The economy remained resilient throughout the quarter despite fairly significant headwinds. The widely anticipated recession has failed to materialize, at least for now, as the jobs market remained robust and consumers continued to spend. The economic data largely surprised to the upside (see Kyron’s Macroeconomic Update below); however, we do not anticipate it to persist as the forward-looking economic data is trending lower.
The biggest shock came in March when Silicon Valley Bank (SVB) failed, which caused repercussions around the globe, and led to additional bank failures and consolidations. At the time, SVB was the 16th largest U.S. bank. To protect depositors and shore up confidence in the banking system, regulators stepped in, along with other banks, to provide additional liquidity. A separate lending facility was also launched to provide additional liquidity throughout the system and ensure there was not a global run on all banks.
SVB became insolvent by grossly mismanaging interest rate risk and not diversifying its business mix. In July 2022, regulators initially warned the bank that they were vulnerable. Bank deposits are traditionally invested in U.S. government securities (U.S. Treasury Bonds), which was the case with SVB. If held to maturity, you receive your money back plus interest. However, in a rapidly increasing interest rate environment, as we have experienced the past 15 months, the fair market value of these existing securities goes down. Most banks hedge this risk through varying maturities, but SVB did not. Additionally, 94% of the deposits were uninsured and from the same type of customers (technology companies), making it extremely vulnerable to a bank run.
With growing solvency concerns from large SVB depositors, a herd mentality set in, which led to a run on the bank. In mid-March, over just two days, $142 billion (over 80%) was withdrawn. To have enough cash to meet withdrawal requests, SVB was forced to sell government securities at a loss, and the bank ran out of money. Ultimately, there was a mismatch between long-term loans and short-term deposits. This has happened many times throughout history, including the savings and loan crisis of the 1980s when rates rose sharply in the late 1970s as the Fed was fighting inflation. Doesn’t this sound familiar?
As I mentioned in our mid-March email update, this is not 2008 all over again. As a result, over $100 billion left small regional banks and moved into larger banks, which has been a boon for large national banks and financial firms like Charles Schwab.
The recent bank failures, or fear of failures, will likely prompt banks to be more conservative, leading to tighter credit conditions. As a result, less lending is possible, which is disinflationary. This means the Fed will likely stop raising rates this summer as inflation continues to come down. However, it will likely cause the economy to slow down faster than anticipated, which is why a recession is conceivable by the end of the year. As we have discussed, we do not expect it to be anything like 2008. We have been waiting for the recession for quite some time and have adjusted the portfolios in anticipation of an economic slowdown.
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