The high-profile failure of Silicon Valley Bank (SVB) and fears of contagion sent US and global markets into a tailspin last week. Bank stocks were particularly hard hit. To very briefly recap, SVB was taken over by US banking regulators on March 10 after suffering a bank run that resulted in “inadequate liquidity and insolvency”. (All banks operate on fractional reserve banking, where only a percentage of deposits are kept in cash for immediate withdrawal. Thus, a sudden rush of customers to withdraw their money all at once will trigger a liquidity crisis. Traditional bank runs are made worse in the age of social media and instantaneous information, where panic can spread like wildfire.)
Then, over the weekend, a New York financial institution, Signature Bank, was closed by regulators after it, too, reported a bank run on the same Friday as contagion fears spread to other smaller, regional banks perceived to be more vulnerable, due in part to their narrower customer bases. That makes it the third bank to be shuttered in a week, including Silvergate Capital, which voluntarily shut down earlier. SVB (a 40-year-old bank) and Signature (founded in 2001) are the second- and third-largest banks to fail in US history, the biggest being Washington Mutual Bank in 2008. Both banks are now under receiverships with the Federal Deposit Insurance Corp.
The banks are, to a large extent, casualties of the US Federal Reserve’s aggressive monetary tightening policy. Although the federal funds rate, at 4.5% to 4.75% currently, is still low by historical standards, the rise (from near zero) has been very steep — happening over a period of less than a year. As a result, traditionally low-risk bonds, including the “safest” US Treasuries, suffered their worst losses on record in 2022. Bonds have fixed income streams, whose values fall when interest rates rise. The longer the term to maturity, the worse the drop. Recall our equation for valuations for stocks and bonds from last week, whereby the intrinsic value (V) is the sum of discounted future cash flows (DCF).
Will the failure of three banks in just one week change the Fed’s interest rate hike trajectory?
The market seems to think so. The yield on the policy-sensitive 2-year US Treasury reversed sharply lower — falling from 5.07% to as low as 4% over the course of just three days — after spending the last month rising steadily on higher interest rate expectations. In fact, expectations of an interest rate cut by year end — some even think this will happen at the next Federal Open Market Committee meeting on March 21 and 22 — is now back on the table.
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We do not think the SVB-Signature crises on their own are significant enough to cause the Fed to move away from its current path. At this point, the odds of their troubles morphing into systemic risks are low.
For starters, regulators have acted very quickly to limit contagion risks. All depositors at SVB-Signature will be made whole and the Fed announced a new lending facility to provide liquidity to other financial institutions. The Bank Term Funding Program will offer up to one-year loans to lenders, using their eligible bond assets (at full face value) as collateral. In other words, lenders do not have to resort to fire sales to meet any surge in depositor withdrawals.
In addition, the troubles for the three banks are, to a certain extent, idiosyncratic — a narrow customer base with over-reliance on tech start-ups, crypto and venture capital firms. These are segments of the economy that had boomed in the era of ultra-low interest rates, enjoying free flows of cheap money from private equity, venture capital, special purpose acquisition companies (SPACs) and IPO fundraising, and so on.
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A lot of the cash ended up as deposits in niche market banks such as SVB, Signature and Silvergate. Since their customers are flush with cash, most did not need loans and a good portion of these deposit monies ended up invested in long-dated bonds (which give higher yields, and profits, for the banks). Case in point: SVB had 57% of its assets in investment securities — mostly US Treasuries and agency mortgage-backed securities — way higher than the industry average. As mentioned above, the Fed’s aggressive interest rate hikes sent bond prices (and the value of SVB’s assets) tumbling.
Over the past year or so, the flow of cheap money also slowed and started reversing as interest rates spiked. Instead of adding to their deposits, customers were now withdrawing them, with the crypto industry in turmoil (particularly after the collapse of crypto exchange FTX) and start-ups continuing to burn cash. These banks were forced to liquidate their long-dated assets, which are trading at huge losses, to meet withdrawal demands. Yes, banks generally borrow short and lend long — but their collapse is more a case of poor management and judgement, including the failure to diversify and, importantly, hedge interest rate exposure.
We have no doubt that we will witness more instances of similar poor judgement across businesses, not just in the tech sector, over the coming months. More than a decade of excessive liquidity and ultra cheap money would have lulled many businesses into complacency, taking on more debt than they should and putting money into less productive investments.
This is in fact the liquidity risk we were warning about just last week — the importance of cash flows, not profits, as well as debt, not just share prices and market caps, when it comes to valuations. Fundamental analysis, including that of gearing, receivables, inventories and such, is all the more critical in the prevailing environment. (Scan the QR code to read our article “Valuation of companies is ultimately about cash generation, not accounting profits” [The Edge Singapore, Issue 1077, March 13, 2023].)
