The Examples Change, the Lessons Stay the Same
We address the current banking concerns, and how some simple steps can help protect investors in the midst of the current economic turmoil.
Five Things You Should Know
Insights for Investors
“The more things change the more they stay the same.” – Jean-Baptiste Alphonse Karr
For all the drama of the last week caused by the bankruptcy of Silicon Valley Bank, the stock and bond markets are largely unchanged — as often happens, though it shook a lot of people out of their apathy as it relates to their cash holdings. We’ve highlighted a number of times this year the opportunity to better your return and safeguard purchasing power by looking at various cash alternatives (see here), but this last week pointed out the necessity to also watch your balances as it relates to FDIC limits.
The scares always look a little different, but two lessons that investors need to always stay mindful of are 1) that diversification and downside protection is a form/component of return, and 2) as we’ve said before, there is a big difference between volatility and risk with too many trying desperately to avoid the former and in so doing bringing on real danger of the latter. In this last week, investors still fretting the bond market (a place we see great opportunity in a number of areas) woke up to the possibility of bank runs and losing uninsured cash.
With the news of various Treasuries from around the world stepping up to insure some deposits and some troubled banks (e.g., First Republic and Credit Suisse) receiving outside investments to shore up their balance sheets, fears of a systemic banking crises have eased but other concerns remain.
Brian Wesbury noted, “SVB is not a systematically important bank that will, through counter-party risk, tear down the whole financial system. Instead, it’s symptomatically important, showing what happens when the Fed ignores Milton Friedman and the money supply and then claims inflation is transient when it isn’t. SVB’s managers made a huge mistake by not hedging its assets’ interest-rate risk. But it's a mistake they were seduced into making by bad monetary policy that was too loose for too long. Expect more trouble ahead…”
So, what else has markets on edge now? The Fed, of course.
Latest on Inflation, with The Fed on Deck
Markets rallied Tuesday as the latest CPI numbers indicated that inflation continues to cool and supports the argument that January’s data was simply transitory. That data, coupled with the last week’s banking woes, has most believing the Fed will not raise by 50bps at their meeting next week as had been previously feared.
Wesbury summed up the week’s events this way as we head into next week saying, “Given recent turmoil in the banking system, the Federal Reserve is likely to only raise short-term interest rates by a quarter percentage point next week, or maybe not raise rates at all. But inflation is still a major problem and needs to be addressed … Put it all together, and Powell and the Fed have plenty of reasons to keep raising rates and tighten monetary policy in the months to come, in spite of news about Silicon Valley Bank, Signature, and First Republic. But what the Fed should do and what they will do can unfortunately differ. The Fed’s resolve is about to face a serious test.”
While investors wait to see the Fed’s next move, they are looking to the increasingly negative yield curve for possible clues. Bespoke addressed the unusual state of the yield curve saying, “We’ve been talking about a lot of different parts of the yield curve in the last several weeks, but one curve we haven’t mentioned is the spread between the 2-year and 3-month Treasury yields. The three-month Treasury is basically a proxy for where the Fed funds rate is at, while the two-year yield can be considered an indicator of where the market thinks the Fed funds rate is going. The further you go out the curve from there, the more other factors like expected economic growth and inflation start to take on added significance in determining the yield. The last time Powell and other officials spoke, it wasn’t a question of if the Fed would hike rates next week, but by how much. Today, the Fed may not be part of the conversation given that it’s in a blackout period ahead of next week’s meeting, but the market is compensating for the absence, and based on the direction of short-term rates, it’s basically daring the Fed to hike rates next week. When the Fed Funds rate is at one level and the two-year yield is much lower, it tends to signal that the market is pricing in economic weakness ahead.” (See accompanying chart).
Brian Wesbury’s take on the current yield curve is, “The bottom line is that a yield curve this deeply inverted is a negative sign for future economic growth. Meanwhile, the M2 measure of money has slowed sharply. The growth of the M2 measure of the money supply was unusually fast through January 2022. In the past year, it is reported as falling for the first time since the 1940s, and at the fastest pace since the Great Depression. If M2 affects “real” (inflation-adjusted) economic output with a lag of a year (give or take) then that support for activity likely peaked very early this year and should dwindle sharply by year end.”
Scott Grannis is taking the other side of the debate and still believes a recession of any real consequence could still be avoided. He states, “So what is it? Will the SIVB collapse mark the beginning of another financial crisis which in turn triggers the long-awaited recession? Or is the economy so healthy that the Fed will need to raise rates even more? Inquiring minds would like to know how these two fears can coexist. I don't pretend to know the answer, but I do know that—outside of the now-famous inverted yield curve—it's difficult to find any signs that a recession is around the corner.”
He continues by highlighting current credit spreads (a solid indicator of perceived risk in the system) and the fact that they have narrowed back to long-term average levels stating, “Chart #2 shows the level of corporate credit spreads. Like swap spreads, these too tend to predict the beginning and end of recessions. Current levels reflect substantially "normal" conditions. The bond market is signaling that the outlook for the economy is generally healthy, and liquidity conditions are good. No signs of a recession here. (See following chart).
The Current Set-Up for Investors
As summarized this week by JPMorgan, “In February, markets suffered as investors grappled with the prospect of higher rates for longer. The S&P 500 fell 2.6%, while the 2-year Treasury yield recently climbed to a cycle high of 4.9% and the 10-year yield breached 4%. Looking ahead, we remain cautious toward equities. Although valuations have improved after February’s sell-off, the S&P’s forward P/E ratio remains slightly above average levels, indicating that equities may come under further pressure due to higher rates. However, despite the recent back up in yields, we expect the economy will eventually slow, inflation will fall and monetary policy will become looser. Therefore, bonds look attractive at current valuations and once again offer investors income and diversification benefits.”
Hard landing or soft landing, fears or opportunities? No one really knows, the good news is for the first time in a LONG time, investors can truly diversify their portfolios not only to protect themselves, but to take advantage of real opportunities to drive returns from various parts of the fixed income market and other alternative investments both in terms of income and longer-term appreciation potential. Income creation is not only a meaningful source of returns, but a powerful dollar-cost averaging tool during such market environments as well.
Enjoy the games this weekend, and remember a good plan lets you keep the “Madness” of March for the tournament and out of your portfolios.
Have a wonderful weekend,
Tim and the team at TEN Capital
Data, Just the Data
Data points this week included: