The Entryway – 2023 Q2: Market Update & Outlook

Market Check-in

Investors experienced an extremely challenging environment in 2022 with the S&P 500 having its seventh worst year on record stretching back to 1928 and the bond market – as measured by the Bloomberg US Agg Index – having its worst year on record stretching back to 1976. In short, investors were ready for new beginnings in 2023.

As the calendar turned to 2023, many of the same factors were driving financial markets and future expectations: rising interest rates, increased borrowing costs, sticky inflation, strong labor markets and continued uncertainty abroad. The first three months of the year brought two additional 0.25% rate hikes in February & March, inflation readings continued to read higher than 5% (23 straight months with year-over-year inflation increases of 5%), and an unemployment rate that finished the quarter at 3.5% – matching its lowest level in half a century.

Despite these same issues, the stock and bond markets started the year strong with most major market indices in positive territory with market participants pricing in a near perfect outcome for Fed policies, corporate earnings, and the consumer at large. In our opinion, the short-term performance of markets in 2023 continues to illustrate why we believe in investing based on a client’s short- and long-term needs versus trying to time markets. History, data and results all suggest that timing the market is a fool’s game, and long-term success is rooted in having a plan, customizing your asset allocation around that plan and controlling what you can control.

At the end of Q1 2023, here is where the major indices stood:

While the first quarter was a great start to the year, it was not short on uncertainty or newsworthy events. Unfortunately, in early March investors and the public were reminded again of how an erosion of confidence in the banking system can have large direct impacts and unintended consequences.

A traditional “run on the bank” – Silicon Valley Bank

In the first quarter, we were all reminded of just how quickly market dynamics can change and how interrelated our financial system is. The latest reminder was the sudden collapse of Silicon Valley Bank (SVB) and Signature Bank, which were the most extensive bank failures since the Global Financial Crisis 15 years ago. These events made everyone question various institutions and their own cash position, and they raised potential concerns that other small and regional financial institutions might face similar liquidity problems. While we believe there are several characteristics that make what happened at SVB and Signature unique, we spent time making sure clients’ cash at Schwab was protected and worked various other channels to ensure backup options were available that would also provide capital preservation, a solid interest rate and liquidity. What happened at SVB and Signature were classic “run on the bank” scenarios where those two institutions failed to properly manage their assets and liabilities on their balance sheet.

Let’s take a deeper look at SVB. Throughout late 2020 and 2021, SVB, like most banks, was flooded with deposits when individuals and entities received COVID-19 stimulus payments. People and companies alike parked massive amounts of cash at banks, and the banks had to do something with those dollars, i.e., make loans or purchase securities. However, there were so many deposits that the banks could not find enough loans to extend. In turn, these banks chose to purchase a significant number of securities, mainly U.S. Treasuries.

In a vacuum, this is not a bad decision as the bank was likely earning more on those loans and securities than they were paying deposit holders in interest. However, these banks misaligned their balance sheet, loading up on longer-dated securities to try and squeeze a little more interest out of their investments. This could not have come at a worse time as the Federal Reserve began aggressively raising interest rates in March 2022, eventually raising the Federal Fund Rate by 4.75% in one year. As a result, SVB was sitting on billions in unrealized losses on their bond portfolio. Once again, this is not an issue if your deposit holders don’t pull deposits as these bonds that are currently showing unrealized losses mature at par value, i.e., no loss. However, for SVB, their deposit base was predominantly ultra-affluent individuals and companies in the private equity / venture capital community. These individuals and companies were some of the hardest hit during the 2022 sell-off and many had liquidity needs. On March 8, SVB disclosed to the public that they had to sell $21 billion worth of securities at a $1.8 billion loss for fund deposit holders who were leaving the bank. This announcement caused further panic and created a bank run as customers withdrew $42 billion in deposits the following day. By March 10, the California Department of Financial Protection and Innovation seized SVB and placed it under receivership of the FDIC.

The collapse of SVB and Signature led the Federal Reserve, U.S. Treasury and FDIC to establish protections for most deposits in those two banks, as well as facilities to backstop other banks whose securities portfolios may be underwater on a mark to market basis. For instance, the FDIC announced that all deposits, both insured and uninsured, would be fully protected under FDIC coverage, and the Fed agreed to provide loans against securities so that banks can meet any liquidity needs without having to realize losses on their portfolios.

The failure of SVB and Signature Bank created a new sense of uncertainty in our economy and led many Fed officials, economists and talking heads to hypothesize that the Fed should stop its monetary tightening program to reduce pressures on the banking system. As the old saying goes, the Fed generally raises rates until it breaks something. Many posited that this was the most recent example and was direct evidence of the potential damage and unintended consequences from the Fed’s aggressive tightening.

While the Fed announced its ninth straight interest rate hike in late March, it was a smaller 0.25% increase. The bigger issue at play, and something the Fed is watching also, is what do the recent events do to credit conditions? In short, do banks reign in their lending? We spoke with numerous local bankers, fund managers in private credit, real estate and private equity, and many believe the answer to that question is a resounding yes. As one of our real estate asset managers stated recently, most banks were already only lending to their A+ relationships before this recent banking issue. Now, they are not lending at all. As we all know, the United States (and the world) is a credit-based system that must continue to extend credit to grow. If lending continues to stall and banks extend less loans, the economy will contract, and a recession will likely follow.

Market Outlook

We mentioned a “sea change” in our last newsletter where the dynamics in place since 2008 were changing and we were entering a new environment where monetary conditions were getting tighter, e.g., banks less willing to lend or lending on less favorable terms, people less optimistic and less likely to spend, and companies reassessing their risk appetite as they feel more uncertain about the near future. We believe the first quarter of 2023 continues to demonstrate this sea change – both the good and the bad. The bottom line is there will always be areas and strategies we can utilize to help families achieve their goals and get a solid return on their dollars over the long term. However, these investments don’t always look the same over time and it is naïve to assume that the same type of strategies will always work. Said differently, the fundamental principles of investing stay the same, but the instruments used to get there will inevitably evolve over time.

If we are entering into a new environment where inflation and interest rates remain elevated from previous decades, we also must evolve our investment strategies to meet these new realities. While this change can be difficult and can cause concern, investors are not out of options. For one, we will continue to control what we can control. We can control our communication with you, the plans we lay out for you, our understanding of your specific needs and then tailor your investments around those stated needs.

In addition, we will not stand flat footed and will continue to play defense. Over the course of !022, we shifted the significant majority of our stock dollars into value companies that are more stable, produce more cash-flow, and are more resilient when the cost of capital is higher. We continue to take advantage of higher interest rates by moving non-stock dollars into short-term individual bonds, locking-in yield to maturities of 4.5-5% (often risk-free individual U.S. Treasuries). We continue to utilize Schwab’s platform to get a healthy rate of return on cash in money market funds: 4.7-4.85%. Lastly, we continue to search and layer in alternative investments that should continue to outperform their traditional counterparts in this new environment.

While change is never easy, we are prepared for the challenges and opportunities ahead. We are resolute in our commitment to our processes, we continue to retain and hire the highest quality people, and we aim to provide a variety of high-quality services to the families we serve. While life is full of uncertainties, we welcome these challenges and have a collection of individuals in our firm prepared and capable to address your needs!