March 2023 Markets Commentary

““There are only three ways to meet the unpaid bills of a nation. The first is taxation. The second is repudiation. The third is inflation.” – Herbert Hoover

March 2023 Markets Commentary

Developments in markets have been moving so quickly that I have had to revise this piece several times since I started it last week.

Last week, some downward pressure came back into equities when Jerome Powell suggested in his Tuesday March 7 Congressional testimony that the pace of future rate hikes may increase. Specifically, he said, “If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes.”

Immediately after Powell’s comment, the probability (as measured by the CME FedWatcher tool) of a 0.50% (50 basis points) Fed rate hike at the upcoming March Fed meeting increased from 31% to 66%. One month ago, the probability of a 50 basis point hike in March was nearly 0%. Stocks, as measured by the S&P 500 fell 4%.

Then to pile on, Silicon Valley Bank’s (SVB) distress last week and bailout on Sunday created rumbles through markets and bank stocks declined broadly. Typically you don’t see bank blowups during strong economies and bull markets, so this hit the confidence of equity investors and volatility increased a bit.

After the SVB blowup and bailout, the probability of a 50% rate hike then declined to 0%, and the probability of no rate hike rose from 0% to 33%. Treasury bonds rallied as the 10-year bond yield fell from 4.0% to 3.5% in two sessions. This is a big move. An even bigger move was the 2-year Treasury yield declining from over 5% in one week to below 4% on Monday. That was the largest downward move in yield in the 2-year Treasury since the crash of 1987. The market is telling the Federal Reserve that it better be done raising rates or it risks a broadening financial crisis. The big question is when the Federal Reserve will admit this.

How quickly things change.

The Fed is now faced with two choices. Continue with rate hikes and risk breaking something bigger than SVB, or tolerate higher inflation for longer. We think it will be the latter, although the Fed will probably raise rates one more time next week to try to maintain a tiny bit of its shattered credibility.

These declines in interest rates have eased financial conditions, which could set us up for a bounce in equities and risk-on mode. Especially the highest risk investments, even though the broad environment carries higher risk than normal. Bitcoin, for example, is up 36% from last week as of this writing. Paradoxically, the SVB blowup,because of lower rates, could benefits equities broadly. If it would not have been bailed out it would be different.

Risk today is higher than normal because of the excesses, leverage and speculation wrought during the long period of suppressed interest rates and money printing since 2008. A lot of those excesses showed up in Silicon Valley. Especially in venture capital, startup tech companies and cryptocurrencies. So, it makes sense that Silicon Valley is the epicenter of trouble and that Signature evaporated. Signature was heavily involved in crypto lending just like Silvergate and other now-liquidated institutions. These were not traditional banks. But is this the beginning of something bigger? We shall see. It is a symptom of inflation, rapidly increasing interest rates and high amounts of debt.

When Bear Stearns collapsed in 2008, and its counterparties were rescued by an orchestrated merger with JP Morgan, the stock market rallied 14%. Thenstocks rolled over again due to a weak economy, rising rates, and the excessive speculation (too high prices) of the prior period. This is why we think it best to continue to stick with a value orientation instead of trying to re-position around what we believe other investors will do. Our stocks may underperform the lowest quality and riskier stocks for a bit. We may even underperform the S&P 500 because the S&P 500 is dominated by large cap tech. Speculators will speculate knowing that the Fed will backstop their failures and imprudence.

We could talk all day about the moral hazard of rescuing ultra-wealthy individuals, venture capitalists and tech companies that placed funds on deposit (in excess of FDIC insurance limits) with a mismanaged bank. Over 97% of SVB $151 billion deposit base was uninsured and upon bankruptcy depositors should have become unsecured creditors of the bank and gotten in line like everybody else. But instead, the Federal Reserve made sure they could get their money out by declaring the bank a “systemically important financial institution”. Changing the rules on the fly has broad and long-term effects.

In the near term it saved us from probably what would have been a nasty banking and credit market crisis, which would have negatively affected all asset prices. In the long term, it encourages speculation, recklessness and makes it more costly for those who play by the rules, and less costly for those who don’t. No punishment will be meted out to those who put the financial system in peril. What it means for markets is unclear, but for the time being participants are breathing a sign of relief as liquidity, credit and settlements go back to normal.

All these developments of the last week are very short term, and we don’t want to be myopic. During periods of stress like today’s the most recent event becomes top of mind and nearly all investment prices are affected. But these effects are short-lived, and we want to see the forest through the trees.

This is not to deny the fact that there are structural issues in the United States such as inflation, excessive debt, an aging demographic, etc., that matter to investors. With a longer-term view, what the Fed does or doesn’t do during this cycle has little bearing on overall investment strategy, positioning and avoiding bad risks.

As we have said in the past, our goal is to earn high average annual returns with low risk. Since we make investments in public markets, that means, sometimes, owning things that are out of favor or challenged, and avoiding what is popular or chasing returns. By owning public equities and bonds, we are occasionally subjected to large price swings driven by other investors, but if we own good investments, use time to our advantage, and stay focused on the big picture, we should have good results over the long run.