Silicon Valley Bank Impact: Why This Isn’t 2008 All Over Again
The surprise failure of Silicon Valley Bank placed a spotlight on the weaknesses of some balance sheets and served as a reminder that despite all the changes since the 2008 Global Financial Crisis, things can still go wrong. But we think the current environment differs from 2008 in some very important ways.
In the current market, investors have focused on issues “hidden in plain sight”. We think investors understand that banks have large unrealized losses in their securities portfolios. So long as banks hold those securities to maturity, the return likely will be as expected when purchased. Unrealized losses on securities really only need to be realized if the funding for those securities is unavailable — a bank run on deposits.
In 2008, banks and other financial institutions exhibited exceedingly poor lending standards, particularly in residential real estate. In addition, they accumulated opaque risks that investors, regulators and in many cases the companies themselves didn’t understand. Off-balance-sheet vehicles and securitized products such as collateralized debt obligations left few with any idea of how deep the hole of losses could go. And it was deep.
Since 2008, regulators have required banks, especially the larger ones, to carry far higher levels of capital and far greater liquidity resources. They also require banks carrying riskier credit structures, if regulators allow them to carry them at all, to hold much more capital. Regulators increased oversight significantly, especially over the largest banks. While these measures clearly didn’t insulate the banking industry from all bad decisions or failure, we think they have helped curb significantly the likelihood of large-scale failure.
Silicon Valley Bank showed that poor risk management, an easily spooked and concentrated depositor base, and less robust oversight can still lead to failure. Regulators acted swiftly in establishing safeguards for other institutions in an effort to restore confidence. The financial system appears plenty durable to withstand this banking crisis.
Still, we expect that investors naturally will worry about where the shoe drops next. U.S. regional banks are major lenders in the commercial real estate market. We think the market may load their worries on those lenders, given concerns about the office market in commercial real estate.
We will be watching closely to see when these systemic fears abate. The length of banking-related volatility is important because eroding confidence from businesses and consumers may also erode economic growth, reigning in investment and spending.
Central banks, which continue to grapple with inflation concerns, are carefully monitoring developments. The Federal Reserve will be watching through the lens of both financial stability and monetary policy. If we see an emergence of stability over the next week, the Fed likely will return to its inflation fight and move its policy rate up 0.25% at its meeting next week. If conditions remain particularly tumultuous, threatening the economy and therefore putting downward pressure on inflation, the Fed could pause and take time to assess. Federal funds futures have collapsed, to where investors now expect the rate to fall 0.75% below the current level. The European Central Bank pressed ahead with its inflation fight with a 0.50% rate increase today, though there was a more cautious tone in its communication as a result of the recent volatility.
What We’re Doing
After our tactical asset allocation group met yesterday, we made no changes to our global policy model that guides asset allocation for our multi-asset portfolios. We remain neutral to risk and our tactical positioning sits close to our strategic benchmark. The size of active bets relative to the benchmark represent the degree of conviction. With a fairly wide range of reasonable outcomes that are exceedingly difficult to predict — both upside and downside — we prefer to maintain a neutral position. Should we deem markets to be too heavily weighting an outcome we find unlikely, we would likely deploy more risk. At present, however, we think the market is reasonably pricing risk in aggregate, and in many asset classes.
We do think the market is expressing too much economic pessimism in the rates markets, so we remain underweight investment grade and overweight high yield. We are overweight cash to benefit from the current yield and the optionality to add risk should the opportunity prove compelling going forward. Developed market equities appear to be appropriately reflecting the balance of risks and opportunities, so we stay neutral. And we are modestly overweight natural resources as way to participate in any persistent emerging markets rally.
What Investors Can Do
We caution against overreacting to short-term market movements during periods of excessive volatility. The information content in such moves can often be distorted, and not reflective of useful insight into potential outcomes. We certainly cannot rule out other shoes to drop and expect market conditions to stay volatile for a while, but we do not think it’s appropriate to adopt a particularly negative position at present. A fading of systemic fears, if soon enough, could leave limited negative implications for growth, allowing the market to reorient toward a thesis of potential recession avoidance and slowly declining inflation.
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