A combination of factors contributed to strong stock market returns in January: a) China abandoned its “zero-COVID” policy; b) indications of peak inflation; c) favorable valuations in certain sectors; and d) expectations the Fed would soon pause interest rate hikes. China’s unreasonably restrictive measures hindered global GDP growth in 2022. Investors anticipated China’s re-opening this year would accelerate global trade. Many indicators supported the argument that inflation had peaked, particularly with respect to goods and energy prices. Supply chains had returned to pre-pandemic efficiency, reversing shortage-related cost spikes in many sectors. Equity valuations adjusted to the new interest rate regime, and while not cheap historically, they were no longer excessively inflated. In addition, other economic indicators raised concerns the economy was contracting rapidly. Given these considerations, most market participants anticipated the Fed would cease interest rate hikes in the first half of 2023. Some investors, less sanguine about economic prospects, argued the Fed would need to cut rates as soon as the Fourth Quarter.
Inflation, unfortunately, did not cooperate as some had expected or hoped. Stubbornly high services inflation contributed to uncertainty regarding Fed policy. Numerous Fed officials emphasized vigilance against inflation. Stock and bond markets responded in February with greater volatility.
Beware the Ides of March! Silicon Valley Bank, the second largest bank failure in history, consumed investor attention during the first few weeks of March. Concurrently, European regulators contended with the failure of Credit Suisse. Over the course of a few days, the general public grew justifiably concerned about the safety of their deposits. Fears of contagion gripped markets, and volatility spiked. While it is premature to dismiss risk of contagion, we believe the collapse of Silicon Valley Bank is primarily the result of idiosyncratic factors. The bank had inadequate risk controls, a concentrated customer base, and a high percentage of uninsured deposits. Rapid deposit flight led to capital inadequacy, and we believe poor management was the principal cause of the bank’s failure. Media reports suggest regulators suffered from inertia with respect to supervisory and enforcement measures.
There is an old Wall Street adage that “the Fed raises rates until they break something.” Some commentators blame the Fed for the eruption of concerns over regional banks. We acknowledge the pace of rate increases was unexpected, but the Fed has been consistent and steadfast in its commitment to defeating inflation. In our view, recent events suggest an unwillingness of certain institutions to adapt to the new interest rate regime. That intransigence proved to be a costly mistake.
In response to growing anxiety about bank deposits, the Fed, Treasury, and the FDIC quickly coordinated regulatory responses that included a new lending facility to support regional banks. It appears their efforts stabilized deposit flows. However, we caution against complacency with regard to these issues.
The current situation contrasts sharply with the Great Financial Crisis. The collapse of the global financial system in 2008 was a credit crisis resulting from excessive leverage; poor collateral quality; and exceedingly complex derivatives structures that obscured risks. In this cycle, bank depositors understandably re-allocated cash to higher yielding money market funds and short-term Treasuries. At the same time, bank assets declined in value as interest rates rose. The combination of deposit outflow and asset mark downs led to capital inadequacy at several financial institutions. Long term, we expect the current situation will catalyze development of a revised regulatory framework to improve deposit security. We are comforted by the recent reduction in volatility and recovery by the stock market despite these uncertainties. Please contact our office to schedule an appointment to discuss these matters and to review your accounts. We look forward to hearing from you.