Jeremy Strickler
jeremy@wwmgreenville.com
Earlier in the week we sent you some perspective on the Silicon Valley Bank failure. This a follow up to that piece to speculate about the direction for interest rates and the economy, the odds we’ll see other bank failures and the prospects for the markets.
Does the Silicon Valley Bank failure suggests that other banks may fail in this process?
Yes, I think so. And that’s not a crisis. This is what happens when you raise rates enough. Some people bust.
Tightening financial conditions mean that some people who were able to refinance debt under favorable terms in the past few years might have to pay much higher interest if they refinance now, or they may not be able to refinance at all. And some people will go out of business.
What we think of as real risk is not price volatility per se, but rather wealth destruction. What’s wealth destruction? When companies go out of business, and some people lose their jobs and people lose a lot of their life savings. That’s obviously bad for those people, and there’s a ripple effect economically.
Thus far, we have seen some tech layoffs, but the broader economy has kept on rolling with net new jobs created most months. People who get laid off may have some pretty good options if unemployment is 3.6%. Up until now, there hasn’t been very much wealth destruction. The economy has been surprisingly strong.
However, let’s think about the spectrum of risk in the system.
The Spectrum of Risk
The higher risk investments in our system might be assets like
- cryptocurrencies
- then private, startup companies
- then higher risk publicly traded companies
- distressed debt
- levered real estate purchases
- small cap stocks
- large cap stocks
If you think about those investments, you can see what can go wrong in difficult times.
On the low end of the risk spectrum, perhaps the lowest risk investments are
- Short term US treasury obligations
- then FDIC insured bank deposits
- then perhaps government agency bonds
- then high quality municipal bonds
- then insurance company guarantees on life insurance or annuity products
- then investment grade corporate credit
These investments usually protect capital in difficult times. When cash becomes scarcer and more expensive, your cash gets more valuable.
You might quibble with that order of risk. But you can understand the point: when there’s a credit contraction, when the price of money goes up, where do you expect to see the failures?
Oh, perhaps the leading edge of risk!
There are some people making mistakes with money right now, today. The logic goes like this: the banking system is in trouble, I better get my money into bitcoin!
I say, that’s a misunderstanding of what you should do in this situation!
The air is coming out of the balloon as the price of money goes up. The system is de-levering.
However, the market is speculating that we are done raising rates, because the failure of SVB and potentially other banks will force the Fed’s hand. The right moves here are to bank more cash and short term bonds.
The market is guessing that the pain for risk assets is over. We doubt it.
Does the SVB failure (and others) mean that we have already hit the peak in interest rates?
You can make that argument. It goes like this: The SVB failure is the canary in the coal mine, and other lower risk banks may also fail (possibly true).
If that’s the case, we will see a larger number of layoffs, a sharp slowdown in economic activity and that slowdown will also continue to bring down inflation. Inflation was already headed the right direction (from over 9% to 6% recently), and weakening financial conditions will accelerate this so much that the fed will need to pay attention to growth and won’t be concerned about inflation anymore.
Ok. Maybe that’s true. The market is speculating about that right now. Here’s a picture of that speculation:
The 1 year Treasury yield dropped almost a full 1% in just a few trading days. So did the 2 year. The 10 year dropped about ½%. This is the market guessing that the fed is done raising rates, and that the economy is weakening rapidly. That’s a possibility.
However in my mind, there are reasons for inflation that haven’t changed, unless the economy is about to go in the tank. And so far, it hasn’t. So far, we haven’t seen massive layoffs or a corresponding drop in consumer spending. In fact, too few people working is part of the inflation problem. So, it only makes sense to lay people off if your forecast for the future of your business isn’t good.
Where are the weak spots?
Are there businesses like this? Sure. The office market is tough. Office just reached 50% occupancies. Let me tell you that business model is not built for 50% occupancies.
Brookfield Office Properties went bust on $700 million of office property in Los Angeles. Why? They have the money to refinance, or the parent company PIMCO does. The only thing I can assume is that they could not make the case for that investment to cash flow this year, next year or the year after. So, they let it go. That means they didn’t try to salvage the situation. They didn’t keep paying the staff. They cut their losses.
