| 1st Qtr.
| 12 Mo.
|10-yr Treas. yield||3.49%||3.88%||-0.39%||2.33%||+1.16%||-0.39%|
|Fed funds rate||4.75-5.0%||4.25-4.5%||+0.50%||0.25-0.5%||+4.50%||+0.50%|
(stock indices are before dividends; yield and rate changes are absolute changes)
Even with a jolt to the banking system, the quarter finished with solid gains for the broad US stock market. The S&P 500 is up 14% from its October 2022 low, but is still 14% below its January 2022 high. With the US dollar softening slightly, international stocks also had a solid return. After easing above 4%, the benchmark Treasury yield backed off with banking fears even as the Fed raised short-term rates twice.
The government stepped in and averted a potential spread of bank failures by guaranteeing all depositors of Silicon Valley Bank and Signature Bank, ignoring FDIC coverage limits. with the assets of both being acquired by other banks. Both First Republic and Credit Suisse (the primary international bank under huge pressure) were essentially rescued by other banks and the Swiss government before they collapsed. The speed of the crisis took regulators and markets by surprise and may indicate the need for new regulatory approaches.
All eyes remained on the Fed, which was not alone in raising interest rates: both the Bank of England and the European Central Bank raised rates in the midst of the banking crisis. Short-term US rates are now at their highest since 2007, and most significantly the Fed abandoned its express intention to implement “ongoing rate increases” while still acknowledging its resolve to raise rates if necessary. This position was far more reserved than just two weeks earlier, before the banking crisis, when the message was that rates would likely need to increase even more than previously expected. The Fed’s favored core inflation measure for February came in at 4.6% for the trailing year and was slightly below expectations for the month and the year. The market clearly sees the end of rate increases on the near horizon, with the yield curve inverting by over 1%, the biggest difference between short and intermediate rates since 1981.
Home prices for the western half of the country (plus Austin) were down from the year prior, correcting from the big prior price increases; prices in the eastern half are still up but their prior increases were much less. The real estate market may have successfully digested higher mortgage rates (which backed off from highs over 7%) with existing home sales in February breaking a 12-month streak of declines and inventory beginning to move up. Still, the shelter component (prices and rent) is the biggest driver of inflation, making up 1/3 of the CPI and up over 8% in the February core CPI increase of 5.5%.
The job market remained strong, with monthly job creation chugging along and the unemployment rate still low at 3.6% (up from 3.4%). The labor participation rate is creeping up but is still below the pre-pandemic level, so there are more workers who can re-enter the market. With supply chains loosening, the trade deficit has increased, and core business investment is down 3.4% from its high. The key manufacturing index was also down, with new orders down for the last six months.
Fourth quarter GDP was revised to a final increase of 2.6%, a slowdown from the third quarter’s 3.2%. Full year 2022 was up 2.1%, also down considerably from the post-Covid rebound of 5.9% in 2021. Fully half of the fourth quarter’s increase was due to higher inventories, and consumer spending for the quarter was up only 1.0%, the lowest quarter post-pandemic, neither of which bodes well for the economy.
The banking crisis raised a lot of questions that need to be answered. Was there a failure of regulation and the rules? (Bank “stress tests” that are intended to identify problems under various assumptions did not include a test for rising interest rates, which is a head-scratcher since rates were so low for so long that they had nowhere to go but up.) Were the regulations appropriate but the supervision and application of the regulations lax? (Silicon Valley Bank was flagged a number of times by regulators, but those flags never rose to the level that compelled SVB to make changes.)
As with any crisis, there were plenty of interesting side stories (besides the social media idiots noted below). “Mainstream media” gave significant mention to a study that showed that 186 more banks are at risk of failure “if only half of their depositors decide to withdraw their funds”. Unfortunately, the study was barely challenged, with no analysis of how often that withdrawal ever happens (very infrequently) or even a discussion of how banking works. Banks accept deposits to make investments and loans, and short of demanding immediate repayment of those loans, hardly any bank could repay half of its depositors in a short period; that’s why banking only works with some level of trust, bolstered by government oversight.
