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interest rates

Where Oceans Meet but Don’t Mix

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He released the two seas, meeting side by side. Between them is a barrier neither of them can transgress.

– The quran 55:19-21

Financial markets work in cycles.

Some cycles are short, lasting only hours. Like those following Fed meetings.

Others, however, last decades.

And when longer-term investment cycles change, things don’t always mix well.

Like many characteristics of financial markets, we see this phenomenon in nature as well.

What implications will this transition of investment cycles have on financial markets?

The Meeting of Oceans

At the southern tip of South Africa, the warm currents of the Indian Ocean meet the frigid currents of the Atlantic Ocean, as seen in the illustration below.

The dividing line between the Atlantic ocean and the Indian ocean is similar to when long-term investment cycles change.

Unlike geographic boundaries, the dividing line where these two oceans meet is determined by the CONDITIONS on each side of the line.

And despite their proximity, the composition of nearly everything in each respective ocean is different from one another.

Lifeforms, currents, temperatures, and mineral composition of the water all differ depending on which side of the boundary you look.

What is common place and normal under one set of conditions is abnormal and unusual in the next cycle.

Today, we are dealing with the transition from a falling interest rate cycle to a rising one.

The investment cycle, much like the meeting point of the Atlantic and Indian Oceans, is a place where forces collide, currents shift, and the landscape changes in unpredictable ways.

The transition between cycles is not always a clean one, either.

It can be messy.

This is because with longer-term cycles, investors become engrained in their belief that the underlying causes of the previous market cycle will continue into the next cycle.

Inflation & Interest Rate Cycles

The cycle we’re dealing with today is the inflation and interest cycle.

Historically, the full cycle lasts 60 years.

That’s 30 years of rising rates followed by 30 years of declining rates.

We can see this cycle on our first the chart below, courtesy of Tom McClellan.

The declining interest rate cycle that likely ended last year is actually quite late getting started.

According to the 30-year cycle, rates should have begun moving higher in 2010.

But the Fed had a different idea, and placed their thumb on the scale to keep interest rates at zero for another decade.

The decline in rates began in 1982. And began moving higher again in 2022.

That’s 40 years of a financial tailwind of declining interest rates supporting higher and higher asset prices.

When interest rates fall, the cost of money decreases. And when the cost of money decreases, profits rise.

This creates a “virtuous circle” of investment, where the declining cost of debt makes investment projects more and more appealing as rates fall.

But the inverse is true also.

Rising interest rates push the cost of capital higher, putting downward pressure on profit margins.

This pressure on profits results in many stocks struggling to grow during rising rate environments, mostly due to the influence of interest rates on valuations.

Stock Valuations and Interest Rates

One of the easiest places to visualize the effect of interest rates on the stock market is via valuations.

The next chart shows a scatter plot of the P/E ratio of the S&P 500 versus the 10-year US Treasury yield.

The yield of the 10-year Treasury is shows on the x-axis from left to right. The y-axis is the forward P/E ratio of the S&P 500 index.

Each blue dot shows the P/E ratio at the end of each month for the past 20 years, along with the corresponding 10-year US Treasury yield.

What this chart tells us is that there is a DIRECT correlation between interest rates and valuations.

And the formula is pretty easy: higher rates = lower valuations.

Most of the market is respecting this phenomenon.

The “Magnificent 7” is a term used for the largest seven companies in the index: Apple, Microsoft, Amazon, Nvidia, Meta, Google and Tesla.

This “Magnificent 7” is still trading as if interest rates were almost zero.

In the chart above, the red dot shows these seven stocks.

At an average valuation of 29.5, they are 72% more expensive than the rest of the S&P 500.

They may have better future growth prospects than other stocks, but this is still a very obvious data point where investors are assuming the lessons of the previous cycle will repeat in the next one.

The implication is that at some point in the next few months or years we should see reality start to set in for these big tech stocks.

That means that eventually we will start to see mid-caps, small-caps, international stocks and other investments start to outperform big tech stocks.

We’re seeing this in our system. We have recently added small caps, mid-caps and international stocks to client portfolios.