That’s how prices come down. Someone else can come buy those assets for less than the last transaction. Perhaps at lower prices, other investors can make a case for converting office space to residential, or create different office concepts that do cash flow. But there aren’t viable uses at the old prices. So, the prices have to come down through fire sales or foreclosure sales or other unpleasant things people put off until they can’t.
This is just an illustration of how tighter conditions and more expensive money force different decisions. It’s how the economy adjusts to the new environment.
I believe you ought to expect near term price pressure on risk assets. The market should experience multiple compressions, especially on higher risk/ faster growth companies. And I think you probably don’t want a lot of exposure to levered financial assets, while we’re still seeing the money system tighten up.
Will the SVB collapse change the market setup and the longer term outlook for rates?
There are other parts of the system that lead, while real estate lags. The chip sector seems to think their lowest earnings hit late last year or early last year. The steel companies set records in profitability, and their order books look good, if you read equity research on stocks like Nucor or Steel Dynamics.
Did SVB completely change the setup?
I don’t think so, but the market is trading as if it did. That’s why tech stocks rallied on bad news. The market is so short-term focused that people are asking whether the price of money is going to come down, and they would rather the economy were bad, which could bring down the price of money rather than for the economy to be good!
So, bad news is good news? And good news is bad news? That’s stupid.
In my personal view, I don’t think what has happened changed enough to tank the economy or create widespread layoffs. And I think the employment picture is a more substantial way to look at the question. The fed will keep fighting inflation until the economy is bad and unemployment rises.
Let’s speculate: We have 6% inflation. That’s still high. It puts pressure on a lot of people. It’s a political problem. Ok, gotta keep fighting inflation.
Let’s say inflation gets down to 4%. Is that really a problem? I mean, it’s above the 2% target. But it’s a manageable situation for most households. It’s not punitive.
Does the Fed want to tank the economy to get inflation down from 4% to 2%? I bet they don’t. Remember, the “Federal Reserve” is the big banks. Do you think they want a lot of credit losses because they brought on a bad recession by setting rates too high for too long?
So, where can the fed change course? If inflation is a good bit lower than it is now. If the labor market is a lot looser.
The SVB collapse didn’t change the labor situation, it didn’t end the war in Ukraine, it didn’t improve relations with China, it didn’t lower the cost of natural resources.
It raised the prospect that the economy could weaken quickly.
Ok, let’s watch that. But I think rates are too low as we sit here today, and I think the fed will need to fight inflation unless we have financial contagion and massive layoffs.
So, what do you do now?
Well a bunch of things that correlated before last week aren’t trading the same way anymore. Credit risk is suddenly being sold off while tech stocks rally.
I think Morgan Stanley is right: tactically, you should sell into rallies on risk assets until prices re-test their lows. So, if you wanted to rebalance a little by selling tech stocks and banking cash, this is a window to cut risk.
Should you buy long term bonds? I think they got a little expensive because everyone is trying to beat the rest of the market to the punch, buying long term bonds before rates go back down. But I don’t think missing the next quick rally ought to be the point of focus.
Is it the right call to add money to bitcoin or high PE stocks right now because interest rates have started coming down and they’ll keep coming down? I don’t think so.
I think financial conditions are still tightening.
And there are multiple forms of tightening that may take some time to play out. For instance, if banks experience loan losses, they have to allocate more of their deposit base to loan loss reserves. This effectively shrinks the risk they can take on. It shrinks the credit they can create. It shrinks the money supply.
Or think about the Federal Budget. The deficits are too large. How do we address that? Spend less. Or Tax more. Those are the options. Borrowing more isn’t as good an option at 5% interest rates. The other options reduce consumption or investment.
So, I think you don’t want credit risk. I don’t think you want to add to the leading edge of risk if you already have the right exposure. I think this is a long process that we’re almost 18 months into, and it’s not done yet. I think you want to buy assets when they trade nearer the lows in the trading range and I think you want to rebalance risk when risk assets trade nearer the highs in the trading range.
Does it seem like real world conditions are improving at the moment?
Do you think bitcoin can substitute for risk management in this environment? For capital controls, responsible lending practices, for a standing military, for a functioning government? Can Bitcoin carry all the responsibility that the dollar based system does? It can’t do that. And the failure of FTX should illustrate to you the difference between unregulated and regulated markets when money gets more expensive.
