Ask Forstrong: How does the failure of Silicon Valley Bank and the rout in other banks impact Forstrong’s investment strategy?

“Art imitates life”, goes the saying. But sometimes, as Oscar Wilde once pointed out, it happens the other way around. So it is with the film Everything Everywhere All At Once, a story about a laundromat owner who discovers that she has countless other selves existing in an infinite number of parallel universes. The movie has been called a “swirl of genre anarchy”, with elements of fantasy, animation, science fiction, black comedy — and because, hey why not, it’s 2023 — martial arts.   

Long-time readers of Ask Forstrong, an investment publication that regularly indulges in metaphor (and extends them well beyond their breaking point), may know where we are heading here. The comparisons between Everything Everywhere All At Once and today’s markets nearly jump off the screen. The world, now awash in new realities, is starting to feel like the film — existing in a realm of lucid dreaming, liminal spaces and the outer wilds of imagination.  

Recall the last few years. Investors have been thrust into a universe-hopping roller coaster with each scene seemingly from a different place or even another time. First, we were back in 1918 (Spanish flu!), then a return to the 1970s (inflation shock!) and now, apparently, 2008 (global financial crisis!) or even 1907 (JP Morgan bails out banks!). 

And, all of this is layered with paradox with markets sending mixed signals. Inflation is high but falling. The yield curve has not been this deeply inverted since 1981 but recession refuses to show up. Commodity prices have made a round trip, back at levels prior to Putin’s invasion. Even the ongoing tussle between America and China is at odds with record trade numbers between the two nations. 

With these chaotic conditions, investors are now invited to turn it all over in their heads like a Montaigne gem and come up with a coherent investment thesis. Markets are simple right?

Unsurprisingly, our inbox has been flooded with questions over the last week. One topic, however, has focused minds far more than others: problems in the global banking sector. We, too, have spent the last week speaking with contacts in Silicon Valley, discussing the outlook with former policymakers and banking experts, recording podcasts and, yes, talking to our clients (we have the smartest ones). Below, we respond to the most common questions.

Question 1: What caused the failure of Silicon Valley Bank (SVB)?

Most have responded to this question with a simple answer: SVB made a huge bet on long-term bonds — which, by the way, prudent banks would not have done — and it blew up. That is an ok response but makes it seem like SVB’s failure was the result of a single, bad trade. It also fails to draw a number of causal links that have roots extending back at least a decade.  

Where to start? Perhaps at the basic business model of banking. Consider that a bank’s balance sheet is the mirror image of its customers. Loans and securities are its assets, while deposits are its liabilities. But SVB had a double sensitivity to higher rates: not just on the asset side (where they failed to hedge duration risk on their long-term bonds) but also on the liability one. 

Back in 2021, the tech startup scene, already outperforming for a decade and now super-charged by the pandemic, was soaring. SVB had a flood of deposits from liquidity events (whether through IPOs, secondary offerings, SPACS or other fundraising activities). The market kept flinging money at SVB’s customers and SVB kept depositing it. So far, so good.

Now let’s talk about the business model of tech startups themselves. In case anyone missed the spectacle over the last decade, this is an industry with a radical vision for humanity. They are not selling plain widgets but blockchain, cryptocurrencies, space travel, flying taxis, etc. Those businesses readily tell investors they will lose money now but promise huge profits in the future. 

This is actually all fine when the cost of money is low and cash is coming in the front door. But what happens when interest rates go up, especially as fast as they have over the last year? Suddenly, investors wake up and want such quaint things like steady cash flows and profits now (and not dog-based crypto). Money rushing into the tech sector stops. Deposits stop flowing as well, but guess what? Those companies still need cash to pay rent and salaries. 

Now, banking has always been a confidence game. What happens if that vanishes? History is littered with bank runs for the simple reason that no bank can survive if all the depositors want to be re-paid at once. For SVB, this was a problem. Not only were startups suffering, but all their depositors were from the same sector (even the same seven group chats, according to one of our contacts). They were also uninsured, rate-sensitive and burning cash. Can you say concentration risk? As it was, SVB’s customers lost confidence in their favourite bank and pulled their money all at once. 

The lesson is twofold. First, years of low inflation and interest rates conditioned many to believe those were permanent features of financial markets. People forgot to ask important questions like how the tech industry would suffer if the world changed. 

