2023 Quarter 2 Commentary

“Monetary policy does not work like a scalpel but more like a sledgehammer” -  Liaquat Ahamed

Over the past month, the overwhelming market story has been attributed to bank solvency and dealing with the aftermath of bank failures of Silicon Valley Bank (SVB) and Signature Bank, as well as potential ripple effects across the economy. It’s difficult to turn to a financial publication like Barron’s or Bloomberg and not see some article or commentary on the causes of the banks’ downfall or otherwise pointing blame one way or another. As a result, it’s not surprising to know that we’ve received many questions from clients asking how this will affect their portfolios and asking whether the contagion will be isolated to these few instances. 

To take a step back and quickly attempt to summarize what occurred, many of SVB’s customers attempted to withdraw funds from their accounts simultaneously because word spread that the bank was insolvent – an event commonly referred to as a bank run. When customers demand money, banks may have to sell their investments, often treasuries and other liquid securities, to pay their deposits back. However, SVB’s holdings of longer-term securities, like mortgage-backed (MBS) securities and long-term treasuries, had lost a lot of value as interest rates increased this past year. When required to sell them to cover customer deposits, it incurred a significant loss. When requests for cash went up to $42 billion, regulators stepped in and took over the bank’s operations.

Some aspects of the failure of these banks have attributes that are considered to be non-systemic. For example, according to Goldman Sachs, SVB had longer maturity securities than the median bank. In theory, SVB could have survived through the next year  without failure if they had more liquid assets. However, when the surge for cash requests came from distressed depositors, SVB’s hand was forced to sell the securities at a large loss.

Another factor to consider is SVB’s unique client base. While the FDIC insures up to $250,000 per person per bank (with many exceptions and stipulations to list), both of these banks catered to relatively cash-rich clients that may be carrying more dollars in deposits than the average household. As evidenced by the chart to the right, over 90% of deposits at SVB were uninsured as of the end of 2022.

Several main arguments made by commentators and experts are that SVB was overleveraged and did not properly manage its assets and, as a result, was forced to liquidate. Auditors at the bank also did not flag some of these risk factors during scheduled audits, which may have alerted regulatory authorities or even clients. Additionally, a more diligent Asset Liability Risk team at the bank could have and should have caught this issue. 

Equity

 In equity markets, the first quarter of 2023 turned out to be somewhat quieter than the previous year, which is certainly considered welcome news for investors. Below, you’ll find the performance of various domestic equity categories over the past 3-, month, 12-month and 3-year periods from Morningstar.

As of the end of the first quarter, the overall U.S. market showed signed of strength with equity markets posting gains of +7.40%. Value stocks are essentially flat for the year in contrast to the performance of the Growth category that had clawed back some of the losses from 2022.

Generally, while markets have looked strong, it’s important to note that much of the returns were off the back of the largest companies in the index. For example, the five biggest stocks in the S&P, and the next 15 biggest stocks, have accounted for many of the gains, as described in the chart to the right.

Many of these “mega-cap” stocks surged in the first quarter after a disappointing 2022. Over the first three months of the year, Apple, Microsoft and Amazon, returned 26.91%, 20.22%, and 22.96%, respectively. Nvidia was another large company with performance of +90% for the same period. We noted in previous iterations of the market investment letter how much technology stocks had declined in 2022. Some investors were buying these at a significant discount.

It has to be noted that the performance of these mega-cap stocks, as some people refer to them, may be hiding some weaknesses in the overall market, especially in non-tech sectors. 

For example, as mentioned in the introduction of this letter, and indicated in the chart to the right, the Financial Services sector has been performing poorly since the beginning of the year. Additionally, Energy has not made any gains after being the only equity darling over the past year.

A potential surprise story in the world of equities has been Emerging Market funds, which have performed relatively well in 2023. These funds have underperformed for over a decade versus domestic stocks and other international equities but are posting surprise gains in recent months. It will be interesting to see if the momentum can continue into the rest of the year.

On the other end of the spectrum have been dividend-focused funds that have underperformed year to date. These funds, which have stronger cash-flows but tend to have lower appreciation potential than growth stocks, saw a reversal in their performance over the past year. There is a possibility that we are experiencing a reversal from Value to Growth stocks. This appears to be similar to what was happening at the end of 2020 and beginning of 2021. 

Fixed Income

With fixed income markets experiencing unprecedented losses in 2022, investors were unsure when the market would reverse. In March, treasuries issued by the United States government saw significant gains as yields declined. As a reminder, there is a well-documented inverse relationship between interest rates and bond prices. 

These higher yields make investing in short-term bonds, specifically those issued by the U.S. government, more competitive versus equity investments, including those that pay consistent dividends. Investors who prefer to invest more conservatively and/or need income from their portfolio have access to many more options today. 

Portfolio Strategy 

Consider overweighting large cap equity in portfolios that have more growth-oriented objectives. This has been an effective strategy this year and may carry momentum going forward.  Also consider adjusting your allocations to mid- and small-cap domestic stocks. 

These securities tend to be more volatile than large-cap equities. However, they also tend to perform well when the market conditions are improving. 

When interest rates normalize, it could be potentially beneficial to reduce the allocation and reinvest the proceed in Core or Growth oriented equities that have better long-term growth prospects. 

International stocks, including emerging markets, may be in a position to make up gains after underperformance versus domestic equities in recent years. Some of the factors for such performance include low valuations and favorable foreign currency exchange environment. Consider revisiting positions for which international stocks are underweight and adjust their allocation upwards. 

Taxability, overall risk tolerance, disbursement needs, etc. will all play a major role in your fixed income allocation. In particular at the end of last year and early this year, short-term treasury securities could have been a beneficial investment to take advantage of the current relatively high yields However, there is also a possibility that longer-term bonds will become more attractive over the next three to six months. 

Thank you and stay safe and healthy!