If interest rates put downward pressure on valuations, what does that mean bigger picture for the stock market?

Let’s look at the last two rising rate cycles for clues.

Rising Interest Rate Cycle (early 1900’s)

The last two times US markets experienced a rising interest rate cycle was in the 1970’s and the early 1900’s.

Let’s look at the early 1900’s first.

The next chart shows the Dow Jones Industrial Average from 1895 to 1925.

During this time, interest rates moved from a low of 3.7% to a high of over 6%.

This was the last interest rate cycle that happened before the existence of the Federal Reserve.

Over this period, stocks returned a whopping 1.4% per year compounded return.

Not great.

Interestingly, both GDP and earnings grew over the same period of time, much faster than the overall growth in equities.

This is because higher rates kept valuations low compared to the low rates of the previous cycle.

That’s great, but can we really compare today’s world to the one 100 years ago?

After all, isn’t everything different?

Sort of.

The one common denominator is us.

Humans are the key to the investment cycle.

With all of our flaws, behavioral oddities and penchant for making the same mistakes over and over and over, we bring our inherent biases to our actions whether we know it or not.

Sure, we think we’re smarter. After all, we have all the information in the world at our fingertips via our smart phones. But we tend to use it to view cat videos. So are we really that much more advanced?

But we digress.

So what about a more recent rising rate cycle?

Rising Interest Rate Cycle (1970’s)

The last time the US economy went through a rising rate cycle was in the 1970’s.

How did this compare to the period in the early 1900’s?

Answer?

Not any better.

In fact, stocks returned 0% over nearly 20 years.

Stocks had a nice move higher post-WWII, but ran into the same valuation wall as it did in the early 1900’s.

Higher interest rates simply make it more difficult for stocks to grow over time.

There are many factors that go into the relationship between interest rates and valuations:

  • High interest rates compete for capital. Cash paying 5% has attracted dollars that otherwise would have gone into stocks.
  • The current value of a future stream of cash flows goes down as the discount rate goes up.
  • Financing costs increase, reducing profitability.

One thing is for sure: we must pay attention as these cycles change.

Mini-Cycles Within the Larger Cycle

If we have indeed made the transition from a declining rate environment to a rising one, we should expect broad stock markets to struggle more than they did in the previous cycle.

In these environments, bull markets will likely be measured in months instead of years.

In both previous rising rate cycles, stocks had mini-bull markets that lasted from 24-36 months.

They were typically followed by bear markets lasting 18-24 months.

During the 1970’s, we saw 5 mini-bull markets, and 5 mini-bear markets, shown in the next two charts.

During each mini-bull market, prices met or slightly exceeded new highs on each subsequent move.

But each time markets would try to push to new highs, inflation would rise and a mild recession would occur. Stocks would fall to the low end of the range, and a mini-bear market would ensue.

This is the definition of a choppy market.

And this is the market that we may very well have over the coming decade.

Flash forward to today, and we’re in a bull market that has lasted 13 months thus far.

If the current cycle is anything like previous ones, we could see this mini-bull last a bit longer, possibly into mid-to-late 2024.

But chances are we should not expect a long-term bull market like we had during the 1980’s, 1990’s and 2010’s.

Bottom Line

The ebb and flow of interest rates and inflation create a dynamic environment that demands careful navigation.

In the coming years, it will become increasingly important to adjust exposure to risk based on non-emotional signals.

It will also become increasingly important to generate yield and not just rely on market appreciation to meet your financial goals.

A higher interest rate environment allows you to reduce risk and volatility over time.

But this rising interest rate cycle is not a two-year cycle that began in 2022 and ends in 2023.

Higher interest rates will likely be with us for many years into the future.

Invest wisely!

Market Video: Orderly Correction & Commercial Real Estate Risks

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In this Market Insights video, we discuss the current state of the market and delve into the stress that is starting to show in the commercial real estate sector.

We also analyze the GDP for the third quarter and present three scenarios that could unfold in the coming months and years.

Join us as we explore these topics and gain valuable insights into the market’s performance.

