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Economy

Take It to the (Debt) Limit

The debt clock is ticking louder.

The nonpartisan Congressional Budget Office recently revised its projections for federal revenues and expenses.

According to the CBO there is now “significantly greater risk that the Treasury will run out of funds in early June”.

Treasury Secretary Janet Yellen said on May 1 that the US government could become unable to pay its bills as soon as June 1 if Congress doesn’t raise the debt limit soon.

These new estimates set a shorter timeline than many experts previously had been forecasting.

House Republicans approved legislation last week that would raise the borrowing limit for about a year, but parts of the legislation are unpalatable to Democrats.

In other comments she’s made recently, Treasury Secretary Yellen is not mincing words: “A default on our debt would produce an economic and financial catastrophe. A default would raise the cost of borrowing into perpetuity.”

President Biden has called top lawmakers from both sides of the isle to the White House for a meeting on May 9 to try to forge an agreement for a debt limit increase.

The situation remains tenuous, with extremely high stakes. As investors, how should we think about this?

The bond fund manager PIMCO has a group of researchers dedicated to understanding how public policy impacts financial markets, and they recently shared their thinking on the debt ceiling.

Here are some takeaways on the debt ceiling issue from a recent PIMCO note:

  • More than 70% of Americans support avoiding a default, even without spending cuts – according to a recent CBS News / YouGov poll
  • Because popular sentiment supports raising the debt ceiling, default is not a political winner, and leadership on both sides of the aisle know this
  • If past is prologue, a resolution will likely happen at the eleventh hour and only after some brinksmanship
  • The average peak-to-trough performance of the S&P 500 in the month before a debt ceiling resolution over the past dozen years has been about -6.5%
  • A debt ceiling deal is the most likely outcome

From my perspective, it is inadvisable to significantly alter long-term investment strategies designed to support long-term financial plans, in anticipation of political events, especially those that have a low likelihood of transpiring.

The key to managing through possible larger-than-normal stock and bond price swings is to hold enough in liquid reserves (cash and short-term investments like money markets and short-term bond funds) to meet your near-term cash needs.

RK

Another Bank Bites the Dust

Turmoil in the banking sector persisted throughout April and continues into May.

As deposit flight persisted at First Republic Bank, the pressure on the bank’s financial situation proved untenable. During the last trading day of April, the bank’s stock price cratered.

Over the weekend, regulators seized First Republic, and after a short bidding process, sold the lender to JP Morgan before the markets opened on Monday, May 1.

Three of the four largest-ever U.S. bank failures have occurred in the past two months. First Republic, which had more than $250 billion in assets at the end of the first quarter, ranks just behind the 2008 collapse of Washington Mutual Inc. Rounding out the top four are Silicon Valley Bank and Signature Bank, both of which failed in March.

While the immediate crisis may be over for the largest US banks, trouble still seems to be bubbling for mid-sized and smaller regional lenders. Los Angeles-based PacWest Bancorp, which had over $40 billion in assets at year-end 2022, experienced a precipitous stock price drop in the past week and is said to be ‘exploring strategic options’.

Persistent problems in the financial sector can be a source of concern for everyone. For folks who’ve been saving and investing for a while, worry about a 2008 financial crisis re-run in 2023 is understandable.

Key points to keep in mind, and reasons to believe that the US financial system is on firmer footing today, are:

  • The biggest US banks are better fortified compared to fifteen years ago, with significant liquidity and healthy balance sheets
  • Regulatory and private sector action has helped contain damage through swift wind downs of troubled institutions
  • Shareholders of the failed banks have borne losses
  • Most importantly, depositors have been protected

For a more in-depth explanation of what’s going on in the financial sector, I found the most recent memo from Howard Marks, Lessons from Silicon Valley Bank, to be helpful.

Marks has been investing in the credit markets for decades and is a sort of ‘Warren Buffet of Bonds’. He believes that another widespread banking crisis, a-la-2008, is unlikely.

In addition to gaining a degree of reassurance from his analysis, I found Marks’ perspective on the psychology of what’s going on to be particularly insightful. He concludes his memo by saying:

“When psychology swings in the direction of hopelessness, it becomes reasonable to believe that bargain hunters and providers of capital (i.e., investors with a long-term perspective) will be holding the better cards and will have opportunities for better returns.”

RK

Bank Turmoil is a Tempest, Not a Tsunami

The turmoil from the mid-March banking crisis seems to have calmed down in early April.

To get a better understanding of what’s going on and how concerned we should be, it can be helpful to hear an insider’s point of view.

It just so happens that the nation’s preeminent banker, Jamie Dimon, at the country’s largest bank, JP Morgan, discussed the matter in his latest letter sent last week to shareholders.

I’ve found Dimon’s communications to be refreshingly plain-spoken for a big-deal financial person, and he has the respect of his peers, as he was Treasury Secretary Janet Yellen’s first call when problems surfaced in mid-March.

