The most common question we hear from clients today is “Tell us what’s going on with the markets?” While we could likely write a doctoral dissertation on that question alone spanning the last 2 decades to explain what has us here today, this article will not be doing that. Rather we wish to address the three main concerns we are hearing from you.
- Why does the market seem so volatile right now?
- Will this get bad like 2008 was?
- What do you see in store?
The best way to answer the first of these questions is to use an illustration of buying a home. Lets say that in 2021 you could get a mortgage financed at a rate of 2.75% this means that for each $100,000.00 borrowed for 30 years the principal and interest payments would have been approximately $410.00 now lets say that a only one year later that same financing cost would be 7.00% changing the payment for each $100,000.00 to approximately $660.00. Put another way in only one year the payment increased by 60%! At this point always ask the question “Do you think that would change how much house you could buy?” Despite factors that may have softened this dramatic change the answer is still yes it would change the price anyone could pay for a home.
This short explanation explains the base of what happened to the bond market last year, what happened and is still adjusting in the stock market, and even the failure of Silicon Valley Bank recently. All these assets are adjusting to a new reality of non-ZERO interest rates. For over a decade we had an interest rate environment that hovered between 0 – 2 % a far cry from the long average of 4%. Because for so long our option was to earn nothing on our money, when we did invest our money, we were willing to be paid back over a long time. At least we were making some return even if we had to pay a high price to get that return. But then inflation happened, and the Fed changed their policy of 0% rates to combat this giving us investors an option of something greater than ZERO. Suddenly when we could earn 4% or more on safe investments, we weren’t willing to wait as long (or put another way pay as much) to get paid back from our other investments. This meant in the case of bonds that a 1% bond wasn’t as attractive as a 5% bond and investors wouldn’t pay as much, or a stock that investors paid 25 X earnings suddenly wasn’t as attractive at that price. Thus, asset prices had to adjust to reflect the change in the short-term interest rates.
So, what happened to Silicon Valley Bank? Before explaining what happened, let’s start with the most recent headlines. Sunday night we got word that the U.S. government would step in to prevent contagion by offering SVB customers access to their uninsured deposits. And by designating SVB as a systemic risk to the banking system, the Federal Reserve (Fed) and U.S. Treasury Department are able to use emergency lending authority to help prevent runs on other banks (by making it easier to borrow against depreciating securities without suffering the balance sheet damage SVB experienced). The top priority in this situation was to prevent runs on other banks, particularly the many small and mid-sized banks not under the watchful eye of the Fed and not subject to sophisticated stress tests.
Now lets consider the above explanations. First SVB specialized in lending to start up tech companies that were betting on large fast growth with IPOs for big valuations. Often these were based on great ideas that would still take years to produce a return on the investment. This makes Tech stocks particularly sensitive to the cost of borrowing. Second because SVB specialized as they did, it meant less of their assets were like most banks we think of lending on home, cars, and other tangible assets. Rather they were depending primarily on buying bonds to simulate that type of lending. So as their primary customers (tech startups) had more and more trouble raising money they needed more and more of their deposits to keep operating. Add to this some pressure from outside investors to pull deposits and suddenly SVB had to release Billions of dollars of deposits and sell the bonds they held for such purposes at Billions of dollars of losses. (Remember our example that as they bought bonds over the last several years at very low interest rates and now had to sell them to investors wanting higher rates, they had to take a much lower price.) The combination of large withdrawals and bond losses resulted in enough risk that the FDIC took over the bank and as we stated above announced that depositors even over the FDIC would be able to get their funds. This calmed the growing fears that many small tech companies depending on their deposits from SVB would now not fail as a result of loosing their deposits in SVB.
A word on Bank failures, according to the FDIC website in the last 20 years from 2002 – 2022 just over 26 banks failed per year with the greatest number being 157 in 2010. Thus far there have been 2 failures both of which have been heavily tied to the startup and tech sectors, and while I believe their will be more, this is not 2008-2012! Our most systemic banks are more regulated than ever and have reserves set aside specifically for these types of markets. Furthermore many of the factors that contributed to 2008 do not exist in our economy and market today. While we do see risks and volatility in the markets in 2023, we do not currently see anything that would indicate a repeat of 2008.
At this time we believe that stocks will be primarily range bound as they try to adjust to three primary factors in 2023.
- Where will short term interest rates settle?
- What will earnings on stocks be this year?
- What if the right price to pay for those earnings based on what interest rates offer in other areas?
Ultimately, we believe this data will become clearer by the middle of the year and the market will be able to more accurately reflect. Will there be a recession, yes, when will it be, no one knows, what we do know is that we have designed our portfolios to weather storms like these so that we can help our clients achieve their outcomes.
A positive note:
Despite all the above there is a true silver lining for savers. For the first time in nearly 15 years investors are getting PAID on their fixed income! What were once interest rates that ranged between 0 – 2% now range between 4 – 8 %. It really is true that fixed income is finally attractive! This dramatically changes the nature of the cashflow that portfolios can produce and allows us more freedom in the creation of the right portfolio for each of our clients. Furthermore we saw interest rates go from ZERO to over 4% last year resulting in a 400% increase in rates. Though we do believe the FED will raise rates more, and we don’t ultimately know how far, we believe it will be more limited than last year. For the same thing to happen this year we would have to see interest rates approach 20%, something that I personally am confident in saying won’t be happening in 2023. This makes it extremely likely that bonds will have a much better year this year than last year and be a contributor to positive returns.
To close the investment world always has something to talk about and our 24-hour news cycle tends to focus on the sensational and the negative. We monitor much of this and define most of it as noise. What really matters is our clients’ personal situations, cashflow needs, time horizons, and long-term desired outcomes. These are what drive the construction of portfolios designed to weather the storms of our changing world. As always, we encourage you to reach out to your advisors and discuss any concerns you have! We are here monitoring the situation and focusing on supporting our clients and making changes to the portfolios as appropriate.
Cautionary side note:
A wave of new social engineering and phishing attacks taking advantage of the recent failure of Silicon Valley Bank is underway. Attackers are impersonating vendors and other banking institutions to send falsified invoices and account change forms that direct funds to attacker-controlled accounts.
Please proceed with extreme caution in the upcoming days and weeks when responding to changes in payment information. Information obtained through email should always be verified for authenticity. Start by verifying the email sender's domain, and always use an out-of-band method such as a phone call or email to an existing contact to verify authenticity.
We also suggest all clients to use extreme caution when visiting links in emails that appear to come from Silicon Valley Bank or other banking institutions.
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth may not develop as predicted and are subject to change.
References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.
Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services. LPL Financial doesn’t provide research on individual equities.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
Past performance does not guarantee future results.
Asset allocation does not ensure a profit or protect against a loss.
