First Quarter 2023 In Review

Market Overview

The biggest financial news de jour is around a seemingly-lurking banking crisis that likely never was and never is to be, which is already fading into memory. We had ourselves a nice little scare for a few days, and as is nearly always the case, a little time and distance makes these moments seem immaterial. Each time it is hard to remember that is the most likely outcome! Plenty of every day investors and talking heads were convincing themselves we were running into Financial Crisis 2.0: The SVB Edition. So let’s talk about banking for a moment and glean a takeaway or two from this round.

First, how does any bank make money? They borrow short to lend long. That is, they borrow depositors’ money (typically in the form of a checking or savings deposit account) and they “use” that money to make long-term loans and investments. There are two major risks with this tactic, and in those risks lies the opportunity for profit (and sometimes loss). One is a mismatch of timing: depositors may decide that they want their money back, but the bank has that money tied up in longer-term investments. The other risk is that interest rates can and do change, which can affect the value of those long-term investments. When rates go up, the value of those assets the bank owns goes down.

What happened with SVB was the perfect match of both risks, fed by one another. SVB made plenty of longer term loans and owned longer term bonds, and the value of that portfolio went down as rates went up. This is a VERY normal thing and likely happened to EVERY bank in the country in the last few years.

Then, a bunch of SVB depositors, many of whom operate in venture capital in and around Silicon Valley, noticed the above. They noticed that the bank said, in public documents, that the value of the loan portfolio had fallen because interest rates went up. Suddenly, on paper, the bank did not look so great. So they panicked! There was a bank run! A very traditional, very “It’s a Wonderful Life” bank run. People lost confidence in the bank, and that caused the bank to fail.

While this event was not “contagious” in the Financial Crisis 1.0 sense that SVB owed a bunch of other banks a bunch of money it didn’t have, the piece that is contagious is confidence, or lack thereof. And that is the real lesson here:

The entire financial system is dependent upon the confidence of its users.

The end! If you write me a check (remember those?), I have confidence your bank will pay my bank the money, so I give you some Girl Scout cookies in exchange. If you use a bank’s credit card, the store has confidence the bank will give them the money, and they give you some Air Jordans. The bank has confidence that you’ll pay the credit card bill (hopefully slowly with lots of interest) so they let you use their money to get some Air Jordans. You buy an I-Bond from the US Treasury because you have confidence they will give you your money back down the road, and you buy stock in Disney because you have confidence in a never-ending stream of comic book movies and spinoff TV shows about cuddly alien babies.

When that confidence falters, and the collective participants in the system start getting squirrely, bad things can happen. Banks stop lending money to people because they are afraid they won’t pay it back. People stop shopping for bigger houses because they are worried about their job. Employers stop hiring new people because they are worried shoppers aren’t buying OLED TVs at ever-increasing rates. Investors stop buying stock because they are worried they’ll be left holding the bag. And if everyone gets worried at the same time, they all prove each other right and create the very world they were afraid of.

Conversely, when the confidence comes back, it works for everybody! Companies are confident in their future so they hire and invest. Shoppers are confident in their paychecks so they buy the next-gen air fryer they’ve been eyeing. Banks are confident so they lend. Investors are confident so they invest, and we get the upward spiral. All collective beliefs are self-fulfilling, whether positive or negative, confident or fearful, greedy or paranoid. In real economies and in imaginary beanie baby economies, this holds. Confidence is the grease on the wheels of the global economy. Sometimes we lose it, and things range from not-great to really-awful, but in the long run we hold on to it and things get better, slowly, in total, for the lot of us.

This quarter, confidence peeked its head out of its hidey-hole and we got decently positive numbers in global markets across the board.

1Q 2023 1 Year 3 Year 5 Year
Large Cap US Stocks 7.50%-7.73%18.60%11.19%
Small Cap US Stocks2.74%-11.61%17.51%4.71%
International Equity8.47%-1.38%12.99%3.52%
EM Equity3.96%-10.70%7.83%-0.91%
Aggregate Bonds2.91%-4.13%-2.32%1.00%

Index performance is provided as a benchmark. It is not illustrative of any particular investment. An investment cannot be made in an index. Past performance is not an indication of future of results. S&P 500, Russell 2000 Index, MSCI EAFE Index, MSCI EM Index, S&P US Agg Bond Index. Returns as of 3/31/23.

Economic Update

Much of the economic discussion in the last year has centered around a large spike in inflation seen in 2022 and the Federal Reserve’s response. All eyes were on the Fed – could they get inflation in check, would it cause a recession in the process? At the moment, it seems that inflation is easing and the economic data is relatively steady, with some slowdowns in housing as one would expect with higher rates.

Year over year change in CPI has softened, down to 6.0% in February which was lower than expected. This is down from the peak of 9.1% in June 2022. It is simple (although not comprehensive) to draw a line from this result back to the Fed’s actions in the last year:

The Fed Funds Rate was 0.0% at the beginning of 2022 and after the most recent meeting in March we are now at a 4.75-5.00% target range. This change has rippled through the bond market, affecting savings rates, Treasury rates and mortgage rates alike. In line with falling inflation expectations, long term rates including 30-year mortgages have cooled just slightly from their 2022 peak.

As mortgage rates have jumped, the nearly straight uphill change in home prices has finally started to level off from 2022, but we are not seeing a widespread dip in prices nationally. The chart below shows year-over-year changes in national home prices, which are still positive.

The labor market remains very tight with low unemployment and job openings at a high level by any measure.

Personal spending remains strong as consumers aren’t showing any signs of weakness in this market.

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