Banking Stress – This is not 2008

Ugh, so how bad is this?
Animal spirits is the term John Maynard Keynes used to describe stock market buyers and sellers.  This certainly seems apt today: bears and bulls struggle for dominance, while other predators and prey thrash about trying to gain tenuous advantage.  For investors, it’s like new revelations inject new energy into successive cycles of endless struggle.  We’ve had plenty of news to keep the animals busy.  So now, why not throw a banking crisis into the mix and see who can gain advantage and who gets pummeled. 

How bad is this current situation?  Will these markets ever calm down and how worried should we be?  Well of course, no one knows the exact answers.  These are somewhat unprecedented times (more on this later), so it’s hard to draw apples-to-apples comparisons with history.  To not bury the lead: this is not 2008, in my opinion.  Certainly, we should be concerned about how this develops because Fed-induced slowdowns can be rough.  But remember that in 1982, after Paul Volker raised rates to near 20% causing a severe recession, inflation was vanquished and the market went on to an almost twenty-year bull market.  Better times are ahead.  We just don’t know how long we’ll have to endure this volatility.

First, some reassurance
This is not 2008.  The level of embedded risk pervading the financial system was an order of magnitude worse during the Great Recession.   Banks were loaded with toxic assets, liabilities to insurance conglomerates were near catastrophic, consumers were greatly overleveraged, the US housing sector was precarious.  The toxic assets held on bank balance sheets became essentially worthless.  In 2008-2009 we saw risk to the entire system.  This is not the case today.  Yes, there are slowdowns in housing and consumers are showing signs of stress, but nothing like the levels of 15 years ago.  And today’s “toxic” assets?  These are US Treasuries purchased prior to rate rises, which have a huge market of willing buyers.  Rapid interest rate increases caused the market value of these Treasuries to go down, but they’ll likely recover to face value if held to maturity.  This is nothing like the CDS (credit default swap) debacle of 2008 -2009.

Rapid government response.  This ain’t our first rodeo.  The Fed, Treasury, FDIC, etc. have acted quickly.  In 2008-09 and 2020, it took precious time to define what to do and then to implement.  Today, these government agencies have moved very quickly to implement practices that were already known and in place.  For example, the depositors of Silicon Valley Bank had their deposits guaranteed, regardless of amount.  And banks are being offered liquidity valued at the higher face value of the assets on their books, not the lower current market rate.  These quick actions serve to reassure investors and minimize overreaction. 

Depositor insurance.  Individual savers at banks already have substantial guarantees from the Federal Deposit Insurance Corporation (FDIC).  $250,000 per person per account per institution is federally insured.  Couples with a joint account have $500,000 in coverage.  Some people use different accounts within the same bank or in different banks to extend this coverage.  There are many ways to diversify safe holdings and also receive a decent return.

Winners and losers.  At the time of this writing, many stocks of banks and other financial institutions are selling off in response to this crisis.  I think it’s very likely that in the coming days and weeks we’ll see separation in outcomes as investors sort out the high-quality stable banks from those that might be more speculative or poorly managed.  The most stable banks and financial firms probably see this as an opportunity to gain market share as customers flee more risky institutions for those that feel safe.  Some may well emerge from this stronger than ever, while others struggle or even implode.

LPL Financial.  For clients, LPL Financial seems relatively strong.  Barron’s had a positive article online on March 14, 2023.  Some quotes pulled out of that article: 

• Michael Elliott, an analyst from CFRA Research raised his opinion on LPL’s stock to buy from hold on March 14. “After significant market pullback, we believe valuation is now attractive…”
• In a more stressed environment LPL may actually benefit because the deposits the company provides to banks will be in greater demand, the UBS analysts say.
• William Blair’s Schmitt rates LPL’s stock as outperform. The company’s stock trades at 12 times 2023 earnings per share currently versus 15 times historically, Schmitt says.

Reality Check – Be careful what you wish for.
However, with all of this going on, we are clearly not out of the woods yet.  Let’s think about some of the major risks and challenges:

Fed’s impact being felt.  The Fed wanted a slowdown to combat inflation, so they raised rates and contracted the money supply.  Well, it looks like their wishes are coming true and the slowdown is happening.  Inflation readings have continued to fall and the overall economy is showing signs of cooling.  But the Fed’s tools are blunt.  Fed-induced slowdowns aren’t known to be a smooth orderly process.  Rather, they typically come in fits and starts with unintended consequences where some areas receive more than their share of pain.   

Sensitive vs sluggish.  We are seeing that the various sectors have different sensitivity to interest rate hikes and cooling inflation.  This makes sense:  housing is very sensitive to hikes as mortgage rates go up; the labor market reacts more slowly for a variety of reasons.  What may be happening now is that the impact of Fed rate hikes has now finally begun to work into the broader economy.  It’s what the Fed wanted and warned of all along.  But now that it’s here, we endure the effects.

The tide’s gone out.  Warren Buffet famously quipped that “A rising tide floats all boats… only when the tide goes out do you discover who’s been swimming naked.”  Applied to the current situation, this means that during boom times many banks can seem to thrive.  But when conditions change and times get tough, weaknesses and flaws are revealed.  That seems to be where we are today.  The tide has gone out, and some of the swimmers probably wish they’d been better prepared, while the well-prepared might greatly benefit.

