March 2023 Market Commentary
April 13, 2023
In many respects, March was a tale of two halves: before the collapse of Silicon Valley Bank (SVB) and after. Prior to SVB’s collapse on March 10, markets had become increasingly convinced that stronger-than-expected employment data and continued inflationary pressures would force the Fed to increase the size of its March rate hike from 0.25% to 0.50% and remain aggressive thereafter, with the Fed Funds rate ending the year at 5.50-5.75%. Following the collapse of SVB, market expectations gyrated wildly, at one point projecting the Fed to raise rates once more in March by 0.25%, to 4.75-5.00%, before commencing rate cuts in May and ending the year at 3.75- 4.00%. However, by month end, with banking industry concerns subsiding, year-end expectations had partially recovered settling at 4.25-4.50%, representing two 0.25% rate cuts between now and December.
The well-documented collapse of SVB, while not directly attributable to the Fed’s current rate hike cycle, was certainly exacerbated by higher rates. Awash in cash in 2020 and 2021 from its venture capital customer base, SVB invested billions of excess liquidity into US Treasury bonds. The mistake SVB made was investing in longer- dated 10-Year Treasuries in an attempt to capture additional yield. At the time, the Fed had been holding interest rates at historically low levels for over a decade and conventional wisdom was that rates would remain low for the foreseeable future. What SVB’s management team failed to account for was the homogeneity of its customer base and the fact that interest rates might in fact rise at some point in the future.
The first lesson in bond investing is that interest rates and bond prices move in opposite directions. When rates rise, prices fall and vice versa. As the Fed began to raise rates in 2022, SVB’s bond portfolio, particularly its longer- dated bonds, incurred significant losses. At the same time, its venture capital client base was relying increasingly on its cash deposits to fund operations as market volatility prevented many companies from accessing the equity markets to raise capital. As those cash demands increased, SVB was forced to sell ~$21B in bonds from its investment portfolio to provide liquidity to clients. In doing so, SVB recognized a $1.8B loss on the bonds it sold. Plans to raise an additional $2.1B in capital to offset the losses created panic about the bank’s health, leading to a classic “bank-run.” On Thursday, March 10, alone, SVB’s clients withdrew $42B. Without sufficient liquidity to meet the redemptions, the bank failed.
Silicon Valley Bank’s failure precipitated significant market volatility, finger pointing, and even some introspection on the part of the Fed, which Chair Jay Powell alluded to following the Fed’s March meeting when he said that the central bank was “committed” to learning the lessons from SVB’s failure to try to prevent similar future events. In fairness to the Fed, however, its mandate is to ensure price stability and maximum employment at a macroeconomic level, not consider how its actions might affect the fortunes of any one specific bank.
An important question that currently remains unanswered is the degree to which the recent banking turmoil will result in tighter financial conditions and what that might mean for economic activity. The Fed effectively acknowledged those concerns by altering the language of its March meeting statement by replacing the sentence used in prior statements reading “The Committee anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time” with “The Committee anticipates that some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.” Speaking afterwards, Powell indicated that the change was the direct result of the recent banking turmoil and expectations that tighter financial conditions resulting from the turmoil could be the equivalent of “a rate hike or perhaps more.”
Economic data released during the month did little to change the recent narrative that economic growth continues, albeit at a slowing pace, labor markets remain relatively robust, and headline inflation continues to slow. Continued upward pressure on services prices, however, presents a challenge to the Fed returning inflation to its longer-term target of 2%. After being under severe pressure for much of 2022, housing data released in March suggested that the sector may have reached an inflection point. New and existing home sales increased to their highest level since August and September of 2022, respectively, while prices showed some modest signs of improvement.
Despite the banking turmoil, large cap equity returns were positive for the month with the S&P 500 gaining 3.5%. Small caps (Russell 2000) did not fare as well, falling 5.3%, impacted by a larger weighting to financials than the S&P 500 and within that, significant exposure to smaller regional banks which came under far greater pressure than the large money-center banks. International market returns were positive with developed (MSCI EAFE) and emerging (MSCI EM) markets gaining 1.9% and 2.7%, respectively.
A decline in yields over the course of the month stemming from the collapse of SVB boosted fixed income returns with the Bloomberg US Aggregate index, the broadest measure of the US bond market, gaining 2.5%. At the outset of the month, it appeared that bonds would remain under pressure as the 2-year Treasury yield reached 5.08% on March 8, its highest level since June 2007. Yields fell sharply in the wake of SVB’s demise, however, as investors sought safe-haven assets such as Treasuries. Yields remained under pressure for much of the month as fears of a broader banking contagion persisted. However, towards month-end as investors became more comfortable with the idea that the issues which triggered the banking turmoil were isolated to a few select banks with unique circumstances, confidence in the banking sector began to recover leading to a modest recovery in yields.
In the immediate aftermath of SVB’s collapse, expectations regarding the Fed’s March rate hike swirled, including that the Fed might choose to forgo any increase. In the end, the Fed raised rates by 0.25%, less than the 0.50% markets had been expecting prior to the banking turmoil, but in doing so displayed its confidence in the health and stability of the broader banking industry along with its commitment to lowering inflation. Despite the rate hike, 2- Year Treasuries experienced their largest monthly decline in yields (and largest monthly increase in prices) since 2008, driven by lowered expectations for future rate hikes.
Like the Treasury market, muni yields hit recent highs in early March before declining in the wake of SVB’s collapse. The fall in yields wasn’t nearly as drastic as that in Treasuries, due to limited supply stemming from higher yields and volatility which had led issuers to hold off on bringing deals to market. As yields drop, expectations are that supply will pick up, but for now the shortage has led to relative outperformance for municipal bonds. Muni yields finished the month at lows last seen in early February.
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