  • 00:45 S&P 500 Index
  • 02:13 Russell 2000 Small Caps
  • 04:54 Performance of Different Markets
  • 05:46 Delinquent Loans in Commercial Real Estate
  • 06:33 Delinquency Rates in Retail, Lodging, and Office
  • 09:23 GDP for the Third Quarter
  • 10:29 Scenarios for the Future

Please don’t hesitate to reach with any questions.

Invest wisely!

2023 Mid-Year Outlook Webinar

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View the recording of our 2023 Mid-Year Outlook webinar.

Here are the topics we discussed and the time in the recording it happens so you can fast-forward to topics you find most relevant:

  • Recession probabilities (1:29)
  • S&P 500, Dow Jones & Russell 2000 (4:51)
  • Concentrated performance contribution YTD (8:48)
  • S&P 500 Index (10:11)
  • Russell 2000 small cap stock index (14:37)
  • Fed Balance sheet vs S&P 500 (16:14)
  • Banking stocks still under pressure (18:01)
  • Commercial real estate loans maturing over the next 5 years (19:24)
  • Yield curve (24:56)
  • Manufacturing PMIs and activity (29:10)
  • Portfolio Equity Positioning (31:27)
  • Scenarios, Risks & Opportunities (35:00)
  • Upside and Downside potential performance based on three scenarios (39:40)

Invest wisely!

The Fed’s Mixed Messages

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Anyone who isn’t confused really doesn’t understand the situation.

edward r. murrow

The Federal Reserve met today, and for the first time in over a year they kept interest rates unchanged.

Typically, when the Fed pauses, it is a signal that they are more confident that their objectives have been met.

But this meeting was a bit different.

It was full of mixed messages.

Instead of signaling to the market that they are seeing concrete signs that inflation is going down, their message was incredibly strong that inflation problems have gotten worse and that higher interest rates are still ahead.

Let’s look at their mixed messages from today’s meeting.

The Projected Terminal Rate Increased

The Federal Reserve has a dual mandate as dictated by Congress: stable prices and full employment.

The “terminal rate” is the rate at which the Fed believes will best balance these two objectives.

Think of the terminal rate like getting two sides of a scale to be in balance.

a golden balance scale beside a laptop

If interest rates are too low, the employment goal is achieved but inflation can run hot.

If they are too high, then inflation is tamed, but it risks high unemployment.

The projected terminal rate went up by 0.5% from their meeting one month ago.

This means they think they will increase rates at least two more times by the end of the year.

That may not seem like much, but in Fed-world, that is an enormous increase.

Which leads us to mixed message #1: They are MORE convinced today that inflation will continue to be a problem than they were at their last meeting. Yet, they chose to RAISE rates at the last meeting, and KEEP RATES UNCHANGED today.

Nine of the twelve voting members increased their projected terminal rate.

One member, in fact, believes the Fed will have to raise by another full percentage point to get inflation contained.

We can view this in the “dot plot” below.

Each dot in this chart represents one voting member’s view on where they think interest rates will be at the end of the year (shown along the bottom of the chart).

The grey dots were their previous projections and the blue dots are from today.

The question is…why pause if they are all so convinced inflation is still a problem?

It frankly doesn’t make much sense.

Especially given that inflation data has consistently been showing signs of slowing for at least a few months now.

So what does the inflation data tell us?

Inflation Data Differs from the Fed’s Message

This is where we start to question what the Fed is looking at.

If we look at numerous inflation data points, without question they are easing.

The next chart looks at a measure of inflation for the services sector of the U.S. economy (in orange) alongside the manufacturing supplier deliveries (in blue).

This is “fast data”.

Which means that it is an up-to-date measurement of inflationary pressures in the early stages of economic activity.

Think of supplier deliveries as the raw material ordered before a good is produced, sold and shipped. From electric vehicles to microwaves to jelly beans, this measures all of the various inputs to those end products.

This indicator tracks the actual deliveries, not just the orders.

And deliveries have fallen off a cliff in the past year.

Deliveries are important because they give us a glimpse into the first things that go into producing goods. Companies have purchasing managers who are responsible for getting the “stuff” in the door to make whatever widget that company produces.

