Market Commentary - April 2023
“This was more a case of a ‘bank-run by idiots’ rather than a ‘bank run by idiots’.”
— Matthew C. Klein; The Overshoot; March 13, 2023
Though we are impressed with his clever word usage, we don’t buy into the thesis. Let’s dive into the demise of Silicon Valley Bank (SVB) to understand what happened and the implications for the financial markets—especially Charles Schwab.
Autopsy on SVB
COVID-19 closed China, the source of countless consumer products and technology components. Supply chains were broken. By March of 2020, much of the U.S. operated under shelter-at-home restrictions. Real GDP in the U.S. contracted by 4.6% in Q1 of 2020 and an additional 29.9% in Q2 (annualized rates). 1 In six weeks, beginning February 10, 2020, the S&P 500 shed over 30%—quickly moving into bear territory. 2 The U.S. government responded with a massive infusion of liquidity from both fiscal and monetary pumps. Personal savings piled up from a combination of government stimulus and unprecedented constraints on shopping, dining out, and travel.
With interest rates pushed down near zero, neither cash nor bonds were alluring in the near term. The stock market was cratering. Where would those excess savings be channeled? Here’s one answer: capital invested in Venture Funds doubled from 2020 to 2021. 3
Venture Capital firms put that fresh capital into “their” bank—Silicon Valley Bank (SVB), where deposits climbed seven-fold between 2019 and 2022. 4
Banks make money by paying depositors one rate and charging borrowers a higher rate of interest. However, the wave of deposits overwhelmed SVB’s ability to place loans. Instead, they invested surplus capital into U.S. government securities (not funky collateralized notes that were at the center of the 2008 banking crises).
Then, the world turned. The Fed had an epiphany in March of 2022 that inflation was not transitory and embarked on a series of aggressive interest rate hikes. 5 Unintended consequences included the diminished attraction of speculative investments, including venture funds. Instead of raking in capital, venture firms started to draw on their bank savings. Meanwhile, the Fed drove interest rates from near zero to almost 5.0%. 6 Who wants “yesterday’s bonds” that pay only 1.0% - 2.0%, when the new ones pay so much more? On paper, the value of SVB’s bond portfolio suffered. WCF typically recommends that bondholders simply hold bonds like these to maturity when they receive their original capital. However, at SVB, the transparency of the bank’s portfolio losses, combined with customers who were savvy CFOs of venture funds, created a rush to withdraw cash. On Thursday, March 9, $42 billion of cash was withdrawn from the bank. 7 Despite SVB’s intention to hold bonds to maturity, that was no longer an option. The paper loss of the bond portfolio reached $18 billion—equal to the entire market capitalization of the bank. Was this a run on the bank by idiots? Not really, considering that 93.8% of its total deposits were uninsured through FDIC. 8 Was the bank run by idiots? We will leave that to the regulators, but the extreme exposure to rising interest rates warrants an inquiry and, hopefully, accountability.
This is not 2008:
The banking system buckled in 2008 under the weight of deteriorating real estate-related loans. However, the challenge today is not poor credit quality, but instead, the interest rate risk of banks’ bonds. This problem solves itself with time. Capital ratios in the banking system are substantially higher than they were prior to 2008. 9
This is not a “Sophie’s Choice”:
The financial media has emphasized the potential struggle for Fed Chair Powell to either maintain the fight against inflation or support the banking system. Yes, the Fed balance sheet expanded temporarily to provide banks with extra liquidity to pacify depositor concerns. Increased scrutiny, combined with fear of a pending recession, should serve to curtail excessive bank lending.
Inflation is heading down, but not out:
Though rooted in COVID-19, the triggers for the current inflationary cycle include unprecedented government stimulus, severely broken supply chains, and a spike in both home and energy prices. Each of these factors are in the process of unwinding. The cost of sending a shipping container from China to the U.S. peaked at approximately $11,000 in September 2021 and is currently near $1,256. 10 Since peaking in the spring of 2022, oil prices have dropped by more than 30%. 11 Housing prices reached their apex in May of 2022 and, as seen in the next graph, have since been sliding steadily downward. 12
Recent research suggests that 70% of the February Consumer Price Index (CPI) increase was driven by “the cost of shelter.” 13 Finally, major corporations have been beating a steady drum of significant layoffs. 14 With all that said, keep in mind, some upward pressure will remain on pricing due to the current political movement away from globalization and slowing population growth diminishing the size of the U.S. work force.
