The first quarter of 2023 stood in stark contrast to much of 2022 as the NASDAQ outperformed other broad stock indices and the yield on the 10-year Treasury note fell. Some voices are calling this the beginning of a new bull market as equity markets seem to be pricing in a mild recession or even no recession at all. We remain cautious, however, and can’t ignore a number of themes that are still developing—the second largest bank failure in U.S. history, what’s likely to be the second straight quarter of declining earnings growth in the S&P 500, and credit default swap spreads on U.S. debt that are higher than they have been at any time since the Financial Crisis. The Federal Reserve also finds itself in the tough position of having to tighten monetary policy to fight inflation while also trying to ease policy to control financial conditions at the same time.

Only time will tell whether the problems in the banking system are systemic, but we feel the odds of a recession have only increased since Silicon Valley Bank failed a few weeks ago. More on this below, but all banks, regardless of size or quality, appear to be in the process of tightening lending standards and risk controls for businesses and consumers alike. The Prime Rate currently stands at 8% while the S&P 500 still trades at more than 18x earnings. Inflation clearly appears to have peaked, but at 5% it remains well above the Fed’s stated target of 2%. We believe the Fed, the Biden Administration, Congress, and especially investors, are in store for some hard choices in the second quarter and beyond. As we’ve said before, one of our favorite quotes about investing is, “There are only 2 losses in the market, a loss of capital and a loss of opportunity. If we protect the capital, there will always be another opportunity” (Louise Yamada). For now, we remain comfortable protecting capital and looking for opportunities that seem more clear.

In March, the unexpected failure of three unique and specialized commercial banks focused the attention of financial markets on the safety of the U.S. banking system. The events surrounding Silicon Valley Bank, as well as Silvergate Bank and Signature Bank, have made investors wonder if we are on the verge of another financial crisis and have caused the value of bank stocks to trade off significantly. Silicon Valley Bank was focused on lending to technology venture capital investors (historically a much too speculative area for traditional banks), while Silvergate and Signature were focused on lending to aggressive crypto-currency market participants (another speculative line of business with new and unknown risks not traditionally borne by banks). In each instance, the bank failed because of its concentration on serving a unique, fast growing, and somewhat unproven niche market, which created illiquid balance sheets, unrealistic risk management scenarios, and concerns from bank depositors. Ultimately, their large, concentrated depositors quickly withdrew funds from the banks at a rate that the banks could not redeem, forcing the Federal Reserve to provide liquidity and the FDIC (Federal Deposit Insurance Corporation) to step in and take over.

Based on our research and experience, we believe that the circumstances leading to these specific failures are very different from the traditional business conditions that most banks operate within, and that well-established regional and money center banks, such as Truist and JP Morgan, are in very little danger of similar fates. These banks are well capitalized, have highly diversified loan and deposit books of business, and are experiencing historically strong credit trends. They are well managed by experienced management teams and are well supervised by the authorities who will be even more active in monitoring the credit, market, and economic risks assumed by these large banks. In fact, we think banks will emerge stronger and better prepared to manage through unexpected financial markets in the future.

It may take much of this year, but we believe the process of restoring confidence in the banking system is underway, and that many bank stocks will recover in value in the near-term. But this episode does leave us with some concerns going forward. The banking business is likely to be more highly regulated and will be required to increase its capital levels. Bank operating costs are likely to increase, and depositors will be more aware of the opportunity cost of maintaining too much in low-yielding bank deposits, so profit margins will be pressured. Banking will be a tougher business in the future, so we expect banks are likely to consolidate further to combat these costs. We do feel that the system is sound and that depositors are well protected, but the longer-term value of banks as an investment will definitely be more limited.

The easy money policies of the last decade largely lulled markets to sleep and slowly compressed the returns in the fixed income markets to all-time lows with the 10-yr U.S. Treasury getting as low as 0.50% in mid-2020. Throughout 2021, yields steadily rose, with the 10-year finishing the year at approximately 1.50%. Then 2022 hit – rates spiked – going from 1.50% to a high of 4.25% in October of 2022. This dramatic increase in yields on both shorter and longer-term bonds correlated with both the Federal Reserve hiking the Fed funds rate from 0% to 4.50% over the course of 2022 and domestic inflation metrics surging to the highest levels we have seen since the early 1980s. Typically, we look for bonds to be a “hedge” or offset to stock market volatility, but in 2022 the opposite proved true. 2022 was one of the most difficult years for bonds in history, with most total domestic bond market indices losing around 13%. For perspective, in the past 45 years, the Bloomberg Aggregate Bond Index has produced negative annual returns just five times! The worst year was in 1994 when the index dropped -2.9%.

What does all this signal for the rest of 2023? The silver lining for our current bond market is that for the first time in a long time, yields are attractive again. For reference, in late 2022, yields touched their highest level since the 2008 global financial crisis! Since October of 2022, yields have retreated but remain at some of the best entry points into the bond market in over a decade. And while we don’t expect yields to drop to the levels we saw during the depths of COVID, where they finish 2023 largely hinges on our economy’s ability to avoid a deep recession. The Fed’s raising of the Fed funds rate has caused inflation to roll over, which is a positive sign. However, we need inflation to keep dropping without the Fed causing too much damage to the labor market. A deep recession would certainly drive bond yields lower, as it would dampen growth expectations and kill inflation. However, if the Fed manages to get inflation down without causing a severe recession, we could see yields moderate and even drift higher over the course of the year and into 2024.

With a deep yield curve inversion (short-term yields higher than long-term yields) it may feel counter-intuitive to buy bonds that mature later, however, if the Fed does start cutting rates due to either softening inflation or economic contraction, locking in some of these yields now may turn out to be the astute market decision. This is why we have selectively been adding duration for many bond portfolios while being extremely mindful of bond credit quality that could be affected by an economic contraction.

Review your banking relationships. You should assess whether the deposits held at each bank are within insurance limits and consider investing any excess balances in high-quality, short-term bonds, which provide the needed safety and pay much better yields than they have in the recent past. We welcome the opportunity to discuss any of this with you at any time and are glad to help identify and address particular risks. 

Did you know that you can pull your credit report for free from each of the three credit bureaus once per week? With the continued rise in the cost of borrowing, it’s not a bad idea to take a look at your credit report and make sure everything is in order. Experian, Equifax, and TransUnion are allowing users this benefit through the end of 2023.

Post tax season is a great time to revisit and evaluate your financial position and plans. We would be happy to meet with you to discuss any changes you may feel are pertinent or to review your financial needs and goals.