Friday, April 14, 2022
We knew the Federal Reserve was serious about increasing rates and stomping out inflation. After bumping up the overnight lending rates in February 2023 by a quarter point to 4.75%, two regional midsize banks, Silicon Valley Bank (SVB) and Signature Bank, struggled to keep up with customer withdrawals as word spread that their portfolios were too heavily invested in longer-term, more illiquid securities. As customers reached for their mobile phones and transferred funds to other financial institutions, the Fed quickly realized these banks would need dollars a lot sooner than they had anticipated (i.e. customers do not wait in long lines any longer to move funds – they simply log into their bank or credit union’s app on their iPhone). Reverberations swept through the banking industry with Switzerland’s Credit Suisse Group also looking for a back-up bank. In fact, Charles Schwab’s banking arm was also rumored to be caught up in owning too many longer-term US treasury bonds. On that note, I would encourage you to watch the CNBC interview of Schwab’s CEO, Walter Bettinger, which I will have CJ attach to this email. If you don’t receive reports via email, please go to www.youtube.com and enter “Walt Bettinger” in the search field – the interview is the second option under the ad. In this video clip, Bettinger first explains that the bank side of Schwab is separate from the brokerage side. He then discusses that they have plenty of reserves to meet demand and – in the more extensive interview – he explains that he actually purchased 50,000 shares of Schwab’s stock to emphasize that he is confident in Schwab’s financial position.
How did this latest financial crisis happen? When a bank receives your deposit, you agree with that bank that they can lend your savings or checking account balances out as loans, or they can choose to purchase securities that will help it boost income. For example, ABC Bank might give you 2% interest on your savings account balance but turn around and loan those same dollars at 5%, thus, they earn a 3% profit on your savings account dollars. When you need those dollars to purchase a car, your bank will give you funds from their cash reserves, which I believe is somewhere close to 10% of the bank’s assets. The other 90% of the bank’s assets will be loaned out or invested in higher yielding securities. A bank can get into trouble if they don’t have enough liquid securities to meet more than 10% distributions. SVB had a small percentage in loans, but then purchased longer term treasuries which are difficult to sell when the Fed increases rates from 0 to 5% in one year. The lower yielding, but longer-term treasuries – while they don’t pose a credit risk because they are backed by the US government – do have duration and interest rate risk. An unrealized portfolio of long-term bonds can have double digit losses, which would make a bank want to turn to another lender or government entity to help bridge the gap between liquid securities and customer withdrawals without having to sell those long-term securities at substantial losses. If they are allowed to hold their long-term bonds until maturity, there is no issue.
After the financial fallout, the Federal Reserve raised the Federal funds rate another 0.25% to 5.00% a couple of weeks later. The Fed mentioned that there were members that wanted to raise 0.50%, but with all the financial tumult they agreed to 0.25%. I have to believe that we are in the 8th or 9th inning of these Fed funds rate increases. After all, the Fed did not begin increasing the Fed funds rate until March of 2022 – a little more than one year ago. I am concerned that it could take a year or two before the full economic impact of these rate increases is felt on main street. Thus, a pause in the hiking cycle might be prudent at this stage. In the meantime, the money market and short-term bond fund yields we have in client portfolios are as good as we have seen in over 15 years. If you have any cash on the side, it is tough to beat a 4.68% money market yield or a six month CD at 5.01%.
As for stocks, the S&P 500 is trading at 17.9 times earnings while it was trading at 21.6 times earnings at the beginning of 2022; thus, large-cap stock prices are much cheaper than 15 months ago. The mid and small company stocks are well below large-caps at around 13 times earnings, indicating that they seem to be a better value. Moreover, First Eagle Overseas is priced at about 12 times earnings and Dodge & Cox International is about 9 times earnings. Thus, foreign stocks seem even cheaper. Recent projections indicate that the Fed will most likely raise the Fed funds rate one additional 0.25% increase and then pause from there (as mentioned above, I hope they pause at 5%). The Fed itself is predicting a shallow recession by the end of the year. As earnings come down during the “mild” recession, we may be in for some more choppy stock market waters going into the second half of the year. Once again, it all depends upon corporate earnings. Patience is a virtue, right?
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William A. Bullock