The Fed Tightening Cycle is Over:
During March, the yield on the 10-Year Treasury Note fell from 4.01% (3/01) to 3.48% (3/31). 15 The S&P 500 rose by 5.98% (day of bank seizure to 3/31). 16 Inflation expectations dropped from 2.52% (on 3/03) to 2.32%. 17 The Federal Funds rate was projected to end the year between 5.25% - 6.00% before SVB failed. By the end of the quarter the markets were projecting a .50% decrease in interest rates by year-end. 18
We have witnessed the value destruction associated with higher interest rates. It’s a positive to be at or near the end of this rate cycle. As we mentioned last quarter, bonds look attractive on a risk-adjusted basis, though yields have eased since SVB. Small and foreign stocks offer compelling valuation owing to the risks associated with a recession or the escalation of conflict in Ukraine, respectively. Though U.S. large cap stock valuations have normalized compared to last year, at 18 times forward earnings, they are not cheap. 19
We are reminded of the perils of binomial forecasts.” As recently as mid-November, the National Oceanic and Atmospheric Administration’s three-month outlook still predicted below-average winter precipitation in California.” 20 Look no further than the all-time high of 700 inches of snow at Mammoth Mountain to see how that prediction turned out. We liken portfolio construction to tire selection and are grateful to have had our “all weather” wheels in place through this recent period of market volatility.
A Special Note: Schwab
Charles Schwab ranks as the 10th largest bank in the U.S. 21 They, too, held bonds that were vulnerable to rising interest rates. However, that’s where the comparison to SVB ends.
According to a report from Schwab, 80% of all deposits held in their bank are below the $250,000 FDIC limit. Earlier, we referenced the fact that only about 6% of SVB’s deposits were FDIC-protected. Schwab’s customer base consists of 35 million accounts from a broad range. Most customers at SVB were Venture firms. On March 1, 2023, Schwab’s corporate bonds traded at 94.072, yielding 5.197%. By the end of the quarter, once the problems at SVB were fully exposed and Schwab’s stock had traded down in sympathy, their bonds traded higher at 94.873 to yield 5.025%. In other words, Schwab’s creditors considered Schwab to be less risky at the end of March than they did at the beginning of the month. Michael Wong, Director of Equity Research at Morningstar, recently penned, “Schwab shouldn’t ever have to change those unrealized losses into realized losses by selling the securities, because it has so much access to cash.” 21
We remain steadfast in our confidence that Schwab will continue to provide faithful custodial services for your and our investments.
- Bureau of Economic Analysis; BEA.Gov.
- Silicon Valley Bank Investor Relations Presentation; Q4 2022.
- “Federal Reserve approves first interest rate hike in more than three years, sees six more ahead.” CNBC; March 16, 2022.
- “Effective Federal Funds Rate.” Federal Reserve Bank of New York; 3/31/2023.
- “SVB Depositors, Investors Tried to Pull $42 Billion Thursday.” Bloomberg; March 10, 2023.
- “SVB, Signature racked up some high rates of uninsured deposits.” Standard & Poor’s; March 14, 2023.
- “SVB, Signature racked up some high rates of uninsured deposits.” S&P Global; March 14, 2023.
- https://fbx.freightos.com; March 30, 2023.
- West Texas Intermediate; YCharts; March 30, 2023.
- Case-Schiller Housing Index; YCharts; March 30, 2023.
- Data from Bureau of Labor Statistics. “Housing Inflation Remains Hot. It’s Not Just Rent.” Barron’s; March 14, 2023.
- “A comprehensive list of 2023 tech layoffs.” TechCrunch.com. 7,000 employees at Salesforce.com; 18,000 jobs Amazon; Microsoft 10,000 jobs; Google10,000 jobs; PayPal 2,000 jobs; Dell 6,650 jobs; Zoom 15% of workforce; Yahoo 20% of employees; Meta 10,000 jobs; Disney 7,000 jobs.
- Federal Reserve Bank of St. Louis; FRED.
- “Weekly Wrap.” Goldman Sachs; April 1, 2023.
- “Why California wasn’t prepared for the atmospheric rivers.” Los Angeles Times; January 25, 2023.
- “Why Schwab, a Financial Giant, Got Hurt in the Regional Banks Panic.” New York Times; March 31, 2023.