- Mario Mota
The Steele Group's Q1 2023 Newsletter
The first quarter of 2023 was the most eventful quarter seen since the 2020 Covid market event. At the start of the quarter inflation continued to slow from the peak of 9.1% in mid-2022 to 5% in March 2023, as shown in the table below. It became clear that the higher interest rate brought on by the US Fed was having the desired effect of lowering inflation. From January to February markets rallied on this news as a stabilized inflation rate can typically signal the next economic cycle and the end of interest rate increases.
It has been seen historically that the impact of higher interest rates on inflation tends to take several months to take effect. Despite the progress already made, in February Jerome Powell (Chair of the US Federal Reserve) signaled to the markets that the US Fed may still increase the interest rates in March by another 0.5%. A typical outcome of higher interest rates is the value of short term bonds falls as seen in the simple illustration below:
Understanding the impact of higher interest rates to temporarily lower bond values helps us understand the banking issues that transpired in March 2023. Many financial institutions (banks) will take deposits from clients and invest the cash in guaranteed US debt such as treasuries/bonds. When these bonds are held to maturity, the entire principal plus interest is returned to the bank. The below simple illustration shows how bonds react in a decreasing or increasing rate environment; this example is assuming a simple 1-year bond:
Using the same illustration above but visualizing billions of dollars’ worth of bonds there can be a situation where banks are under pressure since their treasuries/bonds are currently worth less if sold today and not held to maturity due to the sudden increase of interest rates. Over time as the bonds mature banks are made whole. However, in the short term most banks hedge this risk in the credit markets.
In the case of Silicon Valley Bank – SVB for short (formally the 16th largest US bank or 1/3 the size of RBC for reference), they had not hedged this risk for protection against higher interest rates. SVB had an abnormally high number of large deposits from clients in the tech sector. Several of these large clients realized that the bank would be forced to sell treasuries/bonds at a loss in order to provide temporary liquidity if they started redeeming their assets. This realization resulted in a traditional run on the bank, and due to the size of their deposits it took place at a record pace. The resulting balance sheet loss from the sale of the treasuries/bonds to cover the cash requirements was ultimately a catastrophic loss that ended SVB.
This event triggered a panic within US regional banks and in March 2023 a total of 3 banks: Silicon Valley Bank, Silvergate Bank, and Signature Bank. Swift government intervention ensured all depositors within the US were made whole. The three regional bank failures in the US had a ripple effect which impacted global banks such as Credit Suisse. By mid-March, with the help of the Swiss government, Credit Suisse was bought out by their rival UBS which helped to stabilize some of the market volatility.
On March 22nd Jerome Powell held his interest rate decision. Given the cooling inflation and regional bank failures the US Fed decided on a 0.25% interest rate increase vs the previously projected 0.5%. This signaled that we are at the end of seeing interest rate increases which has resulted in positive returns for sectors that favor stable interest rates such as technology firms.
While all these events can make investors nervous, the first quarter ended with a positive S&P 500 return of 7.03%. S&P 500, which represents the largest 500 companies within the US, is widely considered the most diversified domestic index.
We can remember previous periods of market or economic stress, but from a distance they don’t seem so bad because we know the outcome - markets recovered. Investment markets do not move in a smooth manner. Investors who panicked during the banking crisis and sold on March 1st would have missed out on 4% of the 7.03% return the S&P provided in Q1. The chart below illustrates how the worst periods per year are necessarily how the year ends.
Lastly during Q1 there was plenty of buzz around artificial intelligence (AI) as more and more companies say they're using it or exploring usage. While the diversified portfolios our firm recommends will likely continue to benefit from this growth, it is important to note that it’s not only investments in technology that are benefiting. Customers of tech companies, banks, health care, energy, retail, agriculture, and other sectors are expected to increase spending on AI for productivity gains or a strategic edge on rivals. If a firm is successful in adopting this technology their revenues could greatly increase which could present upside uprises on a wide range of publicly traded companies.
As always, we are here to support you in achieving your financial goals. If you require any assistance or have any questions please do not hesitate to reach out to Cliff, Mario, Mark, or our TSG team.