The February jobs report this week was completely overshadowed by the collapse of SVB Financial Group (SIVB). Within 2 days of trying to raise capital to ensure liquidity, the bank faced a customer run on deposits, leading to a swift takeover by the Federal Deposit Insurance Corp (FDIC) regulator. This was the biggest bank decline in the US since the financial crisis.
The setup here has created something of a crisis of confidence for not only the banking industry, but has also added to concerns regarding the health of the overall economy. In fact, stocks ended the week significantly lower in what was a sell-first, ask-questions-later risk-off scenario. Let’s ask these questions now in an attempt to explain that the market’s “panic” may be an overreaction.
Why did SVB blow up?
The debate right now is about whether the situation with Silicon Valley Bank has subsided or just the tip of the iceberg drawing parallels to the financial crisis “Lehman moment”. In our opinion – it is not.
Remember, SVB had a very unique business model centered around serving venture capital portfolio companies and startups. There was a traditional banking branch with real estate exposure, but overall SVB has made its name as a specialist in some of the riskiest corners of the tech and life science sectors.
This profile extended to the bank’s cash management philosophy, which apparently took on too much interest rate or duration exposure in its investment portfolio through mortgage-backed securities in its hold-to-maturity. This is basically where SVB chose to park its cash deposits from the venture capital customers. In particular, the proportion of SVB’s balance sheet tied to long-term and fixed-rate (MBS) was unusually higher compared to most other banks.
This search for yield proved to be a shot in the foot as the value of these positions came under pressure along with rising interest rates over the past year. This happened just as its main customers were demanding higher turnover in cash, expressed as a “customer burn” in the last quarterly report. For banks, it does not necessarily mean anything about the depositors’ credit profile, they are happy to take your money.
The problem is that SVB was simply too aggressive in what they did with the cash deposits. Through the MBS portfolio, the bank was sort of indirectly betting against interest rates rising, or at least not climbing to the levels they have reached over the past several months. This led to large unrealized losses in the investment portfolio based on interest rate dynamics. The distinction here would be a more worrisome blowout in credit spreads or widespread sector defaults that we haven’t seen.
Fast forward, this disconnect between its balance sheet losing value while customers pulled higher levels of cash pushed the bank to go ahead with the share raise announcement. Management’s mistake is not recognizing that simply signaling a liquidity crunch would set off the classic bank run with depositors questioning the solvency of the entire operation. It escalated very quickly.
Is SVB The 2023 Lehman Moment?
One of them is that SVB’s balance sheet exposure stands in contrast to most other banks, which operate more cautiously with much shorter maturities in their liquid investment positions. From there, whatever weakness SVB faced was not necessarily representative of other regional banks or your typical local credit union.
Similarly, mega-cap bank leaders such as JPMorgan Chase & Co ( JPM ) and Citigroup ( C ) are understood to be much more diversified and better capitalized. These are views echoed by comments from Treasury Secretary and former Fed Chair Janet Yellen that suggest the US banking system remains resilient.
Remember that the legacy of the financial crisis was to improve risk controls precisely to prevent scenarios like this. The results from the annual stress tests testify that the financial system is prepared for even more extreme shocks modeled with ample liquidity buffers. For context, a benchmark for aggregate US financial system tier-1 common equity is 12.4% in Q1 2022, up from levels in the low single digits back in 2008.
Let’s acknowledge here that SVB was not even considered a “global systemically important bank”. This means that although it was technically among the largest banks in the United States, it did not qualify under the Dodd-Frank Act and the Federal Reserve’s criteria. So while this apparent blind spot in regulatory oversight is another topic of discussion, the SVB’s place in the financial system is still relatively isolated.
This does not prevent investors and the market from speculating on links to larger and more important banks, but our position is that SVB should not be seen as a bellwether for any other financial institution. Our view is shared by Wall Street banking analysts, making the case that the SVB collapse was based on company-specific or “idiosyncratic” factors, and the panic selling of financials may have been exaggerated.
What happens next?
Returning to the February payrolls report, the US added 311,000 jobs, which was more than the 205,000 estimate. This follows a series of economic data points that have worked to build a narrative that the economy is “stronger than expected”.
At the same time, average wage growth surprised positively to the downside, coming in at +0.2% compared to an estimate of 0.3%. Unemployment also rose to 3.6%. This is “good” news in the Fed’s inflation battle, to be confirmed with the upcoming CPI reports providing evidence of the ongoing disinflationary process.
Before the SVB fiasco, the bigger issue had been a concern that the Fed would be forced to continue hiking, with some even taking a 50 basis point rate hike for the next Fed meeting as a foregone conclusion. In this regard, one of the most important things in the SVB situation is that the tables have been turned with consensus to a forecast of a 25 basis point rate hike at the FOMC on March 22.
According to the CME “FedWatch Tool,” which quantifies the market-implied expectation of the direction of Fed policy, interest rate futures at 57.5% suggest the Fed will raise by 25 basis points to an upper range in the Fed Funds rate of 5.00 %. This view has shifted from as low as 31.7% over a single day based on the SVB fallout.
The move is also evident in interest rates, with the 2-year Treasury yield falling a significant 30 basis points to 4.6% on Friday, compared to a high of 5.1% just earlier in the week. It is hard to see how or why the Fed would move even more hawkish in the eyes of just the perception that the financial system is fragile.
What about stocks?
Understandably, for the segment of the market that has been bearish on stocks and expects the bottom to fall out since the S&P 500 (SPX) hit $3,500 last year, the latest development adds fuel to that fire.
Let’s not forget that the S&P 500 is still up year-to-date in 2023 and well off last year’s lows. Any expectation of the stock market plunging lower from here will still require some follow-up in the real economy and most importantly corporate earnings.
If the Fed now has room to slow the pace of further rate hikes and ultimately pause sooner, rather than later; which in turn should provide an indication of the economy and risk assets, and help balance any short-term consequences of the SVB fallout.
So what we’re left with here is an economy that remains robust based on recent wage data and retail sales, where the conditions are in place for inflation to make a more convincing deceleration going forward while interest rates stabilize.
Already nearing the end of March, there’s a case that Q1 earnings trends will be solid across the board, following the theme of Q4, when 64% of S&P 500 companies beat EPS estimates.
This is in the context of what appear to be low expectations based on the overriding pessimism, which may not reflect the actual operating conditions of companies for the majority of the quarter. There’s no reason to expect companies to start reporting ballooning earnings left and right.
Given that many companies took steps to cut costs and focus on margin, there is likely room for earnings estimates through 2023 to be revised higher as the economy falters on the pretext that the SVB situation blows over.
So the takeaway here is that for anyone expecting stocks to make a “massive” move lower, signs of an economic hard landing defined by rising unemployment, and more importantly, collapsing corporate earnings, are still lacking. Anyone is free to predict that these conditions will still materialize, but it’s far from certain and doesn’t match the data right now.
The way we see it is that the market narrative will start to play down fears related to SVB and broader financial system spillovers. As the FDIC liquidation process unfolds, causing the insured depositors to take shape while and recovery of the bulk of larger balances, fears should subside. A rebound in other bank stocks could work to support the market, while high-beta tech and growth names are positioned to lead higher.
Ultimately, this recent re-test of the S&P 500 around an area of technical support near $3800 will be viewed as just a bear trap where doom and gloom got ahead of itself.
Again – this is our view as a bullish case for equities, where a return of volatility into a renewed sense of stability next week would be the first step to regain market confidence. By this measure, we still see room to remain cautiously bullish, acknowledging the higher risks.