Even more confounding is that cryptocurrency rallied during the crisis. On one hand, this makes sense since the intention and design of crypto was to operate outside the traditional banking system. On the other hand, crypto has become heavily intertwined with the banking system (banking is necessary to convert crypto to cash, and vice versa), is totally unregulated and is backed by nothing other than speculation. But even the price increase is not necessarily what it seems, as trading has been driven by a small number of wealthy investors who may be speculating that the Fed will stop increasing interest rates, which could benefit crypto. At the same time, investor bets that crypto will decline have increased.
Whether the banking system wobbles for a bit longer or not, it remains to be seen how bank customers and investors will adjust, to say nothing of the regulatory environment. The administration has proposed lowering the size of banks for enhanced regulatory standards and reporting to $100 billion in assets from $250 billion; it was raised from $100 billion to $250 billion in 2018. Of course, Congress will be conducting its own investigations, which will no doubt produce other proposals. Another looming question is whether the FDIC guarantee will change from its $250,000 base amount; the limit is worthless if it will be waived with every bank failure. An unlimited guarantee may mean that routine banking services (deposit accounts and transaction services) are regulated much more strictly than they have been in the past, leaving other banking functions with less protection.
Charlie Munger of Berkshire Hathaway has said that capitalism without risk is like religion without hell; the negative makes the positive work. Hopefully the banking system will maintain some sense of balance.
Well, it’s a new year, and in just the first quarter market leadership underwent fairly seismic change again. Energy, which was by far the best performing sector through 2022, is down slightly so far in 2023. Technology, which trailed the overall market in 2022 after leading the charge for several years, is up well over 20% this year, despite high-profile layoffs and a huge slowdown in funding for new tech companies. Cryptocurrencies have shrugged off multiple failures of crypto exchanges and charges of fraud and other wrongdoing, with bitcoin up over 60% (don’t get too excited, it’s still down over 50% from its highs). Value and dividend strategies, which outperformed the market in 2022, were upended by the banking crisis, with value overall also down about 2% so far this year.
Banks deserve special mention. Changes since the 2008 recession were intended to make traditional banking less risky and to avoid any further meltdowns. But since 2009, the KBW Bank Index has been significantly more volatile, with lower returns, than the overall market. So maybe the recent upheaval should not have come as a big surprise for investors, even if it was very disturbing for the banking public.
With a new year comes the annual headlines that this could be a “stock picker’s year”, with some supporting rationale. Unfortunately, this expectation has been badly dashed in almost every year, but like Charlie Brown trying to kick the football, the pundits keep coming back to the same pipe dream. The speed and severity of market changes has made this a fool’s errand.
We remain happy to take what the market gives us and plan around that, rather than chasing some elusive “alpha”, or outperformance. This is the difference between isolated investment management (where all that matters is performance and higher risk taking is necessary) and portfolio management in the context of comprehensive financial planning (where long-term goals and satisfaction are the measures of success).
The worm has also turned on a bond allocation in a balanced portfolio. In 2022, the headlines blared that “60/40 is dead” (60% stocks and 40% bonds being a classic moderately balanced portfolio). We readily acknowledge that 2022 was a historically bad year for bonds, but with interest rates having gone up as fast as they have, the headlines now proclaim that “60/40 is the place to be for the future”. While rates could go up more, most of the damage has been done, and we discussed in last quarter’s review how bonds will recoup their losses over time.
When the yield curve is inverted (short rates higher than intermediate rates), one of two things will happen to restore the curve to its normal state – either short rates will go down (meaning the Fed will have to reverse its recent moves, probably due to a harsh recession) or intermediate and long rates will go up (probably due to the market riding out the fear of recession and perhaps accepting slower growth). Our positioning of the bond allocation, with less interest rate sensitivity than the overall bond market, softened 2022’s decline a bit, and we think this is still the right place to be going forward. Bond yields have gone up but not enough to compensate for the ongoing interest rate risk if rates go down.
A Brave New World?
We normally prefer to offer our own observations and commentary in this section, but this piece by Daniel Henninger of the Wall Street Journal was so interesting and relevant we wanted to include it in its entirety.
Was the SVB Collapse a Twitter Panic?
The madness of crowds is becoming everyday life in the 21st century.
By Daniel Henninger March 15, 2023
Did Twitter contribute to the panic over the stability of the U.S. banking system? That is the question raised by a thought-provoking piece in this newspaper Tuesday.