I think people should have more cash than normal so they can take advantage of what happens rather than guessing about what will happen. I don’t trust anyone’s forecast. Nobody knows how this will play out. But you don’t need to call each zig or zag to do smart things.
The Culture Wars
Some of you want SVB depositors to lose their money! Not just the bank shareholders. That’s shortsighted in my opinion. We want people to be able to trust the banking system even when some banks fail. Think about it. What if you had $100,000,000 on deposit? Should you go have to find 400 banks to keep your money safe? Because each one can only guarantee $250,000? That’s an inefficient system to say the least.
Maaaaaybe what you really feel is that people with $100 million or $1 billion can go F themselves! Maybe they’re the reason your life is worse?
A lot of people’s sources of information are highly politicized. I’m sympathetic with that problem. So many things in life are served up through ideological filters that have very little predictive power. They’re not well informed perspectives on what is happening and what we should do about the situation.
Rather they serve to simplify complex problems, give people comfort or identify who’s on your team. They’re based in identity, not information.
Anna Freud (Sigmund Freud’s daughter) wrote a book called The Ego and the Mechanisms of Defense. What, you didn’t read that? Well I did. In it she makes the argument that we infer the shape and nature of people’s egos from their psychological defense mechanisms. But it’s not easy to observe the ego directly. We know it by what it blocks.
In other words, what people do that blocks their ability to see things is how we can understand a lot about how they see themselves and how they identify with their beliefs.
At times like this, it’s very important to assess the unconscious ways in which people act and express themselves, because a lot of what has been hidden under the surface will become apparent in surprising ways. What was shoved into the unconsciousness through denial becomes undeniable as the situation changes. And yes, you see this in finance, not just in therapy.
Some people sell denial. They sell blame shifting. They sell NOT knowing things that are difficult to know, from my beliefs, limited point of view or psychological weakness.
In my lifetime, it has become acceptable to discriminate on the basis of ideology, but not on the basis of race or gender. But it’s just a different sort of the same malaise that drags on the human condition: fear of the unknown and blame shifting to “the other.” Locating the causes of human suffering in someone else. Moral grandstanding is the new racism. (And yes racism is still a thing. Obviously. Do I have to disclaim everything or can we just talk here?)
So, ask yourself a moral question, and I’ll bet you’ll get some practical mileage out of the answer:
- Do my influences cause me to look inward and take stock of my own shortcomings? Or do they place the blame for suffering on people that I think are different from me?
- Do my influences cause me to see the world as starkly divided between good people like me and other people who I think are bad and are not like me?
- Do my influences raise my levels of fear and suspicion? Are they divisive? Or do they tend to help me hold people in high regard and show respect for their lives?
All the great moral teachings ask us to hold up a mirror and look at ourselves. They argue that the human condition is fundamental and the problems of life are common to us all. They correctly argue that we have more in common with one another than we have differences that threaten us. They instruct me that I can only fix the suffering in the world by starting with myself.
There will always be false prophets: people who monetize fear and mistrust by playing on the negative side. By pandering to people’s desire for retribution. By inflaming resentments. By pushing people across the line of desire and fear into jealousy and resentment.
How well do those explanations inform our choices? Do they tend towards peace and prosperity? Do they make you happy?
I know you folks. You’ve been alive a long time. Too long to be gullible. Too long to not know who the bad actors are. People who speak false words and inflame divisions spare you the momentary pain of self-reflection, but they take away somewhat from your ability to act on the future in a positive sense. False prophets take a piece of the pie, but they don’t bake the pie. They’ll split the baby.
If people regularly amplify your sense of fear and righteous indignation, how trustworthy are they?
Pay attention to your emotions. Choose your counsellors wisely. Ask yourself what you’re willing to work on within yourself and what contribution you’re willing to make to make a better world. Find the people who speak that language. Those people are trustworthy.
Jeremy L. Strickler, CFP®
Portfolio Manager
This material is provided as a courtesy and for educational purposes only. Please consult your investment professional, legal or tax advisor for specific information pertaining to your situation.
All information contained herein is derived from sources deemed to be reliable but cannot be guaranteed. All economic and performance data is historical and not indicative of future results. All views/opinions expressed in this newsletter are solely those of the author and do not reflect the views/opinions held by Advisory Services Network, LLC.