We performed a simple universal filter for stocks listed on Bursa Malaysia and the Singapore Exchange — for companies with high gearing, and where there has been a material increase in net debt despite reporting cumulative net profits over the last five years, indicating negative free cash flows (see Table).
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To be clear, we are not saying these companies are, or will be, in financial trouble. Companies decide and manage their own capital (funding) structures, of how much debt and equity to carry on their balance sheets. Some prefer to reward shareholders, using their cash to pay dividends and undertake share buybacks, while others retain the cash and/or pay down borrowings. Companies reinvest for the future. Borrowing to invest in productive assets that will generate future cash flows is perfectly fine. Our point is that high leverage translates into increased liquidity risks. Thus, the reasons behind the negative cash flows should be understood and properly taken into consideration when valuing companies.
We say this again: Businesses do not go bust because they make less profit, they go bankrupt when they run out of cash, for whatever reason, whether due to idiosyncratic risks or changes in the macroeconomic environment. Case in point: SVB was still profitable — with positive, albeit slightly lower, net interest margin — when it ran out of cash.
More interest rate hikes appear inevitable
Coming back to the question of the Fed’s interest rate hikes. The latest February jobs report continues to point to an extremely tight labour market. The unemployment rate remains near historical lows, at 3.6%, though marginally higher than the 3.4% in January, with more workers entering the job market.
Meanwhile, the Consumer Price Index for February showed an increase of 6% on the year — far above the Fed’s mandate of stable 2% inflation. Excluding more volatile energy and food, price increases remain prevalent across the economy — core inflation is up 0.5% month on month, with services inflation continuing to accelerate even as goods inflation fell.
The rate of inflation is determined by demand and supply of a basket of goods and services, including wages, in an economy. The Fed cannot directly address supply constraint issues; it can only rein in demand to restore price stability — through monetary policy and the control of money supply, of which interest rate is the primary (only) tool.
Notably, the Fed is focused on the total economy and aggregate demand, not any one sector. Inevitably, some parts of the economy will be booming while others are failing. Each sector is driven by its own dynamics and is not synchronised to precise time. For instance, the real estate and tech sectors are the most sensitive to interest rates, and thus are among the first to be affected by rate hikes. Others will feel the effects, with varying lag times. In other words, even if the overall economy remains resilient, some parts must necessarily already be experiencing contractions (see Chart 1).
The current banking turmoil does complicate the Fed’s job, for sure. It is likely to add caution to deliberations and may stay its hand on a 50-basis-point hike this week, previously seen as probable by the market. We think, however, that the Fed will continue to raise interest rates and keep them higher for longer. Ultimately, it must regain control of inflation, to retain credibility and ensure future policy effectiveness. After all, it is already prepared to accept recession, and some pain for households and businesses, if need be, to get the job done.
We must also accept that the steep interest rate hikes must have repercussions. And there, inevitably, will be weak links, which will be increasingly evident, especially in pockets of the economy where excesses prevailed in the era of cheap money. The only way the Fed will change its mind is if the SVB crisis triggers widespread panic that destabilises the entire financial system and economy. This is certainly not the case at this point; though it is possible, in the worst-case scenario, that we are at the beginning of a liquidity crisis — in which case, cash is king.
We expect to see a sharper cutback in consumer spending as excess savings dwindle, and rising inflation and interest rates bite. Negative wealth effect will further dampen consumption and accelerate the economic slowdown in the coming months. This will be especially true for middle-higher-income households, people who are most likely to have investments in assets such as stocks, bonds and cryptos — all of which have suffered substantial losses since their highs in 2021. In addition, the disposable income boost from cheap mortgage refinancing is over. When mortgage rates were falling, to historical lows, in 2020 and 2021, there was a massive surge in refinancing activities — whereby homeowners saved on their monthly repayments.
In summary, we think recession is increasingly likely. Indeed, the bond market has been signalling imminent recession for some time now — the gaps between the 10-year Treasury and 3-month and 2-year notes are at the widest since September 1981 (at the point of writing) (see Chart 2). Investors would do well to brace for further weakness in stocks, perhaps even a bear market. This is why the Global Portfolio has been more heavily weighted towards bonds than usual. Historically, bonds outperform stocks in the early stages of recession, as their cash flows are fixed and not affected by deteriorating economic conditions.
The Global Portfolio fell 1.9% for the week ended March 20 but outperformed the MSCI World Net Return Index, which lost 3.1%. This was due to our bond holdings.
The iShares 20+ Year Treasury Bond ETF (+4.2%) and ABF Singapore Bond Index Fund (+2.5%) were the only two gainers in the portfolio last week, as sentiment for stocks soured on the back of the global banking tumult and rising recession fears (as we have explained above). The biggest losers were Grab Holdings (-9.8%), Velesto Energy (-9.7%) and Alibaba Group Holding (-4.3%). Total portfolio returns since inception now stand at 22.1%, trailing the benchmark index’s 37% returns over the same period.
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/ or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
