Looking back on the start of this year, financial markets demonstrated promising performance in January, as several technology stocks witnessed a sharp rebound. There were indications of inflation easing, and the Federal Reserve appeared to be following a less aggressive stance regarding rate hikes. However, February brought a setback for the markets, as inflation data in the service sector exceeded expectations, despite a strong showing in job numbers: non-farm payrolls increased by 517,000 jobs as the PCE stood at 7%, or 4.7% ex-shelter, prompting markets to regress.
In March, the Federal Reserve’s aggressive hiking cycle and the expectation of continued aggressive Fed action exceeded what the market had re-priced, causing a shift in investor sentiment. The prospect of a soft landing was abandoned and technology equities were adversely affected once again, leading to dramatic reactions from regional banks with outsized exposure to the sector. As Silicon Valley Bank (SVB) announced the sale of certain parts of its portfolio at a significant loss, the fire sale called attention to the impact of the rapid rate rise on the banking sector. Subsequently, two regional banks, SVB and Signature Bank, were forced to enter receivership, and First Republic remains on the brink. These events culminated in the acquisition of the weakest SIFI, Credit Suisse, which was ultimately purchased by UBS at a discount comparable to the sale of Bear Stearns in 2008.
Despite the comparison, however, the root cause of the SVB crisis differs significantly from the GFC. In 2008, heavily leveraged exposure to the housing market—widespread among financial institutions throughout the country at the time—led to the collapse of two major banks and necessitated the implementation of the Dodd Frank regulations and tighter monetary policies across the board. In contrast, the current bank crisis is the result of poor risk management, specifically the failure to hedge duration risk and manage asset-liability risk in bank portfolios. This has resulted in a seismic shift in treasury yields and possibly the third pivot of the year in expectations of the Federal Reserve’s future actions. Higher interest rates and the need for banks to raise capital will inevitably lead to slower growth, and lending will likely be curtailed as a result.
As we highlight in our most recent market outlook presentation, the Federal Reserve examines three dimensions of inflation: Core goods, which have observed a substantial decrease to 2.5%; Rent, where the consequences of the rate hike take a year to manifest and currently reside at 4%; and finally, core services excluding rent, which are propelled by wages and services. Inflation rates in this aspect remain elevated and seem to be persistent. Presently, the rate stands at 7%, and it is the challenge that the Federal Reserve is presently facing.
Market liquidity will be a crucial factor in navigating these developments. The Federal Reserve has taken proactive measures to bolster a range of liquidity tools, such as allowing banks to repo underwater bonds and providing enhanced currency swap lines for foreign banks to mitigate the impact of the crisis. Nevertheless, money supply and liquidity levels are diminishing and will continue to do so as central banks gradually withdraw support.
In a scenario of reduced liquidity and elevated inflation, investments with secular growth that can adapt to the volatile environment and higher rates are likely to emerge as winners. Companies with higher quality balance sheets and strong cash flow generation, where labor costs are not the primary driver of performance, will also likely perform well across different asset classes. With the structural rise in inflation, central banks may find it challenging to lower rates, which could result in higher volatility over the near term. Thus, it is important to note that simply being long beta and duration may not be effective in outperforming in the years ahead. Moreover, traditional correlations may become less stable, emphasizing the need for a more nuanced approach to portfolio risk and asset allocation.
While the near-term future remains somewhat uncertain, we take great comfort in the knowledge that, throughout our nearly two-decade history, we have provided steadfast guidance to our clients irrespective of the broader economic environment. It is an honor to have earned your trust, and we remain committed to navigating your portfolios through any potential challenges that may arise in the upcoming months.
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