This data is in recessionary territory (a reading below 50 signals a contraction).

You may think that this is just a result of the supply-chain issues being resolved after COVID. But that would make deliveries go UP. Companies would be receiving MORE of the inputs to their products, not less.

This is a sign that DEMAND is going down.

We can see this demand destruction in the business sector as well.

The next chart looks at final demand of producers (in blue) with final demand excluding the more volatile food and energy part of the economy (orange).

This also shows an environment where inflationary pressures are falling quite dramatically.

This is brings us to mixed message #2: the Fed has INCREASED their projected inflation targets while the data is showing exactly the opposite.

To be fair, employment continues to be strong, and the consumer remains resilient.

But employment data is “slow data”. When an employment number comes out it is typically at least a month old.

In fact, at the start of the last 4 recessions, employment indicators were all positive. It’s simply not a great tool to extract future economic activity.

Prioritizing slow data is like driving your car using the rear-view mirror. It doesn’t make much sense and it is incredibly dangerous.

And the Fed is doing just that.

Higher interest rates take time to work their way through the economy. They work on a lag. Increased rates now may take 6-12 months to show up in actual data.

They are prioritizing slow data to justify policies that work on a lag. It simply doesn’t make sense.

But there are very smart people working at the Fed. In addition to setting interest rates, they also provide numerous economic forecasts, including ones on unemployment.

This leads us to the last mixed message.

Unemployment Projections are Inconsistent with Growth Projections

As mentioned, the Fed does economic forecasts as a part of their “job”.

They should….there are over 400 Ph.D. economists employed there.

One forecast is on unemployment.

In May, they forecast that the unemployment rate would be 4.1% next year. (It is currently 3.7%).

But today they increased their forecast to 4.5%.

At the same time, they increased their GDP forecast from 0.6% annualized up to 1.0% annualized.

Here is mixed message #3: they think GDP will be STRONGER than they projected last month, but unemployment will be HIGHER than they thought as well.

We hate to break the news to them, but unemployment has NEVER risen by 0.8% in one year outside of a recession. (From the current 3.7% to their projected 4.5%).

Bottom Line

In our opinion, the mixed messages from today show just how different the potential outcomes are over the coming months.

On one hand, inflationary pressures are decreasing and economic data is showing signs of a slowdown. On the other hand, stock markets have remained surprisingly buoyant on the back of an artificial intelligence tech frenzy.

We’ll review these potential outcomes in our 2023 Mid-Year Outlook webinar that will be held on Tuesday, June 27th. You’ll receive details next week.

Until then we’ll continue to monitor the variety of differing data points to best help you achieve your financial goals.

Invest wisely!

Debt Ceiling: More Smoke than Fire

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image of old building on american banknote

Negotiations on the debt limit are heating up in Washington.

What implications may it have?

In our view, negotiations are mostly political posturing by both sides trying to gauge the likelihood that the “other side” will ultimately be blamed from bad things that may or may not happen as a result of not raising the debt ceiling.

Unfortunately, this political grandstanding is all too common.

Regarding the debt ceiling, agreements have always been reached.

We have thought for many months that the risk of an actual default on U.S. Treasuries is very unlikely. Neither side benefits from this, and both sides are likely to be blamed.

However, politicians are gonna politic.

It appears that our fearless leaders want to sufficiently scare us in order to get their faces on the front page of every newspaper around the globe while we wait for them to announce an agreement.

But we digress.

In order to better understand the situation, let’s look at the history of the debt ceiling first, then look at the potential impact on financial markets.

Debt Ceiling Overview

The debt ceiling was first implemented in 1917 with the passage of the Second Liberty Bond Act.

This was done to fund the war effort during World War I.

The goal was to provide a limit to the amount of debt the U.S. government can issue via treasury bonds while keeping Congress fiscally constrained.

For many years, this worked.

But over the past few decades, the debt ceiling has done absolutely nothing to restrain spending.

The chart below from the BBC shows the debt ceiling (black line) versus total outstanding federal debt. Republican presidents are shaded red while Democrats are blue.

