Does Anyone Remember Lehman Brothers?
The closing of at least four banks over the last few weeks has reminded many of us of the frightening days of 2008, when the glut of sub-prime mortgages in the portfolios of Wall Street investment bankers exceeded the risk limiting benefits of diversification and ushered in a global financial crisis that led to what became known as the Great Recession. Washington Mutual and Lehman Brothers were shuttered while Bear Sterns, Merrill Lynch, AIG, Freddie Mac and Fannie Mae were either sold at bankrupt prices or had to be rescued by extraordinary measures. Several money market funds were found traded at less than $1.00, thereby “breaking the buck.” In the aftermath of that traumatic period, Congress passed the Dodd-Frank Wall Street Reform Act and dramatically increased government regulation of the nation’s financial services industry in order to prevent another meltdown. There’s nothing like increased government regulation to lull the public into a false sense of security.
So here we are again, only this time, the rush to remove deposits from at-risk banks was happening at lightning speed, thanks to social media and the ease of one click transferal of funds. But is this a repeat performance of the 2007-2009 financial crisis? Then, the crisis was precipitated by the failure of mortgages (mostly subprime) which had been packaged and securitized into collateralized mortgage obligations (CMOs) and other derivatives and then sold to banks and financial institutions. These instruments had fed a manic and unprecedented six-year housing boom and permeated the investment portfolios of banks and other financial institutions. Of course, at the time, it was received wisdom that home prices might briefly decline but would not fall off a cliff. The Great Recession disabused us of that superstition. Today’s bank troubles also spring from insufficient liquidity but have little to do with the quality of underlying assets. In the case of the former Silicon Valley Bank (SVB), too many of its assets were in longer-term U.S. bonds whose market value had declined in the face of climbing interest rates: to pay off depositors, the bank had to sell bonds at a loss, and the proceeds were not enough to cover deposits. The point we would like to make is that until we hear otherwise, the current stresses to the financial system are limited to banks that have mishandled the matching of their investments to their deposit base. The risk appears to be specific rather than systemic: there does not appear to be an embedded virus infecting the entire banking and financial system.
Although not a virus, the Fed’s (and other central banks’) efforts to halt runaway inflation are systemic in their effects. A short review of recent history is in order here. During the Great Recession of 2007-2009, the Fed justly slashed overnight interest rates to near zero levels to prevent the economy and the country from falling into a deep depression. Even after GDP returned to growth status, the Fed maintained near zero interest rates for several years to prevent deflation and allow consumer prices to rise at a moderate pace: 2% was considered optimal. About halfway through the last decade, inflation appeared to be settling into an acceptably positive trend and the Fed Funds rate began increasing modestly. It eventually reached 2.5% in 2019, and then the Covid pandemic struck. The Fed Funds rate dropped to near zero again and stayed there until inflation returned with a vengeance in the fall of 2021; the Fed has been playing catch up ever since. The most recent annual inflation measurement (CPI) stands at 6% and the Fed Funds rate, following the most vertiginous increases in bank history, currently occupies a range between 4.75% and 5%. The overnight rate might have been even higher if not for Chairman Powell’s nod to caution after the failures of SVB and Signature Bank. But when the Fed takes its commitment to price stability seriously, it’s generally understood by the market that it will continue throttling the economy until something, or several somethings, break. The recent bank failures are more the fault of individual mismanagement than of a systemwide weakness in asset collateral. Or, as the old chestnut from Warren Buffett warns, when the Fed tightens and the tide goes out, everyone gets to see who’s swimming naked.
It seems to us unlikely that inflation will decline to the Fed’s desired 2% level without an extended period of elevated interest rates and restrictive monetary policy. For now, and despite the recent bank failures, the overall economy appears to be in excellent shape: first quarter 2023 preliminary estimates for GDP growth are at 3.2%, an acceleration from the previous quarter (2.7%); the unemployment rate of 3.6% is near its fifty years low; consumer sentiment, though well below pre-pandemic levels, has rebounded dramatically from its pandemic induced bottom. This is not to say that there aren’t warning signs among the rumors and statistics — the ISM Manufacturing Index is in a contraction mode, the OECD Index of Leading Economic Indicators is negative, corporate earnings and earnings estimates are in a downward trend — but that there doesn’t seem to be enough pessimism in the news to cause the Fed to reverse or even halt its tightening regime, particularly with inflation at 6%. Remember that within two weeks of the collapse of SVM and Signature Bank, the Fed did not pause but raised rates by .25%.
The markets appear to be taking the Fed’s actions and concerns in stride. The Treasury yield curve is of course inverted — six-month yields > one-year yields > two-year yields > ten-year yields — reflecting an expectation of a slowing economy over the next few months. However, credit spreads — the difference between the yields on corporate bonds and comparable maturity government bonds — don’t appear to be suggesting an economic slowdown or recession. The stock market, although down more than 16% from its bull market high in January of 2022 — just before the Fed began tightening — has rebounded 10% from its bear market low of June 2022. On the optimistic side of things, there are conversations circulating among many investors and investment strategists that the Fed is likely to pause and then cut rates near the end of 2023. And some pessimists adhere to the teachings of Peter Lynch and his rule of 20, which holds that the market will bottom when the sum of trailing P/E ratios (currently 18.7) and 100 times the latest annual rate of inflation (6) equals 20 or below. By this measure, a market bottom is still a future event.
There are two expressions that one hears at various points during a market cycle which provide a simple pacifist rule for investing: don’t fight the Fed and don’t fight the tape. Unfortunately, these two imperatives are often, as of now, contradictory: the stock market lately has been trending higher, even though the Fed is clearly in a restrictive mood. The recent bank failures, even without further Fed tightening, are likely to cast a cloud over credit markets and further restrict all but the least risky investments. We don’t believe that another Great Recession, or worse, is in our immediate future, but we do think it’s prudent to exercise caution. And, for now, we prefer to stay on friendly terms with the Fed.
Not Investment Advice or an Offer This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing. Argent Financial Group is the parent company of Argent Trust, Heritage Trust and AmeriTrust.