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The February jobs report this week was completely overshadowed by the overnight collapse of SVB Financial Group (SIVB). Within 2 days of attempting a capital raise to shore up liquidity, the bank faced a customer run on deposits, leading to the swift takeover by the Federal Deposit Insurance Corp (FDIC) regulator. This was the largest bank failure in the U.S. since the financial crisis.
The setup here has created something of a confidence crisis for not only the banking industry but also adding concerns regarding the health of the overall economy. Indeed, stocks ended the week sharply lower in what was a sell first, and ask-questions-later risk-off scenario. Let’s ask those questions now in an attempt to explain that the market “panic” may be an overreaction.
Why Did SVB Blow Up?
The debate right now comes down to whether the situation with Silicon Valley Bank is contained, or just the tip of the iceberg drawing parallels to the financial crisis “Lehman moment”. In our opinion- it’s not.
Keep in mind that SVB had a very unique business model centered around serving venture capital portfolio companies and startups. There was a traditional banking arm with real estate exposure, but SVB overall made its name as a specialist within some of the riskiest corners of the tech and the life sciences sector.
That profile extended into the bank’s cash management philosophy which apparently took on too much interest rate or duration exposure in its investment portfolio through mortgage-backed securities in its held-to-maturity. This is basically where SVB chose to park its cash deposits from those venture capital customers. Notably, the proportion of SVB’s balance sheet tied to long-dated and fixed-rate (MBS) was exceptionally higher compared to most other banks.
That search for yield turned out to be a shot in the foot as the value of those positions came under pressure alongside rising interest rates over the past year. This occurred just as its main customers were requiring a higher turnover in cash, expressed as a “client cash burn” in the last quarterly report. For banks, it doesn’t necessarily matter about the credit profile of depositors, they will happily take your money.
The problem is that SVB was simply too aggressive in what it did with those cash deposits. Through the MBS portfolio, the bank was sort of indirectly betting against interest rates climbing, or at least not climbing to the levels they have reached over the last several months. This drove large unrealized losses in its investment portfolio, based on the interest rate dynamic. The distinction here would be of a more concerning blowout in credit spreads or widespread sector defaults, which we have not seen.
Fast forward, that disconnect between its balance sheet losing value while customers were pulling higher levels of cash pushed the bank to move forward with the equity raise announcement. The mistake by management is not recognizing that just signaling a liquidity crunch would set in motion the classic bank run with depositors questioning the solvency of the entire operation. It escalated very quickly.
Is SVB The 2023 Lehman Moment?
One takeaway is that SVB’s balance sheet exposure is in contrast to most other banks that operate more prudently with much shorter maturity in their cash investment positions. From there, whatever weakness SVB faced was not necessarily representative of other regional banks or your typical community credit union.
Similarly, it’s understood that mega-cap banking leaders like JPMorgan Chase & Co (JPM) and Citigroup (C) are much more diversified and better capitalized. These are views echoed by comments from Treasury Secretary and former Fed Chairman Janet Yellen suggesting the U.S. banking system remains resilient.
Keep in mind that the legacy of the financial crisis was to improve risk controls precisely to prevent scenarios like this. The results from the annual stress tests are evidence that the financial system is prepared for even more extreme shocks modeled with ample liquidity buffers. For context, a reference point of aggregate U.S. financial system tier-1 common equity capital ratios of 12.4% in Q1 2022, is up from levels in the low single digits back in 2008.
Here, let’s recognize that SVB was not even considered a “global systemically important bank“. This means that while it was technically among the largest banks in the U.S., it did not qualify under the Dodd-Frank Act and Federal Reserve’s criteria. So while this apparent blind spot in regulatory oversight is another topic of discussion, SVB’s place in the financial system is still relatively isolated.
