Market Outlook Following the Silicon Valley Bank Failure, Bernhard Koepp, C.J. Lawrence Commentary, 3/14/23
In this video, Bernhard Koepp discusses the fallout from the Silicon Valley Bank (SVB) failure, how it may change Fed policy and the latest data on inflation for February 2023.
Hi there. This is Bernard Koepp from CJ Lawrence coming to you from snowy Midtown Manhattan. It’s been quite a week and I’m not talking about the Oscars on Sunday that were quite uneventful, but the bank run that we saw relating to Silicon Valley Bank that was certainly Hollywood worthy.
It was not like in A Wonderful Life, where Jimmy Stewart was the hero of the day. This all kind of played out more in the social media sphere, and especially on Twitter. Once the word or rumors got out that Silicon Valley Bank was somehow having problems with its balance sheet, or having a mismatch of its assets and liabilities, and had contacted Goldman Sachs to raise capital, rumors started spreading about the viability of the bank. Whether or not this bank actually had real problems, really didn’t really matter. Because, once the rumor started taking hold in social media, it led to its customers withdrawing something like 42 billion dollars in one day. If you look at Silicon Valley Bank at the peak, it had about 180 billion or 190 billion in customer deposits. Losing 42 billion in a day is not something most mid-sized banks can really survive.
What’s the repercussion of this? The banking regulator took it over, and over the weekend, there were all sorts of rumors again about the bank being taken over. Certainly, if you were a shareholder in this bank, you were wiped out to zero. The government was quite adamant, and the Federal Reserve and their banking regulator were quite adamant about reassuring the public that deposits in this bank and deposits at other banks who were now suspect, would be safe. One of the things that happened was the Federal Reserve opened its overnight lending window to smaller banks. This is something we’ve seen before in the Great Financial Crisis of 2008. There were lots of government officials and Fed officials going out there and basically saying, listen depositors are safe, which doesn’t mean shareholders are safe, but depositors are safe.
Here we are on Tuesday and we’re trying to figure out what this means. First, in the financial sector and the banking sector we are now seeing large banks like JP Morgan opening accounts for customers that are fleeing from the smaller banks that are considered more unsafe. We’re seeing this big sucking sound of assets and deposits moving from the weaker banks to the bigger banks. That is something that typically happens during adverse business conditions. That’s why we follow an investment philosophy which we call Bulldog Investing, where we like to invest in companies that take market share during adverse business conditions.
What is happening here is that companies or banks like JP Morgan are taking market share from smaller competitors and we think that will continue. If you’re patient enough to invest in banks in these uncertain days, when it comes to inflation and interest rates, certainly the bigger banks are getting stronger in this downturn. On the way out, I wouldn’t be surprised if they benefit. This is at the sector level and on the company level.
On the macro level, it’s quite interesting that within one week, the whole outlook for what the Fed will do when it comes to interest rates has changed. Up until a week ago before SVB went away, it was still expected that the Fed would be quite aggressive when it comes to raising interest rates. That has now changed quite dramatically. If we look at something that’s called Fed Funds Futures, which is a Futures Market that shows what the market thinks the Fed will do in terms of raising interest rates, Fed Funds are now quite flat for the next couple of months.
The expectation from the market’s point of view is that the Fed may only do another 25 basis points and then maybe be done. If you look at the Fed Fund’s future rates, it’s even pricing in rate cuts starting in June. It’s actually pricing in three rate cuts that for a terminal rate of Fed Funds at about 3.75, which is a huge change from a couple weeks ago when the terminal rate of fed funds was still at around almost six percent.
If we think about how that affects valuations and PE ratios, that’s a huge change. One of the things that our companies as well as our stocks have been suffering from in the last year is this notion of multiple compression. If inflation is high and the Fed is raising interest rates dramatically, you typically have multiples, that is the price to earnings ratio compressed.
In our investment style, where we like to invest in companies that deserve a premium valuation over the market – these are companies that grow faster or more consistently, have technologies that are unique, and have a competitive moat versus other companies – these companies tend to get premium valuations. In a multiple compression environment, these companies tend to get hit more. For us, as a slightly more growth-oriented investor, these are tougher times when multiples compress.
The good news for our investment style is that now the Fed may be closer to done and that was our expectation already a couple weeks ago. But if we think this crisis through, small banks are now less likely to extend lending loans to smaller businesses. Why? Because they need to look after their balance sheet, their deposit base, which is the cheapest part of their capital, and they also will be subject to more onerous banking regulations.
The banking regulators are using money that was paid into the FDIC’s fund to cover depositors. As you saw yesterday, our president went out and said no taxpayer is on the hook for any of these deposits. That is true for now, but because they are tapping into the fund that was created by the banking regulators, and quite aggressively after the 2008 crisis, where obviously you had bank failures. Those funds are being tapped, but after this, the regulations regarding that fund are going to be much more onerous – especially on the big banks – to make sure that everything is properly funded.
The good news is if we’re looking out into the future in terms of interest rates, we may see some relief there from the Fed, because the Fed does not want to break anything else. One of the things we have said in the past that was missing in the cycle was that we did not see a credit event. We’ve now seen the credit event, which is these banking failures and the contagion that we’ve seen into other banks. The rating agency Moody’s has put five other banks on credit watch, and we have seen First Republic, another California-based bank, in the news.
While First Republic is a solid bank, there is an association with what happened with SVB. We will see how that plays out, but certainly if you’re a smaller bank and you’ve seen these withdrawals that are probably going to bigger banks that are safer, there has been quite a shift in terms of how risk is perceived amongst these different banks. On the macro side, just to finish that off, we saw CPI this morning. Everyone was a bit nervous about CPI, because the last thing we want here is a credit event like this happening, which is obviously negative for economic activity. But what we don’t want is inflation to continue to roar ahead which would lead to stagflation.
That was kind of what the market was pricing in last year and the reason why both equities and bonds didn’t work. Luckily, we got CPI and that was pretty much in line with expectations. The headline reading of CPI for February was six percent and that was in line with expectations, and we are now at the level of September 2021. That’s progress.
Also on the core side, which is the better reading of inflation in a sense, because it takes out food and energy and things like that, that was at five and a half percent. Our expectation is still that inflation will continue to come down and our base case for a more constructive market for both equities and bonds for this year is with inflation continuing to come down by the year end.
It is quite interesting to look at what the economists are saying. There is s a lot of disagreement among strategists and economists. We see economists at Goldman Sachs, for instance, who now say they no longer see a 20-basis point or 0.25 percent interest rate hike in March. That’s quite a change from just a couple weeks ago. At Bank of America, they are still a little bit more hawkish when it comes to interest rates. They see 25 bits going every meeting through May for a peak rate of about five and a quarter or five and a half percent.
Also, you have much more dovish economists at banks like Nomura, who are even saying that we may see a cut of 25 basis points on the 22nd of March and balance sheet reductions when it comes to what the FED is doing. I mean I think that’s wishful thinking, but you see what I mean. The community that follows these things very closely is now seeing an end to this interest rate hiking cycle that has been so detrimental to asset valuations in the last year.
The outlook is a game changer, which bolsters our view that typically when interest rates peak or actually come down, that’s typically very good for both stocks and bonds so we’re quite happy about that. Thank you for listening. Shoot me an email at Bkoepp@CJLawrence.com if you have any questions and I’ll see you in the next video.