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“Art imitates life,” goes the saying. But sometimes, as Oscar Wilde once pointed out, it happens the other way around. So it is with the film Everything Everywhere All At Once, a story about a laundromat owner who discovers that she has countless other selves existing in an infinite number of parallel universes. The movie has been called a “swirl of genre anarchy,” with elements of fantasy, animation, science fiction, black comedy – and because, hey why not, it’s 2023 – martial arts.
Long-time readers of Ask Forstrong, an investment publication that regularly indulges in metaphor (and extends them well beyond their breaking point), may know where we are heading here. The comparisons between the Everything Everywhere All At Once and today’s markets nearly jump off the screen. The world, now awash in new realities, is starting to feel like the film – existing in a realm of lucid dreaming, liminal spaces, and the outer wilds of imagination.
Recall the last few years. Investors have been thrust into a universe-hopping roller coaster with each scene seemingly from a different place or even another time. First, we were back in 1918 (Spanish flu!), then a return to the 1970s (inflation shock!) and now, apparently, 2008 (global financial crisis!), or even 1907 (JP Morgan bails out banks!).
And all of this is layered with paradox with markets sending mixed signals. Inflation is high but falling. The yield curve has not been this deeply inverted since 1981, but recession refuses to show up. Commodity prices have made a round trip, back at levels prior to Putin’s invasion. Even the ongoing tussle between America and China is at odds with record trade numbers between the two nations.
With these chaotic conditions, investors are now invited to turn it all over in their heads like a Montaigne gem and come up with a coherent investment thesis. Markets are simple right?
Unsurprisingly, our inbox has been flooded with questions over the last week. One topic, however, has focused minds far more than others: problems in the global banking sector. We, too, have spent the last week speaking with contacts in Silicon Valley, discussing the outlook with former policymakers and banking experts, recording podcasts and, yes, talking to our clients (we have the smartest ones). Below, we respond to the most common questions.
Most have responded to this question with a simple answer: SVB made a huge bet on long-term bonds – which, by the way, prudent banks would not have done – and it blew up. That is an okay response but makes it seem like SVB’s failure was the result of a single, bad trade. It also fails to draw a number of causal links that have roots extending back at least a decade.
Where to start? Perhaps at the basic business model of banking. Consider that a bank’s balance sheet is the mirror image of its customers. Loans and securities are its assets, while deposits are its liabilities. But SVB had a double sensitivity to higher rates: not just on the asset side (where they failed to hedge duration risk on their long-term bonds) but also on the liability one.
Back in 2021, the tech startup scene, already outperforming for a decade and now super-charged by the pandemic, was soaring. SVB had a flood of deposits from liquidity events (whether through IPOs, secondary offerings, SPACS or other fundraising activities). The market kept flinging money at SVB’s customers, and SVB kept depositing it. So far, so good.
Now let’s talk about the business model of tech startups themselves. In case anyone missed the spectacle over the last decade, this is an industry with a radical vision for humanity. They are not selling plain widgets but blockchain, cryptocurrencies, space travel, flying taxis, etc. Those businesses readily tell investors they will lose money now but promise huge profits in the future.
This is actually all fine when the cost of money is low and cash is coming in the front door. But what happens when interest rates go up, especially as fast as they have over the last year? Suddenly, investors wake up and want such quaint things like steady cash flows and profits now (and not dog-based crypto). Money rushing into the tech sector stops. Deposits stop flowing as well, but guess what? Those companies still need cash to pay rent and salaries.
Now, banking has always been a confidence game. What happens if that vanishes? History is littered with bank runs for the simple reason that no bank can survive if all the depositors want to be repaid at once. For SVB, this was a problem. Not only were startups suffering, but all their depositors were from the same sector (even the same seven group chats, according to one of our contacts). They were also uninsured, rate-sensitive, and burning cash. Can you say concentration risk? As it was, SVB’s customers lost confidence in their favourite bank and pulled their money all at once.
The lesson is twofold. First, years of low inflation and interest rates conditioned many to believe those were permanent features of financial markets. People forgot to ask important questions like how the tech industry would suffer if the world changed.
Secondly, at some point in every interest rate tightening cycle, something breaks. As the old saying goes, “Whenever the Fed hits the brakes, someone goes through the windshield.” Which passengers weren’t wearing their seatbelt isn’t always immediately clear. But it is always those parts of the economy and financial markets with the most excess. It was hard to find more excess than tech. Silicon Valley got monumentally drunk on an abundance of cheap capital and speculative greed. Now comes the hangover. (For more on this, see Super Trend 3: Silicon Valley’s Hangover, from our annual 2023 outlook).
