Equity markets generated positive performance in the first quarter of 2023 despite the addition of one previously unforeseen risk–a potential bank crisis. Following a run on two regional banks, the Treasury, Fed, and FDIC took extraordinary action to guarantee deposits throughout the banking system to prevent a broader financial crisis. Investors remained concerned about lingering high inflation, the likelihood of a recession, continued economic and geopolitical friction with China, and the war in Ukraine.

The table below shows the performance of major equity indices for selected time periods.

Equity Performance for Periods Ending on March 31, 2023

Total Return Index Market Sector Quarter 1-year 3-year 5-year 10-year
S&P 500 Large U.S. Companies 7.5% -7.7% 18.6% 11.2% 12.2%
Russell 2000 Small U.S. Companies 2.7% -11.6% 17.5% 4.7% 8.0%
MSCI EAFE Developed Int’l Markets 8.5% -1.4% 13.0% 3.5% 5.0%
MSCI EM Emerging Int’l Markets 4.0% -10.7% 7.8% -0.9% 2.0%

In previous letters, we stated that one of our top concerns has been the possibility of a Federal Reserve policy mistake. Since March 2022, the Fed has raised interest rates by 4.75% to its current range of 4.75% to 5.00%. The Fed’s actions have been intended to lower inflation and slow the economy without causing a recession. Although the year-over-year inflation rate, as measured by the consumer price index (CPI), has declined each month since June 2022, it stubbornly stood at 6.0% at the end of February, significantly higher than the Fed’s 2.0% target. Investors have been apprehensive that the Fed’s aggressive increases in interest rates would cause an over tightening of credit—making it too expensive or even impossible for some individuals and companies to borrow—which could lead to a serious recession. With fourth quarter GDP coming in above expectations at 2.7% and an unemployment rate remaining near its 50-year low of 3.6%, the Fed policy seems to be working. The rate of inflation is declining, and the economy is still strong.

However, the Fed’s well-intended policy produced unintended consequences. In addition to dramatically changing investors’ appetite for unprofitable tech companies (which led start-up funding to dry up), the rapid increase in interest rates over the past year created unrealized losses on long-term investments held by banks. As depositors—particularly tech companies—started to increase withdrawals to fund their businesses, Silicon Valley Bank—whose customers were highly concentrated in this sector—was forced to sell investments at a loss to meet withdrawals. When the magnitude of the sale of investments and the size of the loss ($1.8 billion) was revealed, depositors lost confidence in the ability of the bank to fulfill withdrawal requests, creating a run on the bank. This culminated in the failure of Silicon Valley Bank, and within days Signature Bank, whose depositors feared several similarities to the circumstances that doomed Silicon Valley Bank: concentrated exposure to a distressed sector (crypto currency for Signature Bank), large share of uninsured deposits (deposits that exceed the FDIC insurance limit of $250,000), and high liquidity risk. Over the course of just a few days, regulators had closed both Silicon Valley Bank and Signature Bank, formerly the 16th and 29th largest U.S. banks by assets.

When interest rates rise, the value of fixed income investments decline. When banks receive deposits, the money is generally lent out to borrowers or invested in securities. Most of the securities purchased by banks are issued by the U.S. government and its agencies, since these securities have very little risk of default (credit risk). However, depending on the interest rate and time to maturity, these securities can carry significant interest rate risk. In other words, if interest rates were to change, the value of the securities could change dramatically should they need to be sold before maturity.

To understand how these investment losses materialized, consider a 10-year Treasury Note that was issued on May 15, 2020. This note was issued at a price of 100 and carried a historically low interest rate of 0.625%. It was issued during the pandemic shutdown when the Fed lowered short-term rates to between 0% and 0.25% in order to stimulate the economy. This note now trades at a price of 81.32, netting a loss of almost 19% to the initial owner. There is virtually no risk of default, and the owner can expect to receive 100 at maturity. However, because the current yield-to-maturity (total expected return) for a Treasury note with May 2030 maturity is now 3.62%, potential buyers for this May 2030 Treasury note will only offer a price that will yield an equivalent 3.62% return. Paying 81.32 for this note and receiving 0.625% in interest will result in a 3.62% total return. The higher interest rate for Treasury notes with similar maturities caused the market price of this note to drop to a level that provides a comparable rate of return.

For the last several years we have maintained a relatively short-term average maturity for the fixed income investments in our managed portfolios to minimize the risk related to rising rates. It surprises us that so many banks found these lower yielding, longer maturity bonds to be attractive investments, especially considering the risk.

These losses on the books of banks were unrealized, which meant they would not impact current earnings, unless they were sold. If held to maturity, the banks would have received full value. However, the unrealized losses worried uninsured depositors, causing them to request the withdrawal of their deposits. Both Silicon Valley and Signature faced a “run on the bank”, which would have forced the banks to sell the securities and take the loss. The loss would have eroded the equity of the banks making them insolvent. This scenario put bank regulators in a difficult position in which they needed to shut down the banks, and essentially guarantee all U.S. bank deposits to prevent runs on other banks.