“Posts on Twitter and other social-media platforms,” the Journal wrote, “helped fuel concerns about the U.S. banking system in recent days, as a range of users from prominent investors to internet provocateurs speculated more chaos could ensue.” The Republican chairman of the House Financial Services Committee, Rep. Patrick McHenry, calls it “the first Twitter-fueled bank run.”
Hit the pause button. This is not another example of Twitter colluding with the government to shape events. It is instead a case study in the bad things we do to ourselves using the platforms, or trampolines, of social media.
Especially intriguing is the possibility that the government’s quick and questionable decision, announced at 6:15 p.m. Sunday, to cover all depositors at Silicon Valley Bank and Signature Bank was driven by the feds’ own panic at the doomsaying on Twitter. It might be truer to call this the first Twitter-fueled Treasury run.
The circumstantial evidence is striking.
From startup investor Jason Calacanis Saturday: “YOU SHOULD BE ABSOLUTELY TERRIFIED RIGHT NOW.”
Internet personality Kim Dotcom: “Run on the bank!”
Investor Bill Ackman: “Absent a systemwide @FDICgov deposit guarantee, more bank runs begin Monday am.”
Mr. Calacanis again: “ON MONDAY 100,000 AMERICANS WILL BE LINED UP AT THEIR REGIONAL BANK DEMANDING THEIR MONEY—MOST WILL NOT GET IT.”
The great Scottish debunker Charles Mackay wrote “Extraordinary Popular Delusions and the Madness of Crowds” in the 1840s. Who knew that the madness of crowds would become everyday life in the 21st century?
Recall how in the early days of Facebook in 2006, the platform was adopted by grandparents and moms who wanted to share stuff with the immediate family. Boy, was that the age of innocence. In short order, media platforms, notably Twitter, morphed into personal and political power games.
You didn’t post on Twitter to share a quick thought with close friends. Email distribution lists accomplished that. You posted on Twitter to share your opinions with the whole world. In the Twitterverse, the worth of your opinion—by no means the same thing as the real-world plausibility of your opinion—was measured by retweets and likes on the site.
In about a nanosecond, the Twitter “community,” (a debauched word if ever there was one), learned that the path to popularity was overstatement, snark, serial exclamation points, all-capital letters and other techniques for turning pedestrian reality into entertaining exaggeration.
We all know who figured this out in less than a nanosecond—Donald J. Trump. He played Twitter like a Stradivarius, accumulating more than 80 million followers. The Trump genius was in recognizing that while many of those millions didn’t believe anything he wrote, enough of the rest believed everything—and would send him money for saying it. Much political fundraising today is built entirely around the social-media phenomenon of mass belief.
This isn’t a knock on Mr. Trump, nor on Messrs. Ackman, Calacanis and Dotcom. Ultimately, these postings are little more than flotsam in an ocean of opinion. What’s different is that in an earlier age, much of the opinion that now gets elevated by social media was guys shouting at their television from a couch. Today, couch potatoes adept at Twitter’s overripe vocabulary are “influencers.”
Arguably, social media merely democratized the opinion game. That, anyway, was the early promise behind platforms like Twitter, Facebook and YouTube, which caved beneath the weight of their neurotically politicized employees to cleanse the new forums of conservative opinion.
What intrigues me about the SVB panic is that the U.S. Treasury, Federal Reserve and Federal Deposit Insurance Corp. could have been spooked into a premature bailout by the chance that a social-media wildfire might collapse confidence in the banking system over a weekend.
This isn’t a Twitter problem that needs subpoena letters from House Judiciary Chairman Jim Jordan. The problem is the rise and spread of our own unmediated human credulousness on an unprecedented scale.
Recall how in the early days of social media, a surge in repostings for an opinion or video – “Run on the bank!”- was said to have gone viral. That phrase was an early warning. A virus or pathogen was once thought to describe something dangerous. Now it’s desirable.
The government’s instinct to do a mass bailout over the spreading SVB panic suggests it could happen again—maybe a Biden-media debt-ceiling panic. On social media, the sky is always falling somewhere.
No piece of legislation from Elizabeth Warren will solve human credulousness. But recent experience suggests solutions that worked, until they were abandoned.
The Sam Bankman-Fried debacle with FTX has revived the concept of due diligence. The SVB saga—a decade of euphoric, zero-interest investing topped off with an overnight federal bailout—should renew the notion of moral hazard.
That’s two protective solutions, each explained in two words. Even by Twitter’s short-form standards, that’s efficient.