Q1 2023 Commentary from Andorra
"Bank confidence is a fragile reed, and a troubled bank is damaged by any rumors, true or not."
-- Irvine Sprague, former Chairman of the Federal Deposit Insurance Corporation (FDIC)
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Overview
To repeat the commentary from last quarter, interest rates continue to move higher. But a new twist is that some assets saw a bit of a relief rally during the first quarter of 2023. This rally was primarily in stocks that have seen large declines. So when we hear commentary from financial channels like “NASDAQ has its best quarter in 2 years” this ignores the fact that most large-cap stocks are below their highs they hit in November-December of 2021. As technology stocks are more sensitive to interest rate changes, these quick gains may be short-lived. Now, we are looking back at a 12-month period of wildly higher interest rates and how that might impact the economy and financial markets.
Higher interest rates were bound to have some unintended consequences. First, one of the very public things to “break” due to higher rates has been some rather large banks. Silicon Valley Bank (SVB), which may be unfamiliar to some, was a critical player in the technology and California markets. Additionally First Republic, a California-based bank that primarily served wealthy customers, is essentially insolvent. Interestingly, First Republic and SVB may have many overlapping customers and they certainly both have a large number of California customers. Many are quietly saying the failure of these two institutions will be felt across the state for many years. It was reported that $42 billion was withdrawn from SVB in one day and their failure soon followed. This was a classic bank run. After these two banks entered the crisis phase in March, then attention moved to who might be next.
Many large regional banks sold-off in the first quarter and even Charles Schwab was rumored to be vulnerable. It should be noted that Charles Schwab is in no way similar to SVB or First Republic. We fielded a few calls from clients regarding Schwab. We are aligned side-by-side with our clients and have all of our accounts custodied at Schwab. Schwab in not a typical bank and their brokerage and custody business (where all of client funds reside) is separate from banking operations at Schwab. As they say, Schwab is literally “too big to fail” and, importantly, we believe this is not even a remote possibility. SVB and, to a lesser extent, First Republic had inherently risky business models that were laid bare by a perfect storm of higher interest rates, a tech stock sell-off, and a war on crypto assets waged by regulators.
Economic Commentary
The recent move up in rates has been extraordinary and are the most aggressive hikes in decades. We went from a period where rates were effectively 0% for an extended period of time post-COVID, to now where we have interest rates that are far higher than they were three years ago. For perspective, we have to go back to the 2007-2009 timeframe to when rates were in the 5% range that preceded a recession (see chart below). Currently, talk of a looming recession is becoming louder and is centered on how long and severe the potential slowdown might be in late 2023 and into 2024. This is what gives us pause regarding stocks. Recessions usually mean corporate earnings decline (what we are really buying is a company’s earning potential) and typically the associated stock price declines in tandem.
As we can see from the chart above, rates have moved up quickly and are on a path to where the Fed states it would like monetary policy to be “moderately restrictive”. Higher rates will likely be felt in real estate, high growth businesses (both public and private) and labor markets. The Fed is in a difficult spot; while trying to engineer a slowdown they must go after drivers of inflation while attempting to not create massive unemployment. The Fed knows they can’t control certain input factors like commodity prices that are helping to drive inflation, but they can raise rates that may effectively cause companies to layoff workers. Demand destruction will likely be created through higher unemployment.
We can see from the chart above that unemployment is at a post-WWII low. People who are employed spend money, pure and simple. While they will never publically admit this, the Fed knows that higher interest rates will slow the economy, likely via creating layoffs among the working public. In the past few months there have been numerous stories about large companies announcing layoffs and/or ending future hiring plans. The effect of these announcements will likely take some time but we are already beginning to see the rate of inflation decline. Interestingly, it seems that there has been a coordinated policy response around the globe of higher rates directed at high levels of inflation in many parts of the world. We may be entering a global credit tightening cycle.
Real estate along with labor markets, have been mentioned numerous times as needing to be reigned in by the Fed. Real estate prices have been repeatedly noted as “too high” and labor markets are “too tight” according to Chairman Powell. Unfortunately, the primary instrument used by the Fed to tame these markets is a blunt instrument called interest rates. In the residential housing market, many consumers had locked in a very low rate about a year ago or some even paid cash for a home. But the commercial market is characterized by various floating notes or five-year mortgages that must be rolled over in the coming one-to three years. We are on the frontend of a looming commercial property time bomb. Coupled with the fact that more people are working from home, some office properties are 50% vacant, and companies are actively trying to reduce their office space, means trouble for commercial property.
Commercial loans for office, industrial, and general commercial properties have recently become much more expensive with the associated rise in interest rates. This has many wondering what the commercial property market will look like in one to three years due to many borrowers having old loans at low rates. Large brokers for office space had been touting that existing building can be “re-purposed” into condos or some type of live-work use. In reality the costs associated with turning offices into condos and the fact that the building layouts make most of these projects unviable means that many city centers and their landlords face a major reckoning in the very near future. This coupled with radically higher interest rates may mean property owners and their lenders are in trouble. Refinancing the debt pile illustrated in the chart below at higher rates may be a very tough task.
Circling back to banks and their associated ability to lend, many are worried that the commercial property downturn and refinancing risks will weigh on the economy. We have already begun to hear about banks reaching out to customers and asking for updated financials from their current borrowers to determine if they have violated existing loan covenants. This, combined with many reports that banks have already tightened lending standards, will likely further slow the economy. Due to inflation still running well above Fed targets, interest rates likely will rise even further from current levels. During a recent poll of 330 State Bank Supervisors, some 94% said a recession has already begun. At the consumer level, it’s likely we just haven’t yet seen the impacts of tighter credit and higher rates.
Outlook
Where does that leave us on the investing front with interest rates substantially higher, the refinancing boom of residential mortgages over, and a softening of the labor market? We remain very cautious regarding equity investing. In the short-term, yes, stocks have had a bounce here in the first quarter. But, as corporate earnings stay flat or decline, we expect equity markets to be flat to negative due to a looming recession. This is a very difficult call to make as FOMO (fear of missing out) regarding a potential equity rally is strong among investors. The question we should be asking ourselves right now is, when or what will signal the “all clear” to jump back into the market.
What has proven to be a strong predictor of an entry point for stocks is when the Fed begins to cut interest rates. Due to elevated levels of inflation, barring some unforeseen calamity in the economy, we are likely 6-12 months away from the Fed cutting rates. Plus, the Fed has proven to be reactionary and will have to see evidence that we are in a material economic slowdown before they begin to cut rates. But, as many stocks are still off their highs, we continue to build a list of high-quality recession resistant stocks that should do well in almost any economic environment. We are patiently waiting until we approach the end of the Fed’s current interest rate tightening cycle.