It’s not hard to see that when debt reaches the debt ceiling, Congress simply raises it.

This is not a Democrat versus Republican thing. No one has fiscal restraint in Washington.

And despite “negotiating” spending limits nearly every time the debt limit is raised, there has been exactly zero reduction in spending during any administration, regardless of which party is in power.

We’ll discuss 2011 more below, but part of the deal to raise the debt limit then was that Congress projected over $2 trillion in savings over the next ten years.

What happened?

Debt increased by nearly $20 trillion.

Any talking points from a deal in 2023 is likely to be just that…talking points.

Previous deals to reduce spending failed. Why would this time be any different?

What are the potential market implications if a deal does or doesn’t get done?

Potential Market Implications

When looking at potential market implications with any type of event, it is most important to look at the actual data.

Since 1980, there have been 74 debt limit increases.

Only one of them truly resulted in major market volatility: 2011.

The vast majority of the time, the debt limit does not have any meaningful impact.

The next chart looks at the S&P 500 versus the statutory debt limit.

The orange line is the debt limit and the white line is the S&P 500.

It’s pretty easy to see that periods of volatility did not necessarily correlate to debt increases:

  • During the tech bubble, the debt limit remained flat. This was also the last time Washington was fiscally conservative.
  • The debt limit was increased in 2008, but that obviously was not the cause of the financial crisis.

In fact, you could argue that the markets and the debt limit are positively correlated. This means that when the debt limit goes up, so does the market.

As we mentioned earlier, the only real exception was in 2011.

What happened to asset prices then?

The next chart shows performance of various assets during and after the debt crisis in 2011.

This chart shows asset performance from May through December of 2011, and includes long-term treasury bonds, the broad bond market, large-cap stocks, and small-cap stocks, developed international stocks, and emerging market stocks.

The vertical red dashed line is the date when President Obama and Congressional Republicans finally agreed on an increase. At the same time, U.S. debt was downgraded from AAA to AA for the first time in history.

A few interesting observations from this chart:

  1. Volatility didn’t start until AFTER an agreement was reached.
  2. Ironically, the best performer by far was long-term U.S. treasury bonds.
  3. International stocks performed the worst, with developed and emerging markets both down over 25% through year-end.
  4. The S&P 500 index was down 12% in the months following the debt increase.

The other thing to note about 2011 is that the Fed ended QE2 in July of 2011. So there was a natural headwind from reduced Fed liquidity at the time of this volatility.

There are similarities between then and now:

  • Republicans won a mid-term election the year before.
  • The Fed is in tightening mode.
  • Political divisiveness is high.

Maybe we see a replay of the 2011 situation.

We hear many pundits saying that treasury bond prices will plummet if a deal isn’t reached. Others are saying that markets will crash.

But probabilities suggest otherwise.

Like most political events, this one is likely to have a very short-term effect on markets.

Bottom Line

By all indications, a deal to raise the debt ceiling is close.

But even if it extends out another few weeks, the likelihood that the U.S. defaults on its debt payments and a global catastrophe follows is extremely low.

Any reaction by financial markets, whether positive or negative, is likely to be temporary.

After that initial reaction, markets will go back to looking at data as if nothing happened.

Right now, data is extremely mixed.

Economic indicators are weakening, but overall, the stock market has remained very calm.

As we’ve said for months, risks from an economic standpoint remain very high. This week alone, JPMorgan and Goldman Sachs both announced that a recession this year is highly likely. We agree.

Without question, volatility will increase if negative economic events occur.

But don’t expect the debt ceiling to be culprit.

Invest wisely!

Et Tu Brute

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In Shakespeare’s famous play “Julius Caesar”, a group of conspirators gather in the Roman Senate to assassinate the emperor.

Brutus was one of Caesar’s most trusted confidants.

He and the other murderers pull their swords and stabbed him to death on the Senate floor.

With his dying breath, Caesar looks on in shock and betrayal and utters the words “Et tu Brute”.

Across the country today, regional bank CEOs must feel the same betrayal.

