibly underwritten projects will create value for investors, and there is likely to be greater differentiation among strategies and managers in future years.