Secondly, at some point in every interest rate tightening cycle, something breaks. As the old saying goes, “Whenever the Fed hits the brakes, someone goes through the windshield.” Which passengers weren’t wearing their seatbelt isn’t always immediately clear. But it is always those parts of the economy and financial markets with the most excess. It was hard to find more excess than tech. Silicon Valley got monumentally drunk on an abundance of cheap capital and speculative greed. Now comes the hangover. (For more on this, see Super Trend 3: Silicon Valley’s Hangover, from our annual 2023 outlook).

Question 2: Will there be more contagion? Is this 2008 all over again?

Whenever financial shocks hit the system, the market’s knee-jerk reaction is to overstate the parallels that most readily pop to mind. In this case, we all went back to the 2008 (didn’t you?). Then, over time, markets start differentiating those analogs to the present. That’s the process we are in now. 

There is no doubt there will be contagion. When things break, people get scared. That fear then seeks a host. SVB broke, fear surged and Credit Suisse is now the next target. Why a Swiss bank? Because for the last year, Credit Suisse has been plagued by problems of scandal, a wobbly investment banking unit, declining assets under management and an epic decline of 37 percent in its deposits in the fourth quarter of 2022 alone. The most vulnerable are targeted first.

Will there be more casualties? Almost certainly. But this is not a repeat of 2008, which was the result of reckless lending practices in the entire banking sector during 2003-2007, widespread credit expansion and, ultimately, nationwide housing busts. Broad-based weakness in the banks lasted for years. This is the definition of a systemic issue. By contrast, SVB was highly concentrated in a single risky sector or very poorly managed. Other casualties are likely to be of a similar variety. 

The other key difference between 2008 and the present is the policy response. Most policymakers today are still scarred by 2008, a kind of post-GFC PTSD. That fully explains why US regulators acted so forcefully last weekend, with the Treasury ordering the Federal Deposit Insurance Corporation to effectively make good on all banking deposits in the US (including uninsured ones) and with the Fed providing emergency liquidity through their new Bank Term Funding Program.

Was that policy overkill? Perhaps, but this type of action extends a long trend. Since the 2008 global financial crisis, and progressively so, the policy response has always been to socialize the costs. With every new crisis, the solution seems to be the same: another government backstop, more bailouts, and more currency debasement. 

This was true of the EU sovereign debt crisis and it was particularly true of the pandemic. The political appetite to bear any financial pain simply does not exist anymore. Where does that leave investors? Ultimately, it removes deflationary tail risks and skews the range of potential outcomes towards higher inflation and higher asset prices. This is one of the big themes of the 2020s: the so-called “government put” remains firmly in place. 

Question 3: Ok, it’s not 2008, but will higher interest rates “break” anything else?

Where exactly the pain from the fastest Fed tightening cycle in a generation will manifest next is the big question. But there are already signs of mounting stress. Commercial real estate, with billions of office debt maturing this year and banks shying away from refinancings amid plunging building values, is one area. The leveraged loan market, where private equity firms have layered companies, many of them in residential real estate or the startup space, with mountains of debt is another. In fact, private assets of all kinds, unburdened in the short term by those pesky things like transparency and price discovery, will face dramatic markdowns in 2023.

What do all these assets have in common? Financial excess and rising leverage. This is why our investment team has been avoiding them over the last decade. All of them have commanded an ever-steeper premium as rates steadily declined in the 2010s. This includes technology, growth stocks and the wide array of rate-sensitive investments that soared on ZIRP’s wings.  

Expect all this to steadily reverse. Investment classes that struggled with chronically weak demand and dismal pricing power in the last decade are now primed for multi-year outperformance in a macro environment of higher inflation. This includes select resource-exporting emerging market equities, global sectors with pricing power (industrials, healthcare and, yes, many banks) and international value stocks which now trade on far lower earnings multiples and far higher dividend yields.

Question 4: Do banking failures change the investment team’s view on recession probabilities?

Since the middle of last year, when recession fears surfaced, we have pushed back on the consensus view that the global economy faced imminent recession. Market participants were underestimating economic momentum resulting from the trillion-dollar fiscal packages during the pandemic. 

That view has proven right. However, we also update our outlook when the evidence suggests we should. The new data point here is that financial crises, like the one we are having, do create demand destruction. Banks reduce credit availability, consumers hold off large purchases and businesses defer spending. 

Is all of this enough to tip the global economy into recession in 2023? Perhaps. But recession is a catch-all term. It comes in many forms. It can be a mild decline lasting a few quarters or a sustained contraction. If recession does arrive, we are firmly in the camp that it will be of the mild variety simply because of the lack of major economic and financial imbalances. In fact, most imbalances had largely been worked out in the post-2008 crisis period. 