That doesn’t stop investors and the market from speculating on connections to larger and more important banks, but our take is that SVB should not be seen as a bellwether for every other financial institution. Our sentiment is shared by Wall Street banking analysts, making the case that the SVB collapse was based on company-specific or “idiosyncratic” factors, and the panic selling in financials may have been overblown.
What Happens Next?
Getting back to the February payroll report, the U.S. added 311k jobs which was more than the 205k estimate. This follows a string of economic data points that have worked to build a narrative that the economy is “stronger than expected”.
At the same time, the average wage growth favorably surprised to the downside, coming in at +0.2% compared to a 0.3% estimate. The unemployment rate also ticked higher to 3.6%. This is “good” news in the Fed’s inflation battle which will need to be confirmed with the upcoming CPI reports, providing evidence of the ongoing disinflationary process.
Before the SVB fiasco, the bigger issue had been a concern that the Fed would be forced to keep hiking, with some even penciling in a 50 basis point rate hike for the next Fed meeting as a given. In this regard, one silver lining to the SVB situation is that the tables have turned with the consensus moving into a forecast for a 25 basis point rate hike at the March 22nd FOMC.
According to the CME “FedWatch Tool” which quantifies the market-implied expectation for the direction of Fed policy, rate futures suggest a 57.5% the Fed will hike by 25 basis points to an upper range in the Fed Funds Rate of 5.00%. This view has shifted from as low as 31.7% over a single day based on the SVB fallout.
The move is also evident in rates, with the 2-year Treasury yield dropping by a significant 30 basis points to 4.6% on Friday, compared to a high of 5.1% just earlier in the week. It’s hard to see how or why the Fed would move even more hawkish eyeing just the perception of the financial system being fragile.
What About Stocks?
It’s understandable that for the segment of the market that has been bearish on stocks, and expecting the bottom to fall out since the S&P 500 (SPX) hit $3,500 past year, the latest developments add fuel to that fire.
Let’s not forget that the S&P 500 is still up year-to-date in 2023, and well off lows from last year. Any expectation for the stock market to crash lower from here will still need some follow-through in the real economy and most importantly corporate earnings.
If the Fed now has room to slow the pace of further rate hikes, and ultimately pause sooner, rather than later; that in turn should provide a bid to the economy and risk assets, helping to balance any near-term consequences from the SVB fallout.
So what we are left with here is an economy that remains resilient based on the latest payroll data and retail sales, where conditions are in place for inflation to make a more convincing slowdown going forward while interest rates stabilize.
Already approaching the end of March, there’s a case to be made that Q1 earnings trends will be solid across the board, following the theme from Q4 when 64% of S&P 500 companies beat EPS estimates.
This is in the context of what appears to be low expectations based on the overriding air of pessimism, which may not reflect the actual operating conditions of companies during the bulk of the quarter. There is no reason to expect companies to start reporting ballooning earnings left and right.
Considering that many companies took steps to cut costs and focus on margin, there is likely room for earnings estimates through 2023 to get revised higher as the economy chug along, under the pretext that the SVB situation blows over.
So the takeaway here is that for anyone expecting stocks to make a “massive” move lower, signs of an economic hard landing defined by surging unemployment, and more importantly, collapsing corporate earnings are still missing. Anyone is free to predict that those conditions will still materialize, but it’s far from certain and doesn’t match the data right now.
The way we see it playing out is that the market narrative will begin to downplay the fears related to SVB and a broader financial system contagion. As the FDIC liquidation process plays out, making the insured depositors while of and recovering the bulk of larger balances take shape, the fears should subside. A rally in other bank stocks could work to support the market while high-beta names between tech and growth are positioned to lead higher.
Ultimately, this latest re-test of the S&P 500 around an area of technical support near $3800 will be looked back at as simply a bear trap where doom-and-gloomers got ahead of themselves.
Again- that’s our view as a bullish case for stocks where a rollback of volatility in a renewed sense of stability by next week would be the first step to regaining market confidence. By this measure, we still see room to remain cautiously bullish, recognizing the higher risks.