We now know who has been swimming naked

We now know who has been swimming naked.

Warren Buffett has been quoted as saying, “It is only when the tide goes out that you find out who has been swimming naked.”  We thought this was an apt quote to begin our report for the first quarter of 2023.  Years of low interest rates have encouraged and incented risk taking and now the rapid rise in interest rates is starting to show the cracks in business models that assumed low interest rates would last forever.

In this vein, the failures of Credit Suisse, Silicon Valley Bank and Signature Bank are failures of management.  Credit Suisse, by far the most significant of the three, has faced a series of problems and scandals over the last decade, culminating with panic calls to its large depositors last fall, to reassure them of the bank’s solvency.  Apparently, the depositors didn’t buy into the comforting message put out by the bank and in the fourth quarter withdrew 38% of their deposits.  Collapse was likely inevitable at that time.  What is probably the most surprising is that after such large withdrawals, the bank was able to limp on until March.

Turning our attention to the U.S., we continue to expect there to be more failures amongst the U.S. regional banks.  One study suggests that there are 186 banks that could be pushed to insolvency.  But the fact remains that these banks are generally small and the direct impact on other financial institutions is not significant – particularly given the willingness of the U.S. government to back depositors.  The risk comes from a loss of confidence that leads to deposits leaving regional banks as depositors move money to more ‘secure’ places.  This sentiment has led to large increases in the purchases of money market funds and treasury bills, along with increasing deposits at the large banks.  Even a well-run, stable bank can become unstable if enough deposits leave.  Adding to this strain is the large amount of commercial real estate debt issued by the regional banks.  If defaults rise in that segment of the market as anticipated, the regional banks could be left with a lethal mixture of fleeing deposits and uncollectible loans.

In March, these events in the financial sector led to historic amounts of volatility in short-term interest rates, which then impacts volatility in other markets.  Although by the end of the quarter, the bond markets seemed to be somewhat soothed.

Let’s Not Forget About Inflation

What that leaves us with now are two different issues facing financial markets and strange divergences in policy that make the outcome less predictable.  Because we can’t forget that, despite the damage caused by higher rates, central banks are also still trying to tame inflation.

We will focus on the U.S. for this discussion since in Canada, if you exclude the impact of higher mortgage costs, inflation has reverted to the targeted 2% range, while the U.S. is still facing inflation of 6%.

The U.S. Federal Reserve has clearly articulated its position that it will continue to focus on inflation.  The banking crisis may help in that fight as banks in both Canada and the U.S. are tightening lending standards.  That means less consumer and business loans to be issued, which will reduce demand for some goods.

Remember, to fight inflation you need to get demand back in line with the capacity to supply goods, and the whole point of raising interest rates is to reduce demand.  Now, nervous banks are helping fight that fight as they become far more concerned about protecting their balance sheets and less willing to extend loans for projects big and small.  Lending was already in retreat before the failure of the two regional banks, so it is hard to imagine that the banks won’t become even more cautious after.

Percentage of U.S. Banks Tightening Lending Standards

Source: FRED

Given this, the U.S. Federal Reserve has indicated there is less certainty of further interest rate hikes but has also tried to be clear that there is no expectation of interest rate cuts.

The banking crisis also increases the risk of the economy slipping into recession in the coming months.  There is a significant lag in the time between interest rates rising and the economy feeling those impacts.  Given that the sharpest rate increases were last spring/summer, the Canadian and U.S. economies should start to feel the full impact of those interest rate moves in the second and third quarter of this year.  When this is combined with reduced access to credit, the economy could slow more than previously anticipated.

Many (including us) have pointed to the strength in the jobs market as a positive that may help moderate the impact of the economic slowdown.  And that remains a possibility, but we also need to be conscious of the fact that historically employment has remained strong right up until the start of the recession and then turned quickly negative.

We are in a strange period, where we would expect the economy to start slowing – but there are few signs of that.  The U.S. Federal Reserve is giving with one hand while taking away with the other.  After months of raising interest rates and reducing the size of its balance sheet (pulling money from financial markets), it has potentially paused raising rates, but in a follow up to the bank failures has also again flooded the financial markets with money.

U.S. Federal Reserve Balance Sheet over last 12 Months

Source: USA Federal Reserve

Without such active intervention from the central bank, we would expect a significant decline in financial markets and a recession to follow.  As the economy slows, corporate earnings would decline, and higher interest rates would lead to lower valuations.  Equity markets are still expecting corporate earnings to be relatively stable this year.  However, based on historical data, Morgan Stanley has modeled earnings to drop by up to 30%.  The real answer is likely somewhere in between.  Similarly, based on current interest rates, valuation on the S&P500 would normally be around 15 times earnings, not the current 18 times earnings.

We also know that whenever 2-year real interest rates (posted rates less inflation) have turned this negative, some kind of event has followed.

When 2-Year Real Yields Drop Below -0.75% Problems Tend to Occur

Source: The Irrelevant Investor

These historic frameworks are based on the idea that higher interest rates will lead to a slower economy.  But the engagement by central banks may prevent the economy from naturally retrenching.  The markets don’t believe that central banks intend to hold interest rates high and have begun to price in lower rates.  Each time since the Great Financial Crisis that central banks have pushed liquidity into the financial system markets have gone up.  So, will a proactive central bank prevent this from playing out the same way it would have historically?  We really don’t know for certain.  We continue to bias towards a further slowdown and one final downturn in equity markets before this bear market is over.

Part of the reason our bias is in that direction is that we still see issues that have not been fully addressed.  For example, in the U.S. it is estimated that there are $1.4 trillion in leveraged loans.  The vast majority of these are floating rate loans that are unhedged to interest rates.  Most of these loans have been used by venture capitalists and private equity funds to purchase target companies.

The problem is not only the rapidly rising cost of financing the loans, but also the fact that some of these companies have declined in value dramatically.  Anecdotally, we are hearing stories of private equity backed companies having to raise capital at 5% to 10% of their previous valuation. That means existing shareholders have lost 90% to 95% of their investment!  This coincides with statements from a well-recognized leader in the private equity sector last fall, indicating that in some sub-sectors of the industry companies’ real value was 75% to 90% below where it was being officially valued by the funds.

And that is the issue, there is no market to value these private firms, so many funds have not restated the value to what these companies are truly worth.  If that happens, lenders may wake up one morning to discover that there are $1.4 trillion dollars of loans backed by nothing much more than air.

Our Closing Thoughts

To summarize, there remain several sources of risk to equity markets over the coming months.  Earnings expectations could decline, valuations could revert to levels more reflective of current interest rates, strains in financial markets in the form of bank failures and loan losses could mount.  However, we have never faced similar periods of tensions with central banks proactively trying to address the risks.  In the past, central banks have only intervened after these events triggered liquidity problems in the markets.  That makes this uncharted territory as markets swing between what probably should happen but recognizing this time may be different and these events may not happen.

What we do know is that there are some signs of liquidity being strained, which at a minimum suggests that volatility will likely be higher than normal in the next quarter.  If financial markets do experience one final leg lower, that should set the foundation for the next bull market.  Therefore, although in the near term we are working diligently to manage the risks, we also remain conscious of where opportunities may materialize, in order to ensure you benefit from the next stage in the cycle.

Logan Wealth Management

March 31, 2023