Put another way, we expect an “income statement recession”, in which spending and profits cool in the face of tighter policy, rather than a “balance sheet recession” like we saw in the 2010s, which involves an extended period of debt reduction, cleansing of previous excesses and financial system repair.

Question 5: Will all of this impact the monetary policy path in 2023?

Every central banker is fully aware that banking stress tightens credit conditions and does heavy lifting for monetary policy. That means the recent crisis will hasten the end of central bank tightening cycles, at least for now. We expect the Fed to hike 25 basis points this week as a final bone toss to its inflation mandate. From there, they will likely insert some language in their communications about deflating commodity prices, tighter bank lending and big base effects. That will put them on hold for a period of time. 

But don’t be fooled: the longer-running battle with inflation is not over. We have written extensively on the stickiness of inflation. Even though some disinflationary dynamics are taking place today (goods and supply-driven pricing), other inflationary dynamics are still persistent (services and demand-driven pricing). The lesson from history is that when prices rise as much as they have over the last year, reverting back to a period of benign sustained inflation takes time. And so, the looming policy risk that should be monitored is central banks taking their foot off the brake too soon.

Question 6: Does the SVB failure and regional banking stress damage the view that the US is the best place for investors to be?

For more than a decade now, US assets could do no wrong. Starting from a base of undervalued stocks and an undervalued currency in 2008, US equities soared along with corporate profits, while the cost of capital steadily declined. The US also had a crown jewel and a huge comparative advantage: Silicon Valley. With the slow global growth backdrop of the 2010s, the sector engaged the market’s collective imaginations and investors bid up everything tied to US technology. In fact, anything America outperformed: stocks, bonds and even the US dollar was a chronically strong tailwind to total returns.   

All this is changing. For one, the tech sector is struggling. And, now, we have financial stress in the US. Bank runs aren’t a good look for any country. Bailouts aren’t either. With each successive government intervention, the US becomes less attractive as a destination for capital. The US has even been the venue where the most bankruptcies and even fraud have taken place (SBF and crypto exchange FTX).

By contrast, financial conditions were far more constrained in the Eurozone, Japan and across emerging markets. The cost and access to capital never reached the levels seen in the US.  Stock markets never caught a steady bid. In fact, many local stock markets in those regions remain at levels seen over a decade ago. Local currencies were obliterated as capital rushed into the US.  

These regions, many of which did not pull out fiscal bazookas during the pandemic, are now primed for a long period of outperformance. In fact, this is already happening with US equities underperforming the MSCI World ex-US since July 2021. Emerging market bonds have even massively outperformed over the last year.

And yet investors continue to chase past winners in 2023. Profitless tech, cryptocurrencies and even Big Tech have all outperformed this year. But these are classic “echo bubbles”, a pattern that can be seen in periods after all the biggest manias. The psychology behind it is that, as Steve Eisman recently said, people don’t give up their paradigms easily. Many refuse to abandon the assets that have made them a lot of money in the past. And so they continue to pile in. But the echoes gradually fade as serial disappointments kill the faith.

Question 7: Financial markets have tested my patience over the last year and now we have banking crises to deal with. When does the volatility end?

Ever since The Matrix, the multiverse has been having a moment. These films readily defy the laws of probability, plausibility and coherence. But the parlor trick of parallel universe cinema is to make all the loose plot details come together for the finale. 

Markets do this too. Bear markets, like the one over the last year, always create higher volatility as investors attempt to discern the new, durable trends ahead. We are living through this in real-time and it can be a frustrating process. But over time the new macro environment will become increasingly clear. Volatility will subside.

A key trend to recognize is that the era of low interest rates is over. With secularly higher interest rates, investors will no longer be able to rely on the continuous re-rating of many asset classes, especially long-duration growth stocks and leveraged investments of all stripes. 

The good news is that the return prospects for balanced portfolios are much higher than they have been for a long time. For the income side of portfolios, investors no longer need to suffer low rates or even take big risks. Staying short duration and high up on the credit spectrum is now well compensated. For the growth portion, echo bubbles in 2023 are an opportunity to further align with the new investment leadership — assets with tangible exposure to the real economy such as resources and value stocks. Investors should look past current volatility. Banking panics always create buying opportunities. And, increasingly, it will become clear that the big macro trends have changed everywhere — and all at once.