Markets rallied hard yesterday afternoon following increased intervention into beaten down banks. First, it was across the pond as the Swiss Central Bank injected up to 50 billion Francs to support their 2nd largest lender, Credit Suisse. Domestically, First Republic was rumored to be taking deposits from numerous large banking institutions totaling more than $20 billion. No acquisition, no preferred stock, just a good old-fashioned deposit to another bank. Financial stocks rebounded, but capital continued to flow even more heavily into growth stocks following the rumor. The Nasdaq went from down 0.7% to close +2.5%. After hours, it was confirmed that First Republic will be taking $30 billion in deposits from 11 of the largest banks. Their CEO also noted that the rush of withdrawals was subsiding. With clientele similar to Silicon Valley Bank, they were lucky to survive.
Concerns are Not Like the Great Financial Crisis:
While Credit Suisse was yet another Government bailout for a mismanaged bank, concerns now arise as to what will be the next shoe to drop. Many of these banks hold loans and bonds issued from one another. When a large bank gets hit, it causes a chain reaction down the food chain. However, as we have been noting, this is nowhere near 2008. Banks are certainly in much better shape than prior years. While there are many items to a balance sheet, below is one of my favorites for this period:
The top of the graph reflects bank deposits. Clearly, Covid handouts and lack of services spending over the last few years helped swell bank balance sheets as consumers kept piling cash into their accounts. Today, banks are earning 4%+ on those assets while simply parking them at the Fed, but in 2021 they earned next to nothing which damaged margins. Banks are in the business of borrowing at low rates and lending at higher ones. When loan demand dries up, there is no need for excess deposits (assuming there are no Bailey Building and Loan runs on withdrawals).
The bottom of the graph reflects a ratio of loans to deposits over the past 40 years. Never before have banks had so many assets and so few loans. Some of this is demand driven. When companies were handed free PPP money and stimulus checks, they did not need to borrow. Loans have been picking up lately, but are still well below what would be considered normal. In fact, it was only a couple of years ago when banks were against taking in more deposits. This is a major reason (along with making excess profits) that interest on our checking accounts stayed at 0.0%. When banks have excess cash and zero loan demand, they are forced to invest excess capital. Most of the well-run banks bought U.S. Treasuries at or near 0% rates. The riskier ones stretched into long-term muni’s. Either way, margins came down and investors looked for answers. Those long-term investments only matter when customers demand withdrawals at an accelerated rate, which is happening in spades right now for smaller regional banks. Since each bond purchased is carried at par on their balance sheet, it does not hit capital ratios unless they are sold at the market. There is no real concern of default on most of those investments. This is quite different from the Great Financial Crisis.
When pricing those bonds at current market rates, the picture becomes cloudier:
While Government officials do not want to call this a bailout, the Bank Term Funding Program simply takes away those mark to market losses. The paper losses shown above (assuming they are Treasuries, agency debt and mortgage-backed securities) disappear. It was reported last night that banks took in $12 billion from this new facility. However, and much scarier, banks borrowed nearly $150 billion from the Fed Discount Window. Over $142 billion was also borrowed for banks seized by the FDIC. This equates to $303 billion borrowed in nearly 10 days, more than any similar period in 2008 when banks were failing. Even though the Fed’s balance sheet just spiked by $300 billion, this is not really Quantitative Easing. Rather, liquidity is drying up and banks need cash to pay off withdrawals. These are not going to be turned into profitable loans like normal QE periods.
Clearly, this is not a credit issue, at least not yet. Banks simply do not hold enough loans to be overly concerned. Further, business is solid in most markets. However, lending standards are only going to get tighter from here. Just like in every other Fed cycle, money supply is slowing. Loan approvals will slow. Only the least risky projects will get approved. It is likely we see more defaults as over- leveraged companies learn that you cannot build an empire with debt alone. When XYZ Company goes back to the bank for another loan they are more likely to get declined in today’s environment. 7-year auto loans are likely to be either really expensive or only available for the highest of credit consumers. Commercial property markets, in particular, seem ripe for a letdown.
Less capital flowing around leads to lower spending, less hiring, slower growth and a rise in the unemployed. That should be enough to put an end to the inflationary scare that inflamed from the $7 trillion in Covid spending stimulus. Here’s hoping the Fed notices this very normal scenario and ends this tightening cycle.
GDP estimates are coming down. Economists pull forward their recession time frames. Corporations follow suit and get more conservative. The playbook is eerily similar, cycle after cycle. This game is pretty simple when you take a step back. Inverted yield curves and aggressive central bank actions precede a recession. The Fed always wins, and in doing so, they blow a few things up along the way. Silicon Valley Bank and Signature Bank blew up in a matter of days. They are the 2nd and 3rd largest U.S. Bank failures in history. The regional bank index dropped 16% last week, its 4th largest decline ever. The other 3 occurred during the Housing Crisis and Covid. Pretty scary periods to say the least. Good news though, stocks have already priced in a lot of this negativity. Bear markets are common. We have been spoiled over the past decade to have avoided these larger corrections.
2022 was a disaster for investors. While some areas held up okay like Energy, select Industrials and some commodities, those are now being taken to the woodshed this week. Recessions wind up hitting everyone at some point. Going back to those previous banking scares, most acted as clearing events. Future market returns were quite impressive. That does not mean that the bottom is here today, rather we are in the final innings of this bear market. Long-term thinkers rejoice.
Case in point, even though the Dow Jones Industrial Average is down ~6% this year, several FANGMAN stocks left for dead are already perking up. Facebook (I thought Tik Tok was the only app people used?) and Nvidia lead the way, up 65% and 50% respectively so far in 2023. Tesla (I thought no one wanted their electric car?) is +45%, Apple 20%, Amazon (I thought people stopped shopping?) +19%, Microsoft +15%, Google (I thought ChatGPT took over search?) +14%. The QQQ’s (Nasdaq 100) are up 15% this year as well. Bull markets are born out of corrections. The recent interest rate collapse will do wonders for growth stocks.
The game plan has not changed much. A recession and a Fed-induced destruction of value are quite typical. We could retest the old lows, but this bear market is becoming long in the tooth. For all the daily gyrations investors worried about, the S&P is at the same level from two years ago. Values are being created. Sticking with high quality usually wins out. More importantly, this is the time to get exposure to NEXT decade’s winners, selectively and slowly. Secular changes are occurring. There are plenty to choose from: artificial intelligence, electrification, onshoring/reshoring, robotics, new forms of medicine, lack of housing supply, retiree travel demands, Green Energy…any other ideas?
Lastly, today is the first Quad-Witching day for 2023, where four different sets of futures and options all expire. As crazy as this market has been over the past two weeks, some added volatility could be apparent, though futures are oddly muted as I type this pre-market.
Actors Kurt Russell, Rob Lowe and John Boyega are 72, 59 and 31 respectively today. Gold Medalist winners Mia Hamm and Katie Ledecky are now 51 and 26.
Happy St. Patrick’s Day to all my Irish brethren… sláinte!
James Vogt, 610-260-2214