When the Levee Breaks

By Paul Morrone, CFP®, CPA/PFS, MSA

The first quarter of 2023 may have been the moment we have all been waiting for.  As an investor it didn’t feel particularly noteworthy, although many were pleased to see increased portfolio values as most broad markets posted marginally positive results through the end of March. There was plenty of headline risk, however, which echoed those painful and not-so-distant memories of the 2008 financial crisis. While the failure of the Silicon Valley Bank (SVB) – formerly the 16th largest bank in the country – is not to be taken lightly, there is a silver lining to seeing stress in the financial system (it should also be noted that SVBs collapse was shortly followed by Signature Bank and Credit Suisse failures, as well). It means that the Fed’s tightening measures are starting to work, said differently, the Fed raised rates until something broke. 

For you Zeppelin fans… “If it keeps on raining, the levee’s going to break…”

A confluence of factors led up to the first major bank failure since 2008, which we’ve covered in past updates. At the risk of being redundant, and for those who are looking for a quick refresher, the following timeline explains how SVB found itself in a bind seemingly overnight:

• The US was operating in a very low interest rate environment since 2008, and the extreme measures taken during COVID further depressed interest rates to historical lows on traditionally safe investments such as long-term government debt
• Banks, in an attempt to generate income on the deposits held by their customers, purchased hordes of long-term government debt at very low rates over the past several years
• The Fed aggressively raises interest rates throughout 2022 and into 2023 to slow the economy in its fight against inflation
• Bonds have an inverse relationship with interest rates, meaning if rates go up, the value of existing bonds in the marketplace goes down (think rationally – you wouldn’t pay the same price for a 2% government bond as you would for a 5% government bond – the 2% bond would be worth less, all other things equal)
• In an attempt to meet demand for customer withdrawals, banks were forced to liquidate their long-term bond holdings that they had never planned to sell, which realized losses that were previously unrealized – and the losses were significant
• SVB had more money ‘on paper’ based upon the long-term value their bonds, not the ‘fire sale’ value which they had monetized their bonds at. This death spiral forced SVB into insolvency as it did not have enough assets to cover total customer withdrawal request
• SVB was quickly placed into receivership and the FDIC took over. Together, the FDIC and Treasury created emergency funding to protect all depositors’ funds in full (typically the FIDC insurance only covers the first $250k in deposits). These stopgap funding measures have since been made available to all US Banks in an attempt to prevent a similar problem occurring 

“If it keeps on raining, the levee’s going to break…”  

And break it did. The inevitable market reaction that followed was largely muted, although there were pockets of extreme volatility (to no one’s surprise, in the banking sector). More importantly than the market reaction, however, is that this is yet another indication that the Fed is getting its desired results. Pressure on the banking system, a key part of the economy’s backbone, will almost undoubtedly have an effect on the economy at large as banks tighten their lending standards in the coming months. And while most banks remain well capitalized (mitigating the chance of another failure), they will be more conservative with their lending activities making it harder for their customers to grow. This should provide much needed help to the Fed in slowing down economic activity – and the resulting inflation that it is causing – to a level that is deemed ‘sufficiently restrictive,’ soon marking an end to the vicious tightening cycle that began at the beginning of 2022.

“When the levee breaks, I'll have no place to stay…”

Which isn’t entirely true. The Fed stepped in with the Bank Term Funding Program (BTFP) within a matter of days of SVB’s collapse; a swift action resulting in an elegant solution to solve the crisis at hand. This quickly calmed the short-term turmoil and eased the fears of many who had significant deposits in banks. The FDIC and Treasury have set an important precedent showing that they do not want depositors to feel that their funds are at risk, regardless of the amount. 

“Don’t it make you feel bad when you’re trying to find your way home, you don’t know which way to go...”

Clarity is impossible to find, but the path forward is looking a bit less murky than it was only a few short months ago. You could argue that we are currently on the precipice of the best forecasted recession in history – which, on the surface, sounds worse than it is. If it is forecasted, markets have already considered the impact of a recession and are looking past it. Markets react far more unfavorably when they are blindsided, which has not been the case thus far in 2023 (save for the banking blunder). The Fed maintains telepathic in its communications, inflation trends are coming in favorably and the labor market is starting to show signs of weaking.

“Cryin' won't help you, prayin' won't do you no good, No, cryin' won't help you, prayin' won't do you no good”

Our message to investors during the first half of 2023 is no more or less optimistic than it was only three months ago. Headline risk remains, especially out of Washington. The prospect of a Fed misstep aside, front and center over the next few months will be the debt ceiling negotiations. Although, candidly, I believe we’ve all heard this song before. That does not mean that unfavorable news won’t cause short-term bouts of volatility, but we do not foresee this being a limiting long-term factor at this point. 

“All last night sat on the levee and moaned Thinkin' 'bout my baby and my happy home”

The good news is, however, that we’re now three months closer to wherever the end is. We know that the Fed is committed to keep tightening – which we expect they will at their upcoming meeting – but the number of remaining hikes and the size of those hikes will pail in comparison to what we saw during 2022. More importantly, they are largely expected and priced in to current valuations. 

This means that, at least theoretically, the correlation between fixed income and equity should be far less than in the past 18 months. Portfolios should benefit from the lower correlations as fixed income once again should provide the diversification benefit it has been touted for in the past. 

With respect to equities, markets are still searching for a catalyst to spring back up. There is plenty of pent-up demand, cash on the sidelines and negative investor sentiment that can easily turn into a rally bringing us out of the current bear market. Timing that entry point is impossible, which is why remaining focused on the long-term is so important. Staying disciplined and invested through market turbulence can help avoid the single biggest mistake any investor can make: missing the rally when it happens. 

_{The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
All investing involves risk including the possible loss of principal. No strategy assures success or protects against loss.
The content is developed from sources believed to be providing accurate information.
Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.
Tracking: 430106-1}