Whenever financial shocks hit the system, the market’s knee-jerk reaction is to overstate the parallels that most readily pop to mind. In this case, we all went back to the 2008 (didn’t you?). Then, over time, markets start differentiating those analogs to the present. That’s the process we are in now.
There is no doubt there will be contagion. When things break, people get scared. That fear then seeks a host. SVB broke, fear surged, and Credit Suisse became the next target. Why a Swiss bank? Because for the last year, Credit Suisse has been plagued by problems of scandal, a wobbly investment banking unit, declining assets under management, and an epic decline of 37% in its deposits in the fourth quarter of 2022 alone. The most vulnerable are targeted first.
Will there be more casualties? Almost certainly. But this is not a repeat of 2008, which was the result of reckless lending practices in the entire banking sector during 2003-07, widespread credit expansion, and, ultimately nationwide housing busts. Broad-based weakness in the banks lasted for years. This is the definition of a systemic issue. By contrast, SVB was highly concentrated in a single risky sector or very poorly managed. Other casualties are likely to be of a similar variety.
The other key difference between 2008 and the present is the policy response. Most policymakers today are still scarred by 2008, a kind of post-GFC PTSD. That fully explains why U.S. regulators acted so forcefully last weekend, with the Treasury ordering the Federal Deposit Insurance Corporation to effectively make good on all banking deposits in the U.S. (including uninsured ones) and with the Fed providing emergency liquidity through their new Bank Term Funding Program.
Was that policy overkill? Perhaps, but this type of action extends a long trend. Since the 2008 global financial crisis, and progressively so, the policy response has always been to socialize the costs. With every new crisis, the solution seems to be the same: another government backstop, more bailouts, and more currency debasement.
This was true of the EU sovereign debt crisis and it was particularly true of the pandemic. The political appetite to bear any financial pain simply does not exist anymore. Where does that leave investors? Ultimately, it removes deflationary tail risks and skews the range of potential outcomes towards higher inflation and higher asset prices. This is one of the big themes of the 2020s: the so-called “government put” remains firmly in place.
Where exactly the pain from the fastest Fed tightening cycle in a generation will manifest next is the big question. But there are already signs of mounting stress. Commercial real estate, with billions of office debt maturing this year and banks shying away from refinancings amid plunging building values, is one area. The leveraged loan market, where private equity firms have layered companies, many of them in residential real estate or the startup space, with mountains of debt is another. In fact, private assets of all kinds, unburdened in the short term by those pesky things like transparency and price discovery, will face dramatic markdowns in 2023.
What do all these assets have in common? Financial excess and rising leverage. This is why our investment team has been avoiding them over the last decade. All of them have commanded an ever-steeper premium as rates steadily declined in the 2010s. This includes technology, growth stocks and the wide array of rate-sensitive investments that soared on ZIRP’s wings.
Expect all this to steadily reverse. Investment classes that struggled with chronically weak demand and dismal pricing power in the last decade are now primed for multi-year outperformance in a macro environment of higher inflation. This includes select resource-exporting emerging-market equities, global sectors with pricing power (industrials, healthcare and, yes, many banks), and international value stocks which now trade on far lower earnings multiples and far higher dividend yields.
Next time: Global banking rout, part 2: recession probabilities; monetary policy path; U.S. investment risk; volatility.
Tyler Mordy, CFA, is CEO and CIO of Forstrong Global Asset Management Inc., engaged in top-down strategy, investment policy, and securities selection. This article first appeared on Forstrong’s Global Thinking blog. Used with permission. You can reach Tyler by phone at Forstrong Global, toll-free 1-888-419-6715, or by email at tmordy@forstrong.com. Follow Tyler on Twitter at @TylerMordy and @ForstrongGlobal.
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Content © 2023 by Forstrong Global. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. Used with permission.
The foregoing is for general information purposes only and is the opinion of the writer. The author and clients of Forstrong Global Asset Management may have positions in securities mentioned. Performance statistics are calculated from documented actual investment strategies as set by Forstrong’s Investment Committee and applied to its portfolios mandates, and are intended to provide an approximation of composite results for separately managed accounts. Actual performance of individual separate accounts may vary with average gross “composite” performance statistics presented here due to client-specific portfolio differences with respect to size, inflow/outflow history, and inception dates, as well as intra-day market volatilities versus daily closing prices. Performance numbers are net of total ETF expense ratios and custody fees, but before withholding taxes, transaction costs and other investment management and advisor fees. Commissions and management fees may be associated with exchange-traded funds. Please read the prospectus before investing. Securities mentioned carry risk of loss, and no guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.
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