THE WEEK ON WALL STREET
Amid the reverberations of two U.S. banks being taken over by regulators and the spread of uncertainty to European banks, stocks trended higher last week on the strength of the technology sector. The Dow Jones Industrial Average was flat (-0.15%), while the S&P 500 rose 1.43%. The Nasdaq Composite index picked up 4.41%. The MSCI EAFE index, which tracks developed overseas stock markets, dropped 3.12%.
FACT OF THE WEEK
In an attempt to lift the state out of the hard times of the Great Depression, the Nevada state legislature voted to legalize gambling on March 19, 1931.
Located in the Great Basin desert, few settlers chose to live in Nevada after the United States acquired the territory at the end of the Mexican War in 1848. In 1859, the discovery of the “Comstock Lode” of gold and silver spurred the first substantial number of settlers into Nevada to exploit the territory’s mining opportunities. Five years later, during the Civil War, Nevada was hastily made the 36th state in order to strengthen the Union.
At the beginning of the Depression, Nevada’s mines were in decline, and its economy was in shambles. In March 1931, Nevada’s state legislature responded to population flight by taking the drastic measure of legalizing gambling and, later in the year, divorce. Established in 1905, Las Vegas, Nevada, has since become the gambling and entertainment capital of the world, famous for its casinos, nightclubs, and sporting events. In the first few decades after the legalization of gambling, organized crime flourished in Las Vegas. Today, state gambling taxes account for the lion’s share of Nevada’s overall tax revenues.
Stocks Gain Despite Banking Woes
Stock prices gyrated as investors wrestled with banking troubles that appeared to spread to Europe. Worries of financial instability rocked financials and sent bond yields falling. While the rush into Treasuries was expected, the dash into technology stocks was a surprise. Falling yields made the high-growth names more attractive, though investors targeted their buying in high-quality companies that offered defensive characteristics, such as profits, healthy cash flows, and strong balance sheets. When Switzerland’s central bank provided a lifeline to a troubled Swiss bank, and a group of U.S. banks provided aid to a struggling regional bank, stocks powered higher on Thursday. Banking jitters, however, returned on Friday, closing out a tumultuous week and paring some of the week’s gains.
Less than two weeks ago, Fed Chair Jerome Powell testified interest rates might have to be hiked higher and faster. Since then, two U.S. banks were placed in receivership, sparking worries of financial instability and changing the market’s outlook on future rate hikes. The question now is if the Fed will hike short-term rates at all. By Thursday, traders saw an 18.1% probability of no rate increase at the March Fed meeting, which concludes this Wednesday. Just a week ago, it was a 0% chance. Traders also see a 0% chance of a 50 basis point rate increase in March. A week earlier, there was a 68.3% probability. Where the market previously saw little likelihood of a rate cut this year, the probability of a rate cut by July was 63.7% by Thursday.
FINANCIAL STRATEGY OF THE WEEK
Overview: Silicon Valley Bank (SVB), a significant financial lender servicing California regulators shut down venture capital firms and tech companies on March 10, 2023. At the time, SVB was the 16th largest bank in the U.S., with over $212 billion in assets. SVB specializes in venture capital funding. In fact, it apparently does business with nearly half of all Venture Capital backed startups in the US.
In 2021, SVB saw a mass influx in deposits, which jumped from $61.76 billion at the end of 2019 to $189.20 billion at the end of 2021. As deposits grew and the interest rate environment remained low, SVB invested its deposits in treasury bonds and mortgage-backed securities (MBS) in attempts to generate higher yields (aka, higher profitability on the capital it held from depositors).
Two main issues arose from this:
1. While Treasuries and MBS are very safe investments from a credit risk perspective, they pose substantial interest rate risk. The weighted average duration of these investments was about six years, implying that if interest rates rose by 100 basis points (1%), the value of those securities would decline by 6%.
2. These Treasury and MBS securities were held on a long-term “hold-to-maturity” basis. Meaning SVB did not have to mark-to-market those bonds until they were sold, leaving investors with a somewhat distorted view of its balance sheet, because as interest rose at its fastest pace in history, SVB was not marking these bonds at a significant loss.
If SVB were able to hold those bonds for a number of years until they mature, then it would receive its capital back. However, as economic conditions soured over the last year, with tech companies particularly affected, many of the bank’s customers started drawing on their deposits. SVB didn’t have enough cash on hand, so it began selling some of its bonds at steep losses, spooking investors and customers. To fund the redemptions, Silicon Valley Bank sold on Wednesday a $21 billion bond portfolio consisting mostly of U.S. Treasuries. The portfolio was yielding an average of 1.79%, far below the current 10-year Treasury yield of around 3.9%. Forcing SVB to recognize a $1.8 billion loss, which it needed to fill through a capital raise. Compounding SVB’s problems was an apparent lack of risk management oversight by the board and risk management team. SVB was without their senior most risk officer for about eight months in 2022 and only in January 2023 brought a new Chief Risk Officer on board.
Steps Taken by the Department of the Treasury and the Federal Reserve:
Federal regulators, including U.S. Treasury Secretary Janet Yellen, Federal Reserve Board Chair Jerome Powell, and FDIC Chairman Martin Gruenberg on March 12 announced "decisive actions" that would "fully protect depositors" at both Silicon Valley Bank and the now-shuttered Signature Bank. "Depositors will have access to all of their money starting Monday, March 13, 2023. No losses associated with the resolution of Silicon Valley Bank will be borne by the taxpayer," according to a joint statement from the regulators.
The fate of SVB may be a harbinger of tougher times for technology start-ups and companies in general but does not cause significant concern for the banking system contagion seen during the Great Financial Crisis. In a recent banking stress test issued by the Federal Reserve in June 2022, the nation’s largest banks remained well-positioned to absorb a range of potential economic shocks while continuing to support their depositors. The test investigated a severely adverse scenario in which unemployment rises to 10%, GDP declines in tandem, commercial real estate prices drop 40%, home prices dip 28.5% and stock prices plummet 55%. All of the banks put to the test were forecasted to maintain their minimum capital ratios in spite of projected losses of $612 billion, propelled by $463 billion in loan losses and $100 billion in trading and counterparty losses. In such a scenario, the banks’ aggregate common equity capital ratio would be expected to decline 2.7 percentage points to 9.7%. The Fed said that level would be more than double the minimum requirement of 4.5%.
Impact for Portfolios: In this environment, we could see a shift from momentum and growth stocks to stocks of higher quality, which should support active management as valuations and earnings become more important in security selection. Similarly, we believe it is always prudent to position portfolios for volatility. Therefore, portfolios with shorter duration allocations in fixed income as well as allocations to liquid alternatives should provide downside protection when stocks are under pressure.
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