AAF Wealth Management Q1 Market Update

1^st Quarter 2023: A Record-setting Start

Reflecting on the start of 2023, it strikes us as interesting that we’ve just endured yet another volatile period that has seemingly become the norm for markets during the months of February and March. For the past five years, at least late winter through early spring, market turbulence has come with increasing regularity. From the “Volmageddon” event of February 2018 to the Covid swoon in March 2020 and the most recent bout of volatility last month, this time of the year has become no stranger to large, unsettling stock market shifts.

The Banking Crises: Looking Back 15 Years Later

With 30 days or so under our belts since the latest crisis, we’re now able to better understand the causes of and potential contagion from this event. Thankfully, it seems as though what was once originally feared to be the worst-case scenario is unlikely to occur. A little perspective and a lot of government intervention has helped to alleviate the initial panic that drove comparisons of the Great Financial Crisis of 2008-2009.

Unlike its predecessor 15 years ago, more recent banking issues were largely driven by a specific, proximate cause that few banks had exposure to on their balance sheets. In particular, venture capital and to a lesser degree cryptocurrency were common factors that aligned Silicon Valley Bank, Signature Bank, and Silvergate Bank. Each of these financial institutions shared a unique business model, one that became compromised over time. Soon depositors were demanding their cash all at once and, in the process, those bank runs brought each entity down.

In a world where 24-hour news and real-time social media coverage informs the public, word spread quickly. What started as a specific concern in a handful of banks quickly grew into something far broader, with fears of contagion spreading to even the smaller more regional banks. Within days, videos of bank clients lining up outside of branches circulated, with depositors moving assets to larger, Too Big to Fail (TBTF) banks after the US government tacitly claimed it would backstop those in the event of an emergency.

What’s important to take away from this event, even as imminent bank failure is no longer a likely threat, are the key lessons learned. What we witnessed in those first few weeks of March demonstrated the power of social media and its influence on society. As more videos surfaced, collective fear mounted. It was ultimately the quick thinking and rapid response of several governmental agencies that curbed its spread.

Likewise, it grew apparent that a number of US banking institutions are significantly leveraged to US government bonds, which in turn now trade at significant losses on their balance sheets. What this means to you is that the after-effects of the Covid economic shutdown may be felt for some time. It was both incredible amounts of stimulus and the Federal Reserve’s actions to rein in inflation as a result of stimulus efforts that led to our current situation. Flush with much of the excess cash generated during the past few years, banks have invested their excess reserve deposits into US government securities as required.

With low interest rates at the time, banks unfortunately chose maturities well into the future, as those bonds provided the highest yield. And as is the case when rates rise, longer duration bond prices may fall as the Federal Reserve hiked interest rates from 0.00 percent at the outset of 2022 to 4.5 percent by year end.

Key Takeaways From a Crisis Averted

It is now common knowledge that many US banks are sitting on hundreds of billions of dollars in unrealized losses from US government securities. As such, capital ratios have been weakened. Strong capital ratios intrinsically tie into a bank’s solvency, hence their ability to conduct business. Given a bank’s primary purpose is to grant loans to its community, and a weaker capital ratio degrades a bank’s ability to make loans, it is easy to see where this can lead over time should banks lose the ability to improve their balance sheets.

To solve this, the US Department of the Treasury enacted a new credit facility called the Bank Term Funding Program (BTFP). This provides a lifeline where troubled banks can exchange bonds of which are trading at a loss for actual cash on hand. While this measure may assist a troubled bank in shoring up its balance sheet capital ratio, it comes at a price, as the Treasury sets the loan rate at about 4.5 percent per year. Regardless of whether or not a bank chooses to use this new facility, its effect may be felt nationwide. It may also be felt through a likely reduction in their own earnings and in the markets as banks grow more selective in the loans they grant, thereby slowing economic expansion.

This brings us back to the stock market through the Federal Reserve and continued efforts to curb inflation. At present, the market is discounting about a 43 percent chance that the Federal Reserve will raise rates by 0.25 percent at their next Federal Open Market Committee (FOMC) meeting on May 2^nd. Ultimately the Federal Reserve’s decision to raise, cut, or let rates stand will largely be determined by the next set of inflation figures released in mid to late April. But we continue to see conflicting data here, as was the case for much of 2022, making handicapping Federal Reserve actions more challenging.

On one hand, much of the structural inflation that we experienced in the past 12 months, largely attributed to food, energy, and certain durable goods orders, has begun to trend downward; at the same time, services-related inflation, which is often tied to more experiential type spending such as dining at restaurants or taking vacations, has remained persistently high. This constant push/pull based on CPI, PPI, and other data releases points to uncertainty as to where we are and, more importantly, where we are headed. And while the market continues to wrestle with the question of when versus if the Federal Reserve will cut rates, the Fed has repeatedly pushed back stating it will look to do so when good and ready as opposed to when the market says it should.

What Does this Mean for My Portfolio?

The burning question we should all be asking ourselves is, “Where does this put me?” After all, without using our data for good, all previously mentioned points are merely academic. Going into 2022, we had significantly changed the construction of our portfolios to accommodate what we felt was going to be a rough year for growth stocks and longer duration bonds. Through a combination of reductions in growth-oriented in exchange for more value-oriented products and the sale of more long-duration bonds in favor of short-duration and alternative ideas, we were able to generate positive client returns. In essence, we played defense and hunkered down to wait out the storm.

In looking at portfolios through the last several months, we observed a strong resurgence in positive performance as equities have rallied since late fall through the first half of Q1 2023. And while the banking situation in March affected nearly every investor to some degree, our exposures to small and mid-sized banks were limited to a small number of funds.

We continue to look at 2023 as a year of opportunity versus one steeped in concern. Yes, we believe the markets could show signs of stress later this year if, in fact, earnings come under pressure or if the Federal Reserve continues to hike at a much higher level than most think possible at this point. That said, the market has shown significant resilience in the face of adversity of late, and that unto itself is a bullish sign longer term.

We are of the opinion that longer-term rates are in the process of peaking. If they do reverse and shift downward, we could see a strong resurgence in what has already been a good 90 days of bond-related returns. Further, if the economy squeaks out a soft landing, which at this point is not out of the question given consumer willingness to spend even through the highest levels of inflation that many of us have experienced, the lows we saw during the past year might turn out to be lows of this bear market cycle.

A Call to Action

We wrap up as always with a call to action. But unlike our usual calls, this ties back more to your safe money than funds invested in the markets. Our job is to shepherd those funds to the best of our abilities. And rest assured, we are doing that.

To this day, we continue to speak with clients who are under-insured per current FDIC safeguards. While Janet Yellen, the Federal Reserve, and other governmental figures have come to the rescue recently, this does not change the fact that the government is ill-prepared to extend blanket coverage to the $17.6 trillion US banking system, even when faced with suggestions that this could happen.

Many emergency-related moves to backstop uninsured bank depositors may not likely take place again should another significant event occur within the banking system. It behooves each and every bank depositor to review holdings, ensure proper coverage is in place, or take measures to protect underinsured assets.

What we learned from last month’s banking crisis is a stark realization that a significant amount of bank assets are well above FDIC’s limit, which is $250,000 per account registration. If this applies to your assets, speak to us. We are prepared to discuss various ways you might remedy that situation.

As always, we thank you for your continued business and look forward to serving you and your family’s financial needs.

AAF Wealth Management is a Registered Investment Adviser. Advisory services are only offered to clients or prospective clients where AAF Wealth Management and its representatives are properly licensed or exempt from licensure. This blog is solely for informational purposes. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by AAF Wealth Management unless a client service agreement is in place.