It is with great irony that we note that Barney Frank has been on the board of Signature Bank since 2015, earning $2.4 million in compensation during his tenure. Following the financial crisis of 2007-2009, he led the passage of the Dodd-Frank Act in 2010 which set tougher regulations on banks with more than $50 billion in assets. In 2018, he supported the Trump-backed legislation which raised the regulatory threshold to $250 billion. Since then, Signature Bank assets more than doubled to $100 billion, and the bank significantly expanded its exposure to the high-risk crypto sector. Signature Bank is now the third largest bank failure in U.S. history.

The Fed’s rapid increase in interest rates almost broke the banking sector. It could be considered a policy mistake, as the Fed obviously did not anticipate that its actions would damage bank balance sheets and cause bank runs. But the crisis must also be attributed to a failure of supervision by banking regulators and poor bank management. We doubt that new regulations would have prevented the current crisis or thwart the next one.

The problems in the banking sector caused many investors to believe that credit would significantly tighten and the economy would slow, as banks would become more conservative in lending to companies and individuals. This resulted in a drop in yields for long-term fixed income securities, with the 10-year Treasury note declining from a yield of 3.97% on the day prior to the news of Silicon Valley Bank’s failure to 3.55% currently. The Bloomberg U.S. Aggregate Index, the broadest representation of the taxable U.S. bond market, had total returns of 3.0% during the quarter. Ironically, the lower yields and positive returns on long-term fixed income securities actually decreased the size of unrealized losses on bank balance sheets, helping to calm investors’ concerns.

In the initial days following the collapse of Silicon Valley and Signature banks there was a fear of contagion spreading to other banks, despite the deposit guarantees made by the FDIC and other measures. In Europe, Credit Suisse was taken over by rival UBS to prevent a complete failure. Nevertheless, by the end of the quarter, bank stocks had recovered some ground as investors felt that the problems had been contained. First quarter earnings reports over the next few weeks will shed light on the conditions of this sector. In general, we believe the banks that failed were atypical and that the banking sector is relatively strong and well-capitalized.

So, what about the market’s other concerns coming into the quarter?

As noted previously, CPI inflation is declining year-over-year, but at a slower pace than desired by the Fed. While price increases in certain expenses such as food and shelter (primarily rental) remained stubbornly high, there were favorable trends in other categories. The last reading on producer prices showed a 4.6% annual increase, the smallest increase since March 2021. Natural gas, gasoline, and oil prices are down from this time last year. Lumber prices touched a 5-year low, and S&P CoreLogic Case-Shiller Home Price Index fell for the seventh consecutive month in January. We believe that inflation will continue to decline, although a quick return to the Fed’s 2% target might require a recession.

Leading economic indicators continue to decline and point to slower economic growth. The Conference Board Leading Economic Index declined for the 11th consecutive month to a level that has historically predicted a recession. This and other indicators lead us to believe that a recession is likely, but we also think it will be relatively mild and short in duration. The stock market, which is down approximately 16% from its all-time high, may already be reflecting a recessionary scenario, with limited further downside risk.

Ongoing tensions with China and Russia continue to cast a cloud over geopolitics and equity markets, but are not significantly impacting the U.S. economy. Supply chain constraints related to China trade have mostly been alleviated and the global energy supply chain, which was severely disrupted by the Ukraine war, is less of a concern. While problems associated with these countries could worsen, they currently do not appear to have a significant impact on U.S. equities.

High valuations for larger U.S. companies might be a hinderance to strong equity returns over the next year. According to FactSet Research, the S&P 500 Index has a price-to-earning (P/E) ratio on forward earnings of 17.8, which is above the 10-year average of 17.3. In addition, we see considerable risk that earnings might miss expectations as the economy weakens, adding to a less attractive valuation. While large companies look relatively expensive, we find that mid-size and small companies, developed international markets, and emerging markets trade at more attractive valuations. The P/E ratios for these market segments are 14.8, 13.0, 13.1, and 11.7, respectively.

Fixed income investments currently provide a more attractive alternative to equities than at any time in the previous 15 years. It is now possible to earn more than 5% on investment grade (high quality) fixed income investments. The higher return potential from fixed income investments will likely act as a constraint on equity price appreciation.

In the investment world, a black swan refers to an extremely rare event, that was not generally forecasted, and has potentially severe consequences. Considering there have been three black swan events in the past three years (COVID-19 pandemic, Russia-Ukraine War, and large bank failures), the U.S. economy and its markets have shown considerable resilience. The lingering impact of recent events contributes to near-term uncertainty. However, we believe the longer term remains favorable for both equity and fixed income markets.

John D. Frankola, CFA      Lawrence E. Eakin, Jr.       Matthew J. Viverette

Vista Investment Management, LLC is a Registered Investment Advisory firm. Under no circumstances does this article represent a recommendation to buy or sell stocks. This article is intended to provide information and analysis regarding investments and is not a solicitation of any kind. References to historical market data are intended for informational purposes; past performance cannot be considered a guarantee of future performance. Neither the author nor Vista Investment Management, LLC has undertaken any responsibility to update any portion of this article in response to events which may transpire subsequent to its original publication date.