Mid-Quarter Market Update

As always seems to happen when we write these mid-quarter updates, during the editing process some event causes us to rewrite a portion of our letter.  With the collapse of Silicon Valley Bank (SIVB) late last week, this quarter’s letter is no different.  The stock market recovery that began last October started fading recently as hawkish Fed-speak sucked a little air out of the room.  The failure of SIVB added to the pressure on equities and brought prices back to the levels of early January.  On the bright side, bond prices increased as interest rates declined significantly with the stampede to safety.  Notably, this is exactly the diversification benefit bonds typically provide.

Rather than being a canary in the coal mine for a larger crisis, SIVB seems to be an outlier in the financial system.  Without getting too into the weeds of how banks work, SIVB was a poorly run bank, both on their deposit and asset bases.

• SIVB carved out a distinct and riskier niche than other banks, setting itself up for large potential capital shortfalls in the case of rising interest rates or deposit outflows.
• Rather than sticky retail clients, their deposit base was nearly entirely from corporate clients and early-stage start-up companies, mostly in the tech industry. 
• As funding dried up over the past year, companies pulled deposits to fund their ongoing cash needs.
• SIVB quadrupled deposits over the past five years.  Much of these new deposits were invested in credit-safe government bonds.  However, SIVB bought longer maturity bonds and took on interest rate risk that was in a world of its own compared to other banks. 
• As interest rates rise, the value of bonds goes down.  Unlike every other bank, SIVB did nothing to hedge their portfolio against this risk.
• As their investment portfolio lost substantial value, depositors withdrew cash, which in turn forced SIVB to sell its longer-term investments at a loss.  This is an example of a duration mismatch between the high-quality assets they purchased and their deposit liabilities.  Not good.
• A bank run quickly followed, and SIVB was out of liquidity and insolvent. 
• Other regional banks, while much better capitalized than SIVB, are feeling the effects of similarly scared customers.

U.S. authorities have acted quickly to help prevent wider contagion by protecting depositors from bank failures. The U.S. Treasury and Federal Reserve moved to ensure that depositors affected by the regional banks have access to their cash.  The Fed also announced a new lending facility for banks providing one-year loans against their bond portfolios.  Unlike in 2008, this is not about assets with opaque valuations clogging bank balance sheets.  The assets at the heart of the current bank troubles, such as U.S. Treasuries, are among the most liquid and transparent.  Those investment characteristics help the effectiveness of the Fed’s combined measures and should prevent wider contagion.  Bank shareholders enjoy no such safety net.  The SIVB collapse hit many regional bank stocks hard.  Our portfolios have exposure to financials, but we do not have direct exposure to any regional bank. 

Before the SIVB news, this letter was focused primarily on high interest rates.  We think it’s still important to review that factor.  Investors currently have access to high yields on treasuries and money market funds nearing 5%, a rate not seen in over a decade.  High returns on risk-free investments beg the question: are high risk-free interest rates bad for stocks by lessening their demand, leading to poor future returns?  If you can get 5% risk-free, why take risk in anything else?  The analysis is more complex than that and deserves a deeper look.  The chart below shows average stock market returns by decade alongside the average treasury yields, dating back to the 1940’s.  Investors consider the 3-month T-Bill Yield risk-free, averaging 3.4% since the 1940’s.  Today this rate is 4.8%.

The highest average yield occurred in the 1980’s, which was also one of the best decades for stocks.  The 1990’s risk-free rate is similar to today, and equities generated strong returns.  Low rates in the 2000’s certainly didn’t help stocks.  Yields were high in the 1970’s and saw poor returns.  There is no clear correlation between stock returns, the level of interest rates, or the direction of interest rate changes.  More critical is rising or falling inflation.

Since 1928, stocks have returned, on average*:

• 9.7% during periods of rising interest rates.
• 9.6% during periods of falling interest rates.
• 5.5% during periods of rising inflation.
• 14.7% during periods of falling inflation.

                     _{*Data: NYU (S&P500, returns annualized); Rates: 10-year treasuries}

We believe inflation will fall for the year.  The SIVB meltdown should help the Fed lower inflation as fear and caution work their way through the economy.  While falling inflation doesn’t guarantee stocks do well, history has shown that this environment can see above-average returns.  Notably, stocks do not perform poorly just because of high cash rates.  

Bank failures are alarming.  We know memories of the Great Financial Crisis are still fresh in everyone’s mind.  This is not 2008.  We remain optimistic for the year while recognizing this situation will likely cause near-term headwinds and volatility for the market.