Bank lending contraction.  Whatever happens, it seems a highly probability that in result of this, banks will focus inward on how they manage their own operations.  This could certainly mean they become more stringent in who they loan to.  A borrower who seemed an acceptable risk a few months ago may be rejected today.  If this happens, it could well lead to the type of broad-based slowdown the Fed has been looking for.

Contagion?  This is often a central concern whenever there are problems in the financial sector.  The threat may not be that there actually is a system-wide risk – there probably isn’t.  But if enough people become fearful, a relatively isolated risk could become pervasive.  Scary, yes.  And that’s why the rapid and resolute response from the Fed, Treasury, and FDIC has likely gone a long way towards restoring faith.

What’s a reasonable/rational way to view this?
Remember, we’re still in the midst of aftershocks from the pandemic shutdown/reopening.  These are uncharted waters in that we’ve never before gone through a massive, coordinated intervention to shutdown/reopen the global economy.  These are the days of recovery or aftershocks from that global shock in 2020.  Or a better way to think of it: these are days of restructuring.

Restructuring.  Almost anywhere you look, you see sectors and businesses undergoing dramatic restructuring:  The supply chain is being completely reorganized around themes of cost and resilience.  The workforce, who before 2020 had rarely if ever used teleconferencing, now considers flexible workspace a birthright.  The monetary system has gone from decades of structurally falling rates to a rising rate regime.  The energy sector is being revamped and rethought around us.  Hybrid cars are no longer unique and electric vehicles have become a legitimate alternative. 

Restructuring does not mean decline.  To investors, restructuring can look like renewal and opportunity.  But it is not a simple or obvious process, except when viewed in retrospect.  As we go through this, there are sure to be winners who seem prescient and wise.  But there will also likely be losers who, sometimes by no fault of their own, find themselves in circumstances that are untenable, even desperate.  This restructuring has now apparently reached the financial sector.  This may ultimately make it even more strong and resilient, though the process might be messy. 

Durability.  Like other moments in history of great stress, we are faced with challenges that cause people to wonder whether the economic system is durable or fragile.  Time will tell, but if long-term history is any guide, the US economic system has consistently proven itself to be quite durable.

Considerations.
It’s quite mind-blowing to consider all that we’ve been through over the past few years.  Pandemic collapse in early 2020, stimulus-led V-shaped bull market, bear market response in 2022, rampant inflation, historically fast interest rate hikes, land war in Europe.  And now a banking crisis.  What to make of it all?

Improvement.  Several months ago, it was clear we needed improvement in big global themes.  Many of those improvements seem to have arrived in a manner that we longed for in early 2022.  I’m not saying these problems are completely fixed, but we have seen substantial improvement:

• China reopening.  After a prolonged and difficult pandemic shutdown, the reopening seems well underway, leading to reported signs of economic growth.  This is a potential huge positive for the global economy.
• Inflation trending down.  As we’ve said above, this is not an easy or comfortable process, and we are probably not out of the woods yet.  But clear progress has been made on inflation trends and there are reasons for optimism that the progress will continue. 
• Nearing the end of rate hikes?  Before the recent banking headaches, there was much talk about the Fed nearing the end of its rate hike program.  Now, given all of the dynamics of the current risks to the financial sector, excessive further tightening from the Fed seems unlikely.
• War in Ukraine.  I’m really not qualified to comment here.  The headlines are depressing as we enter the second year of this conflict.  China has apparently scheduled talks with leadership of both Russia and Ukraine.  While this may signal some welcome peace talks between the active adversaries, it may also indicate complicated geopolitical realignment.  “Progress” on this front is ambiguous at best.

Conclusions
Bear markets are a process.  They say a bear market isn’t over until all of the sellers have sold.  Investors who have faith in the long-term typically look beyond these types of events to the prosperous times ahead.  But skittish investors sell, often at the worst times.  Maybe what we see here is a flushing out of the skittish investors.  They call these “weak hands” meaning that scared investors don’t hold their investments very tightly.

Finally, has the market been right all along?  Something that has been bothering me all year is how many commentators and journalists have routinely argued that the bulls are trading off of hope, foolishly expecting a “Fed pivot” (from raising to cutting rates).   This argues against the long-held concepts of the wisdom of the crowd and the efficient market theory.  Certainly a few weeks ago it seemed naïve to hope for a Fed pivot to save the markets.  But now?  Seems well within the rational conversation. 

I’m not saying that the market knew that this specific set of circumstances would play out this way.  But it now seems more than plausible to consider that the Fed’s rapid rate increases might eventually cause something to crack, which could lead to a change in rate policy.  Maybe the hopeful bulls were right?

And remember, investing over the long-term can lead to dramatic gains.  Even during times of duress.  If you had invested in the S&P 500 index on the worst day possible before the Great Recession (say mid-October, 2007), your investment would be up over 150% today, including the most recent selloff.  Not bad.