1st Quarter 2023: Market and Economy

Market and Economy

There is a saying that “the Federal Reserve will tighten until something breaks.” Entering March, Fed Chair Jerome Powell hinted at accelerating rate hikes to dampen persistent inflation, promptly sending stocks and bonds lower. But something did break in the following weeks, causing interest rates to fall and resulting in a strong three-week stock rally to close out the first quarter.

And so, despite enduring high inflation and two of the largest bank defaults ever, markets closed out the first quarter on a positive note, with all major asset classes posting gains. The S&P 500 led the way, rising 7.5%. Bonds made strides towards recovering 2022’s losses, with the Bloomberg US Aggregate Bond Index returning 3.0%.

Rumor Becomes Fact for SVB

In early March, rumors of a potential failure spread among Silicon Valley Bank (SVB) depositors, resulting in a bank run—so named because of people running to withdraw their deposits before a bank closes its doors. Exacerbating the panic, 94% of SVB deposits exceeded the $250,000 protection limit, and thus were not insured by the Federal Deposit Insurance Corporation (FDIC). On March 10, the FDIC took possession of SVB and guaranteed all of the bank’s deposits.

Although SVB’s collapse affected just a sliver of the economy, depositors at other regional banks began actively searching for signs of weakness, ultimately triggering bank runs at Signature Bank and First Republic Bank, both of which held a significant amount of uninsured deposits. In Europe, the Swiss central bank’s $54 billion lifeline failed to save Credit Suisse, resulting in the sale of the 167-year-old bank to UBS. Fortunately, for now, the banking crisis appears to be contained thanks to effective guarantees by the FDIC and the Fed on all US deposits, insured or not.

Comparing the 2008 and 2023 Banking Crises

In 2008, the failure of Lehman Brothers triggered a major financial crisis and sent shockwaves throughout the global economy. Though it is possible other banks may be affected by the fallout from SVB, the current banking crisis is markedly different from what occurred in 2008.

Lehman Brothers fell because of subprime loans, as lenders were offering easy credit to homebuyers. The incentive to lend to anyone, regardless of their ability to repay, resulted in leveraged exposure for Lehman Brothers and others to bad loans through derivatives and off-balance-sheet investment vehicles, which were largely kept hidden from investors.

Furthermore, at the time, the US economy was already nine months into a recession, with unemployment elevated at 6.1%. As mortgage delinquencies and foreclosures reached record levels, losses mounted, leading to 25 bank failures in 2008, 140 in 2009, and 157 in 2010.

In contrast, only two banks have failed in 2023. More could follow, but the situation is unlikely to deteriorate to 2008 depths. Moreover, Lehman Brothers had to pay out its losses, while bank losses today are mostly unrealized losses on what are generally considered the safe assets.

Banks hold government-backed bonds, like Treasuries, as collateral for customer deposits. In recent years, reaching for yield in a low-interest environment, many banks bought long-dated bonds that won’t pay out for a decade or more. Much like in bond portfolios held at Bragg Financial, bond prices fell as rates rose, but longer-dated bonds plunged the most. SVB alone had $15 billion in book losses, but would still be operating today if depositors had not withdrawn funds en masse. As explained in the classic film “It’s a Wonderful Life,” the perception that SVB might fail led to the bank actually failing, when it was forced to sell those bonds to raise cash and realize $15 billion in losses.

Additionally, the US is not currently in a recession, with US GDP growing at an annualized rate of 2.7% in Q4 of 2022, and the latest Atlanta Fed estimate showing GDP rising at 1.7% in the first quarter. In every recession since 1948, unemployment has risen at least 1% and has averaged an increase of 3.9%. While still possible, we have a ways to go with unemployment currently only 0.2% above January’s lows, sitting at 3.6% as of February.

Fed Pause for Effect?

Before SVB fell, Fed governors’ top worry was an economy running too hot. Consumers, flush with cash from COVID-19’s monetary and fiscal responses, have been on a buying spree, sustaining high inflation even once most supply chain disruptions have been resolved. To combat inflation, the Fed increased interest rates faster than at any point in the last four decades, leading to selloffs in stocks and bonds.

While the current banking crisis appears contained for now, it will have ripple effects on the broader economy. The reason the Fed raises interest rates is to make borrowing money more costly, causing consumers and businesses to make fewer large purchases and investments.

Bank managers concerned about facing the same fate as SVB will probably be more cautious in their lending practices going forward. To reduce risk, they will likely lend less and increase reserves to cover deposits. The cost to cover the $22.5 billion of the FDIC’s deposit coverage for SVB and Signature Bank will also be paid by all banks receiving FDIC insurance, reducing profits and leaving less cash to lend. Congress may also decide to implement new regulations to stabilize the banking system, which could further limit how much banks can lend.

Reduced lending means fewer new construction projects, business investments, and ultimately rising unemployment. The reaction to SVB’s failure may just finish the job the Fed began by raising interest rates.

Many experts expect the Fed to raise rates 0.25% one final time in May before pausing, which would be good news for investors. Following the end of the last six Fed rate hike cycles, the S&P 500 had an average return of 17.6% in the year after. While we aren’t counting on that type of return, it’s reassuring to know that the potential exists.

Congress Playing a Game of Chicken Over the Debt Ceiling

The recent banking upheaval puts the US economy on weaker footing and at greater risk of a recession, but with plenty of room for interest rates to drop, the Fed has ample ammunition to avert a deep recession. However, there is another major risk on the horizon: the federal debt ceiling. In January, the Treasury Department hit the debt ceiling, meaning the national government has maxed out its credit limit to pay its obligations, such as Social Security, Medicare, and defense. The Treasury has resorted to “extraordinary measures,” accounting tactics to keep paying bills for now and delay default. A divided Congress has made little progress on raising the debt ceiling, and unfortunately, the current measures only buy so much time. The US is approaching a possible default in late summer.

Congress has approved raising the limit 78 times since it was instituted in 1917, but this kind of brinksmanship has become highly politicized in recent decades. Despite the lack of current progress, we hope a default remains unlikely because doing so would erode economic confidence, not to mention severely damaging US credibility.

Preparing for More Volatility

Through March, the S&P sat 14.3% below the last all-time high set on January 3, 2022. Though it is painful to see account values linger below their high-water marks, it is actually normal for investors. Stocks historically trade below highs the vast majority of the time. From the March close dating back to 1950, the S&P 500 only closed at new all-time highs on 7.7% of trading days. Across all of those trading days, the S&P 500 on average closed 9.7% below previous highs. Despite the fact that investors have been disappointed with stock prices on the average trading day, the S&P 500 has still returned a staggering 24,526% since 1950. Staying invested has paid off and will continue to reward long-term investors.

Several concerns continue to weigh on markets, and market volatility will likely continue in the coming months. While it is probably not the time to take additional risk in your portfolio with a potential recession looming, it is also not the time to be too conservative as markets usually turn well before economic news improves. Owning bonds was painful last year, but those same holdings are offering more protection against falling markets than at any point over the last decade, with ample room for rates to fall. Diversification today offers better protection than it did last year, both to offer safety if markets start dropping again and appreciation potential when prices move higher.

This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.