With the first quarter of 2023 behind us, we thought it would be worthwhile to review what happened in Q1’23 before we dive into what we think will happen in Q2’23. Looking first at U.S. GDP growth on a year-over-year basis, it grew only 0.9% in 2022 versus 5.7% in 2021, a significant deceleration. For the first quarter of 2023, GDP growth was 1.1%, with strength seen in consumption, but offset by weakness in investment spending. The unemployment rate as reported in April 2023 was 3.5%, unchanged from year-end 2022. On the other hand, forward-looking data, such as manufacturing, service survey data and consumer confidence, are pointing to an economic slowdown ahead. Inflation remains an issue, with the latest reading showing that the Consumer Price Index (CPI) increased 5.0% in March 2023 from March 2022, well above the Federal Reserve’s 2.0% target. 

Asset markets rebounded nicely in Q1’23, perhaps because of an easing of recession fears or maybe a simple relief rally after the negative returns seen in 2022. On a closing price basis, the S&P 500^® rose 7%, while the Nasdaq^® and Russell 2000^® indices gained 17% and 2%, respectively. Emerging market equities gained almost 4%, while developed market equities outside of the U.S. had positive returns, ranging from a gain of 2% for the U.K.’s FTSE index, an almost 8% gain for Japan’s Nikkei 225 index and a 12% gain for Germany’s DAX index. The U.S. Treasury curve inverted even more, with 3-month Treasury rates rising 38 basis points to 4.75%, while 10-year Treasury rates fell 41 basis points to 3.47%. Below is a snapshot of the market movements since the beginning of 2022. (Bloomberg Barclays indices, data as of 12/30/22)

There were some headline-grabbing bank collapses in March 2023, namely Silicon Valley Bank and Signature Bank. These two banks were taken over by the FDIC after experiencing large deposit flight. For context, the Silicon Valley Bank failure was the second largest bank failure in U.S. history and the largest since Washington Mutual failed during the Great Recession in 2008. The failures triggered a sharp drop in stock prices for many regional banks and other firms in the financial sector, with even large, systemically important banks like J.P. Morgan and Bank of America not left unscathed as fears of a banking crisis/contagion ran through the markets. Two examples of the sell-off in equity prices in March: J.P. Morgan’s equity price fell 8.6% in the month, while First Republic Bank’s (a regional bank) equity price fell 88.6%.

The key question is whether a systemic banking crisis is at hand, and in our opinion, the short answer is “No.”

We believe there were unique reasons for each of the bank collapses that occurred in March. We won’t go into the reasons for each but, instead, confine our comments to Silicon Valley Bank (SIVB). From year-end 2019 to 1Q22, SIVB saw its deposit base roughly triple to $198 billion as money flowed in from private equity fundings and technology sector-related sources. Most of SIVB’s deposits were reportedly uninsured (i.e., they were over the $250,000 FDIC insurance threshold), with only about $5 billion fully insured. SIVB also had a very low reliance on stickier retail deposits which tend to stay at banks and are relatively insensitive to interest rates.

SIVB took this deposit money (most of it uninsured) and bought fixed income securities, which created a duration mismatch between its assets and liabilities. As interest rates rose in 2022, SIVB’s securities portfolio lost money; recall that Treasuries and other traditional fixed income securities – mortgage-backed securities, asset-backed securities and corporate bonds – lost between 12% and 15% in 2022. When fast money deposits of private equity firms began to flee the bank as they realized the extent of the losses in SIVB’s portfolio and that their deposits were uninsured, SIVB was faced with a classic bank run. The liquidity shortfall cascaded into a capital shortfall as SIVB could not liquidate its securities holdings fast enough and the losses were high enough to destroy SIVB’s equity capital, resulting in an inevitable bank failure.

In response to the bank collapses, the Federal Reserve created a new program, the “Bank Term Funding Program” (BTFP), which offers loans of up to one year in length to eligible depository institutions pledging U.S. Treasuries, agency debt and mortgage-backed securities and other qualifying assets as collateral. These assets will be valued at par; there won’t be a haircut to current lower market prices. The BTFP, combined with the FDIC’s guarantee of all failed banks’ depositor balances and the FDIC’s $128 billion deposit insurance fund (as of year-end 2022), appears to have calmed depositor fears and averted a possible banking crisis. The other good news is that SIVB’s problems appear unique to the bank – an undue reliance on fast money deposits coupled with poor risk management and an untenable duration mismatch. In other words, SIVB’s problems were largely idiosyncratic.

The first piece of bad news is that the SIVB and other bank collapses will likely result in tightened financial conditions. Bank loan officers were already tightening lending standards before all the turmoil hit the banking sector. Going forward, we believe investors will be more cautious about funding smaller banks and raise the credit premiums these banks pay for capital. Deposits will also likely move from smaller banks to larger banks. The higher credit premiums and deposit flight will further tighten the amount of capital available to commercial real estate and smaller enterprises – recall that regional banks own about 60% of the commercial real estate loans in the U.S. Further, the recent higher residential mortgage rates have hurt another key part of regional banks’ business.

The second piece of bad news is that there was only one truly systemic common element in these bank collapses: the sharp rise in interest rates engineered by the Federal Reserve in its fight against inflation. Unfortunately, the inflation problem has not gone away. As mentioned earlier, the latest CPI as of February 2023 was 6.0%, and as shown in the charts below, the components of inflation seem quite sticky as we are seeing a fall in goods inflation while services inflation remains high. Until inflation slows to at least the 3% to 4% range, the Federal Reserve may still need to raise interest rates a few more times. This raises the risk of a recession and/or other financial turmoil, perhaps centered in the commercial real estate and residential housing markets. As such, we are cautious on the outlook for the second half of 2023 and believe we could see a reversal of the gains we expect for 1H’23.