Yesterday, the Federal Reserve raised rates an additional 0.25%.

The Federal Reserve is supposed to be the banking system’s most adamant supporter.

After all, their primary job is “financial stability”, and they are considered the “lender of last resort”.

Yet, they inexplicably betrayed the entire banking system with another unnecessary rate hike.

In the midst of an obvious banking crisis, Chairman Powell referred to the banking system as “secure and resilient”. In the past month, we’ve had 3 of the 4 largest bank failures in history. Ah yes, the epitome of strength and resilience for sure.

The primary problem in the banking system right now are deposit rates versus safe alternatives.

This banking crisis is NOT over by any means.

In fact, risks right now are higher than we’ve ever seen them.

Let’s look at the Fed, Regional Banks and the Commercial Real Estate market to assess risks.

The Fed’s Last Hike

In their meeting yesterday, the Fed left the door open to additional interest rate hikes.

Let’s be clear. We believe there is NO REASON for the Fed to hike again.  Whether they will or not is anyone’s guess.

They have yet to explicitly acknowledge it, but inflation is no longer the problem.

They are fighting a banking crisis that it nowhere close to being over.

Instead of pausing, Chairman Powell felt he had to project confidence in the financial system.

He was faced with a difficult choice:

  • Don’t raise rates, and risk markets interpreting that as fear over the health of the banking sector;
  • Raise rates, but risk making the banking crisis worse.

Powell woke up and chose violence.

In the world of instant public relations campaigns, not raising rates would have been an admission that the financial system has major problems.

Even if the system is weak, they can’t let the market perceive that they think the system is weak.

But if they raise rates (like they did), they all but guarantee more stress on the banking system by boosting rates on money markets, increasing the risk of deposit flight.

And if banks try to raise rates to slow the deposit outflow, they destroy any profitability they had.

In the end, the Fed decided to roll the dice and increase rates again.

Unfortunately, this will likely prove to be an incredibly poor decision.

In fact, markets are now pricing in a 15% likelihood that the Fed will CUT rates at their meeting in June. Not next year, but next month.

The chart below shows the implied Fed Funds rate through January of 2024.

The blue line (and left side of the chart) is the expected interest rate on the date along the x-axis. The orange bars (along the right side of the chart) is the number of expected cuts by next January.

Fed Funds implied interest rate for the remainder of 2023. Number of rate cuts and projected interest rate decreases.

Markets expect 4.5 interest rate cuts this year, and the rate to go from 5.25% down to 3.9%.

This is quite extraordinary given that the Fed raised rates YESTERDAY.

It firmly implies that markets think the Fed made a huge mistake with this recent hike and that the economy is about to be very bad.

Let’s turn our attention to the regional banks next.

Regional Banks

Regional bank stocks are suffering massively.

3 of the 4 largest bank failures in history have occurred in the past month, and there are more to come, likely this weekend with Pac-West Bank. It won’t be the last.

The next chart shows the ticker KRE, which is an ETF comprised of regional banks.

Regional bank stocks are down almost 60% since their highs last year.

They have also have given up ten years of gains. This is simply astonishing.

What this tells us is that the market thinks the banking crisis is much more urgent and important than inflation.

We agree.

Commercial Real Estate

Economic data is weakening. Fast.

Bank lending is one of the biggest contributions to economic growth. We live in a time where loans are the backbone of the US economic engine.

There has been more than $2 trillion of outflows from smaller banks over the past month.

If you are a bank CEO, do you think you would be aggressively handing out loans right now?

No.

You’re keeping all the reserves you can, hoping your customer base is loyal.

Lending standards were tightening before the banking crisis began. Now that it is accelerating, the problems will begin to spread.

The biggest area of concern for us is in commercial real estate.

Let’s look at some stats:

  • 67% of all commercial real estate loans were made by smaller banks.
  • 83% of all CRE loans are balloon notes. This means they mature and the owner is forced to do something (refinance or sell the property).

In the next two years, over $300 billion of CRE loans mature, as shown in the chart below from CRED IQ.

