Plum Street Advisors
2023 Q1 Commentary
The first quarter was one of those times when the newspaper headlines and the market’s returns seemed to tell two entirely different stories. Not to minimize the potential risks of the banking crisis, as we’ll discuss later in the “Looking Ahead” part of this commentary, but markets overall seemed largely unfazed. Despite the failure of Silicon Valley Bank and Signature Bank in the US and Credit Suisse in Switzerland, fears of a widespread contagion quickly ebbed and broader stock and bond markets rallied.
After gaining 7.6% in the fourth quarter of last year, the S&P 500 continued its recovery off 2022 lows with another gain of 7.5% in the first quarter of this year. Bank stocks fell almost 20% (as measured by the KBW Regional Bank Index), but overall the markets were happy that inflation seemed to be better under control. Since March 8, when the banking crisis began with the news about Silicon Valley Bank, the S&P 500 is up more than 2.5%, in large part due to the decline of longer term interest rates.
Despite many people warning of an imminent recession for much of last year, the economy has remained robust, with GDP rising 2.6% in the fourth quarter, and estimated to gain another 2.5% in the first quarter. The consensus seems to be that a recession has been delayed, not avoided. Risks have grown in the banking sector and elsewhere, but at the same time inflation is headed in the right direction and the economy is still showing signs of strength which should help to mitigate the severity of a future downturn.
The Russell 1000 index gained 7.5% in the fourth quarter. Growth stocks rebounded from a difficult year in 2022, and the Russell 1000 Growth index gained 14.4% while value stocks rose by only 1% (as measured by the Russell 1000 Value index). The most beaten-down technology stocks of 2022, like chipmaker Nvidia and Facebook parent Meta, rose most strongly in the first quarter with gains of 90% and 76% respectively (despite those impressive figures, both stocks remain below their 2022 highs).
Bank stocks declined sharply in the quarter, as concern grew about losses in their holdings of long-term bonds. The failure of Silicon Valley Bank and Signature Bank wiped out their shareholders. Larger banks generally held up better than regional banks, but overall, the KBW Nasdaq Bank index fell 18.7% for the first quarter.
International stock returns were strong in the quarter, with developed markets (as measured by the MSCI EAFE Index) jumping 8.5%. International markets had a small tailwind during the quarter from a weakening dollar. Emerging markets (as measured by the MSCI Emerging Markets Index) rose a more modest 4.0%.
The US Federal Reserve (the “Fed”) continued raising short term rates in the first quarter, but at a much slower pace of just 0.25% in February and 0.25% in March.
Rising rates have hurt the prices of existing bonds, but the expectation that we may be reaching the end of the Fed’s increases helped bond markets in the first quarter. The broad Bloomberg US Aggregate Bond Index gained 3.0% in the quarter, while the shorter-term (1-3 year) component of this index gained 1.5%.
Commodity prices overall declined during the quarter, with the S&P commodity index falling 4.9%. Oil prices declined (NYMEX Crude Oil was down 5.7%), and natural gas lost over 50%. However, gold rose 7.8%, building on gains in the fourth quarter, as the dollar fell and as concerns about the banking sector rose.
Last year’s declines across most asset classes put investors on edge, and this quarter’s banking crisis caused many more to wonder if we are headed for another 2008. In 2008, risky mortgage lending practices had created a house of cards that brought down many large financial institutions in a manner that sent shockwaves through a fragile economy as they collapsed. Today, while concerns remain about the banking sector, the broader American economy is in a different place. For example, American households were more indebted in 2008 than at any point in history– greatly amplifying the impact of an economic downturn. Today, American households hold below-average debt burdens.
There is legitimate concern about whether we are headed towards a 1980s style savings & loan crisis, where approximately 1/3 of all savings and loan associations failed due to rapidly rising rates. In the case of Silicon Valley Bank this March, a combination of over 90% of loans being uninsured (and therefore more likely to flee) and over 90% of assets being held in long term bonds that had lost a lot of value due to rising rates led to its collapse. In the 1980s crisis, the initial losses from rising rates were exacerbated (by some estimates, by a factor of five) by S&Ls taking risks – in some cases buying junk bonds – to earn more yield in a desperate bid to remain solvent. History doesn’t repeat, but sometimes it rhymes, so could this bout of rising rates create another 1980s-style disaster?
For more Silicon Valley Bank-style failures to occur, we would need to see large outflows of deposits combined with losses from banks having to sell bonds hurt by rising rates. There is some reason for optimism on both points.
On the first point, banks have seen some outflows as larger deposits moved to higher yielding money markets, but not at levels that create significant concern. As of the end of March, deposits had declined by over $700 billion from the start of the year. This sounds like a large number, but it only represents about 4% of all bank deposits, and the deposit balances have leveled off in the most recent weekly release. Of course, some banks with high levels of uninsured deposits, like First Republic Bank, are seeing higher outflows than others.
Second, the losses realized on bonds banks might need to sell depends on how high longer-term rates are. The most recent trend has been a pullback in rates as inflation seems more under control – we have seen 10 year Treasury rates fall from a high of over 4% in early March to under 3.5% as of this writing. This helps explain why things have calmed down recently. However, these trends could change and we will be closely watching these two metrics to understand whether the situation is continuing to improve or becoming more worrisome.