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Weekly Market Analysis: SVB’s Failure and Emergency Actions by US Authorities

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3 Things to Know

A large failure

The Federal Reserve, Treasury Department and FDIC took unprecedented steps Sunday evening to ensure access to deposits at the two lenders that failed this past week, Silicon Valley Bank (SVB) and Signature Bank. They’ve drawn the line: Regulated banks will not default on deposits. Policymakers’ actions should forestall further US bank runs at institutions that had similar balance sheet profiles, as well as to regional and smaller banks whose businesses could be impacted if deposits flowed “upwards” to systemically important banks. The cost of making uninsured depositors of SVB and Signature Bank whole will be a levy on the banking industry. Avoiding a much wider panic is well worth this cost. While CIO expects this could help stem a social-media age confidence crisis, it’s not clear if the two banks are the sole institutions that will be resolved by regulators. In CIO’s view, these recent events underscore the unanticipated weaknesses caused by the Fed’s rapid rate rises, quantitative tightening and impatience with inflationary pressures.

US banking system is healthy

Panic can be a very potent fundamental – when rational or otherwise. The overall US banking system is much more strongly capitalized than it was prior to 2008/2009. This doesn’t mean every bank has been wisely and prudently managed. And even if depositors are protected, it doesn’t mean the same for bank equites or even unsecured credit.

Macro policy partly to blame

The effects of the Fed’s tightening of financial conditions are reaching beyond the channels market commentators typically cite – equity and bond markets. At an advanced stage, Fed tightening impacts bank lending, which impacts both the real economy and leveraged borrowers.

Summary

The Federal Reserve, Treasury Department and FDIC took bold and unprecedented steps Sunday evening to ensure access to deposits at the two lenders that failed this past week, Silicon Valley Bank (SVB) and Signature Bank. Their actions should forestall further US bank runs at institutions with similar balance sheet profiles, as well as to regional and smaller banks whose businesses could be impacted if deposits flowed “upwards” to systemically important banks. This weekend, a number of US banks whose stocks had come under significant pressure have already used alliances with larger banks to strengthen their position with depositors. More are likely to tap a new Fed lending facility in coming days. For now, CIO expects the Fed will take note of the SVB failure, but not assume its monetary policy tightening cycle needs to be reversed at this time -- even as CIO expects SVB’s losses to have direct negative economic impacts for firms closely linked to it.

Portfolio considerations

The silver lining to the lagged effect of Fed tightening is it gave CIO time to adjust portfolios in anticipation of current emerging economic weakness. CIO is underweight equities, with a particular deemphasis on small and mid-caps. These firms tend to have weaker balance sheets than larger, well-established firms that have the resources to raise dividend payments.

US bank failures (FDIC) and total assets of failed banks, inflation adjusted (latest data includes SVB)

Source: Haver Analytics as of March 10, 2023

A large failure

The Federal Reserve, Treasury Department and FDIC took unprecedented steps Sunday evening to ensure access to deposits at the two lenders that failed this past week, Silicon Valley Bank (SVB) and Signature Bank. They’ve drawn the line: Regulated banks will not default on deposits. Policymakers’ actions should forestall further US bank runs at institutions that had similar balance sheet profiles, as well as to regional and smaller banks whose businesses could be impacted if deposits flowed “upwards” to systemically important banks. The cost of making uninsured depositors of SVB and Signature Bank whole will be a levy on the banking industry. Avoiding a much wider panic is well worth this cost. While CIO expects this could help stem a social-media age confidence crisis, it’s not clear if the two banks are the sole institutions that will be resolved by regulators. In CIO’s view, these recent events underscore the unanticipated weaknesses caused by the Fed’s rapid rate rises, quantitative tightening and impatience with inflationary pressures.

The US banking system is healthy

Panic can be a very potent fundamental – when rational or otherwise. The overall US banking system is much more strongly capitalized than it was prior to 2008/2009. US regulators have been preparing for this moment since the Great Financial Crisis. All US banks, and particularly larger, more systemically important ones, meet strict capital requirements and undergo severe annual stress tests. This doesn’t mean every bank has been wisely and prudently managed. And even if depositors are protected, it doesn’t mean the same for bank equites or even unsecured credit. Other actions taken by the Treasury and Fed will help banks. A new one-year lending facility called the Bank Term Funding Program will allow banks to receive loans to bolster liquidity. An important feature is they will receive the credit for pledged Treasury and mortgage-backed securities at par, rather than a price that has potentially been deflated by Fed rate hikes of the past year. This is, of course, comparable to the price if held to maturity, and can limit mark-to-market losses for banks.

Macroeconomic policy partly to blame

Many have gone out of their way to note the highly unusual business model of SVB. This is true. Still, US macroeconomic policies bear some of the blame for these events. US Treasury Secretary Yellen noted that rising interest rates used to combat the inflation caused, in part, by excessive liquidity used to support the economy over the pandemic were a core problem for Silicon Valley Bank. Its assets, including bonds, mortgage-backed securities and loans made to venture-backed companies, had mark-to-market losses in the face of rising rates. Fiscal and monetary easing was drastic in 2020-2021 and Fed policy tightening in 2022 was equally drastic. Fed stress tests never included scenarios of surging policy rates. Stemming an unexpected confidence crisis will not stop the US economy from slowing in the months ahead for reasons we discussed in our latest CIO Bulletin. The shaky ground bank investors feel and the actual economic slowdown to come should help Fed officials see that their hiking cycle is nearing completion.

Portfolio considerations

Global markets took comfort in the action from policymakers. It followed a day of panic over potential default on a large bank’s uninsured customers. Following the weekend’s drama, CIO’s strategy remains the same. CIO is underweight equities, particularly small and mid-cap firms with less balance sheet strength. CIO is overweight the most consistent dividend growers, who have the strongest balance sheet resources. CIO is overweight US Treasuries of all maturities at the expense of high yield credit. While the strongest categories of high yield borrowers have not been particularly impacted by the SMID bank news, CIO would expect a slowing economy to shift concerns from interest rates to credit in coming quarters. Tighter bank lending standards tend to have a disproportionate effect on smaller, lower quality firms, where CIO remains significantly underweight relative to large caps. Indeed, 23% of the Russell 2000 is made up of Financials and public REITs, vs just 13% for large caps, as of March 10, 2023. And as fears over rising rates morphed into fears related to banking fragility and recession, the correlation between stocks and bonds broke down late last week. Positive returns in US Treasuries (falling yields) have helped to dampen equity weakness for diversified portfolios, a phenomenon which largely disappeared in 2022. CIO remains comfortable with its quality biases for now, though would look for any overshooting to the downside as a potential opportunity to add equity risk.

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