We must keep in mind that commercial real estate is a diverse market, and not all properties are created equal.

There are some areas of strength:

  • Manufacturing facilities are moving back to the U.S. from overseas, creating support for industrial space.
  • Grocery-anchored shopping centers (with an HEB for example) are doing quite well.
  • Senior-housing facilities are poised to benefit from aging demographics.

But these are relatively small areas in the CRE market.

Currently, these smaller and mid-size banks are dealing with a liquidity crisis.

They may start to face problems with their balance sheet. This would be an entirely different ballgame.

Bottom Line

Risks are incredibly high right now.

Despite that, markets have been relatively calm.

The next few months are perhaps the most important months of the past decade.

If we can get through them with relatively little damage from an economic and earnings standpoint, there is a chance that we avoid some very bad scenarios.

Until then, it is appropriate to err on the side of caution.

IronBridge clients continue to be extremely below their target risk, with elevated holdings in cash equivalents and various short-term high-quality fixed income holdings.

We anticipate that will continue, but as always we will continue to monitor markets for signals to add risk where appropriate.

Please do not hesitate to reach out with any questions.

Invest wisely!

Bank Run: Silicon Valley Bank Goes Under

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Today, Silicon Valley Bank became the second largest bank failure in US history. What happened and what does it mean going forward?

Who is Silicon Valley Bank?

  • Silicon Valley Bank, or SVB, was the 16th largest bank in the US.
  • This was the second largest bank failure in US history.
  • Based in Santa Clara, California, they focused on startups, founders and private equity investors.
  • Frankly, this was a great bank with fantastic employees, seemingly well capitalized, that went under incredibly quickly. So what happened?

How did SVB get into this Situation?

In order to fully understand the events that transpired this week, we first need to look at the past few years.

The roots of their collapse started in 2021. Their deposit base jumped from $61 billion at the end of 2019 to $189 billion at the end of 2021.

When banks bring in deposits, they have to do something with them.

Like all banks, the goal is to lend the money out, and earn profits by charging higher interest rates on loans than what they pay on deposits. This difference is called “Net Interest Margin”, or NIM. Banks charge you 6% on a loan, and they pay you 0.5% on your cash. Voila, they earn 5.5% in NIM.

Because their deposit base grew so quickly, they couldn’t underwrite enough loans to put that money to work. In order for them to earn a higher yield on their customers’ deposits, they purchased over $80 billion worth of Mortgage Backed Securities, or MBS. These are financial instruments similar to bonds that are made of up of many different mortgages.

97% of the MBS they purchased had maturities of longer than 10 years. These were purchased before interest rates began to increase last year. (This is important.)

Why did they Go Under?

When banks buy securities with customer deposits, they have to put them in one of two buckets: 1) Available-for-Sale, or 2) Hold-to-Maturity.

Available-for-Sale assets must be “marked-to-market”. This simply means they report the current market value of each investment they hold, just like you see on your investment statements each month.

Hold-to-Maturity securities, on the other hand, don’t have to be reported that way. If you bought your house for a million dollars, and the value fell, you could still report the value as a million dollars.

The $80 billion of MBS were held in the Hold-to-Maturity bucket.

Last year, when interest rates rose so dramatically, the value of these securities fell. A lot. They lost billions of dollars. And because SVB had longer-maturity securities, they fell more that shorter-duration ones would have.

This week, they had to sell at least $21 billion of assets to meet withdrawal requests after depositors essentially made a run on the bank.

Once Hold-to-Maturity assets are sold, any gains or losses must be disclosed and reported. The sells they had to make this week resulted in a nearly $2 billion loss.

Between the MBS losses and continued customer withdrawals, the bank was forced into receivership by the FDIC.

What Does it Mean for You?

First, recognize what a bank deposit really is. Banks do not have a safe where they keep your money.

The following clip from “It’s a Wonderful Life” perfectly exemplifies what really happens when depositors want to withdraw money from a bank. (Fast forward to 3:50 in the clip to view the most relevant part.)

Banks don’t keep your funds. They lend them out, and invest it, and do other things to make themselves a profit.

As George Bailey says, “You’re money is not here.”

Why do you think the new account agreement is so big when you open a new checking or savings account?

You are not an account owner of a bank account. You are a bank creditor.

You lend the bank your money.

They do with it what they want.

Now that people can earn a decent yield on short-term cash funds and US Treasuries, there is competition for those deposits.

This is a good reminder to pay attention to your deposits, especially now that there are good alternatives.

Is there Risk of Contagion?

Quite frankly, yes there is.

That doesn’t mean that other banks will definitely go under, but it is absolutely possible.

Smaller and regional banks are most at risk right now, but there is also risk to the broader markets.

We have long been saying that risks are incredibly elevated right now. This is a good example of what can happen when risks are high. Banks don’t tend to fail in bull markets.

In our opinion, the full effects of higher interest rates have not been felt yet.

This is a major example of the unintended consequences that can happen in a complex system like financial markets.

Portfolio Implications

IronBridge clients continue to be very underweight risk exposure right now.

We believe that risks will remain elevated at least through this summer, and you should position your portfolio for continued volatility.

We discussed the two most likely scenarios in our recent video from last week.

We further reduced risk this week for clients, and view any rallies attempts in markets as good opportunities to de-risk even further.

It is much better to not participate in short-term rallies than to participate in long-term declines.

As always, let us know if you have any questions.

Invest wisely!

Thanksgiving Appetizer Report

by

Fall theme charcuterie board for holiday entertaining

Just wanted to provide a quick update as everyone prepares for the holiday week. We’ll send out a more detailed report next week.

Big Picture

  • Markets have remained calm after the massive gain two weeks ago following a milder than expected inflation number.
  • Earnings for the most part have been better than feared.
  • Markets are entering a seasonally strong period. From the Tuesday before Thanksgiving thru January 2nd, markets are up on average 79% of the time, averaging a 2.7% gain.  This is what is commonly known as the “Santa Rally”.
  • Despite these positives, many
    warning signs still exist: leading economic indicators are weak, overall
    financial conditions are deteriorating, and the housing market is under
    stress. These conditions have not shown up in economic numbers (yet).

Economy

  • The good news: Economic activity remains resilient. GDP was up 2.6% in the 3rd quarter. 4th quarter GDP, according to GDPNow, is tracking up 4.2%. View it HERE.
  • The bad news: Leading economic activity is at recessionary levels as shown in the first chart below.
  • If you’re curious as to what makes up the Leading Economic Index, the second chart below shows the ten components with contribution from each.

Equity Markets

  • On November 10th, the S&P was up nearly 6%, and the Nasdaq was up 7.4%. This accounts for more than half of the return in the past two months.
  • The big jump in markets on was due to inflation coming in at 7.7% instead of 7.9%.
  • Big daily increases like this do not occur in good markets. The chart below shows the 20 largest increases in Nasdaq history.
  • 17 of the previous 19 largest daily increases occurred during major bear markets and did not mark the bottom.
  • The other 2 happened one week after the ultimate bear markets lows in 2009 and 2020 under very different conditions than we have now (VIX then was above 80, while VIX currently is at 22.)
  • Near-term, markets could continue to drift higher. Looking past the next few weeks, things appear to be very weak. Caution is advised.

Interest Rates

  • The Fed is likely to increase rates by 0.50% in December, then another 0.25% in February. The market anticipates that the Fed will stop raising rates after that.
  • Longer term rates appear to be calming down, and may be starting to price in recessionary risks.

Bottom Line

While the relative calmness has been a welcome respite from the volatility this year, we do not believe this is a time for complacency.

We would love to believe that the bear market is over. At our core, we are optimists.

But more importantly, we are realists.

Equity exposure has steadily increased in client portfolios this quarter. If market and economic conditions continue to improve, we will continue to do so.

But we view any new equity exposure as potentially having a very short shelf-life.

We will not hesitate to reduce equity exposure, increase cash levels, and do more hedging to protect portfolio values if and when these actions are warranted.

We hope you and your loved ones have a wonderful Thanksgiving holiday.

Invest wisely!