Here are key points on the current banking crisis from the JP Morgan Annual Report, penned by Dimon, that provide a degree of comfort that the March tempest is unlikely to be a precursor to a 2008-style tsunami:

  • The current crisis was the result of regulatory shortcomings and risk-management failures at a handful of banks
  • The most prominent risks were hiding in plain sight, including interest rate exposure and uninsured deposits
  • The current crisis is not yet over, and there will be repercussions from it for years to come (tighter regulation likely will follow)
  • However, recent events are nothing like what occurred in the 2008 global financial crisis (which barely affected smaller banks)
  • Back then, the trigger was $1 trillion of consumer mortgages that went bad, held by many financial institutions, and included the accelerant of enormous leverage (excess debt)
  • Today’s crisis involves far fewer players and fewer issues that need to be resolved

If you’re interested in hearing his take on the recent bank issues, you can watch Dimon’s CNN interview.

From my perspective, to be confident that a banking crises has been resolved, we typically need to see three conditions met:

  1. Government support
  2. Resolution of failed entities
  3. Passage of time (with no additional failures)

We have seen significant government support through a new Federal Reserve lending program and the swift resolution of three of the failed entities – Silvergate Bank, Signature Bank, and Silicon Valley Bank. Also a large foreign bank, Credit Suisse, was taken over by its main competitor, UBS, following governmental intervention.

As for the third condition: if summer arrives without additional failures, I’ll feel comfortable calling “all clear”.

Banks Go Bust

When well-laid plans didn’t come to fruition, Rooster Cogburn, a US Marshal and fictional character in the Western film True Grit, exclaimed: “Well, that didn’t pan out.”

A financial drama in the West of the US played out last week, where two California-based lenders that took big, mismatched bets got into hot water. Unfortunately, those situations didn’t pan out, either.

Silvergate Bank, a smaller bank catering to the crypto economy, was taken over on Thursday, March 9. Silicon Valley Bank, a much larger lender (19th in the US by asset size) was shut down on Friday, March 10.

The tremor in California was part of a fast-moving, system-wide quake.

Signature Bank, the 29th largest bank in the US was shut down on Sunday, March 12. And First Republic, the country’s 14th largest bank, got support from the Federal Reserve and from JP Morgan.

No other medium- or large-sized banks failed on Monday, March 13. Overall, the stock market remained relatively calm. But Treasury bond prices shot higher – what Wall Street people call “a flight to quality” – and bank stocks tumbled.

The table below (data from the Federal Reserve) presents the 30 largest lenders by asset size in the US as of December 31, 2022. Orange highlights show the banks that recently got into trouble.

Government Steps In

Following government actions on Sunday, March 12, a brief press conference was held Monday morning March 13 where President Biden emphasized the following:

  1. Depositors will be protected
  2. Investors will not be protected
  3. No losses will be borne by taxpayers
  4. The administration will order a full accounting of the situation
  5. More regulation is likely to follow

 

When compared to the Global Financial Crisis of 2008, the current situation has significant differences.

First and foremost, this time government action has been swift, decisive and coordinated. In 2008, it took months for authorities to develop a plan and to act.

Second, the current problem emerged at deposit taking institutions, the issues are transparent, and depositors are being protected.

In 2008, the problems started with real estate lenders and migrated to brokers, and the issues were largely hidden from view or misrepresented for some time. When trouble finally hit retail deposit-taking institutions, the problem had grown so large that the entire financial system was at risk.

Third, investors who hold stocks and bonds of the troubled banks will not be supported, and management of failed companies will be shown the door.

In 2008, part of the ‘solution’ initially was to try to boost stock prices and work with incumbent management teams that had caused the problems.

What actions has the government taken to stem the current crisis?

After taking over Silicon Valley Bank and Signature Bank, the Federal Reserve designated them as systemic risks to the financial system, which gave the Feds authority to backstop uninsured depositors at both institutions. This means people and companies with bank accounts will be able to get their money back in a timely manner.

The Federal Reserve then introduced a new lending facility, called the Bank Term Funding Program, which allows banks to pledge certain assets, like US Treasury bonds, in exchange for loans of up to one year.

This new Fed-run lending facility allows commercially viable banks to avoid selling assets at a loss and helps banks get cash to meet their customers’ demands for their deposits.

 

Causes of the Crisis

In basic terms, the seeds of the recent bank failures were sown through rapid growth, concentrated customer bases, and shoddy risk management. If you can recall the bank run at Bailey Building and Loan in It’s a Wonderful Life, then you have a reasonable sense of what happened last week.

In the case of Silicon Valley Bank (SVB) and Signature Bank, though, Sam Wainwright wasn’t available to advance the billions of dollars needed to keep the institutions afloat.

SVB seems to be a victim of its own success. SVB developed a niche focus working with technology companies and individuals involved in the tech space. It claimed to have served a majority of US startups.

Following the pandemic, SVB grew like gangbusters, and plowed a lot of its deposits, which are short-term obligations, into relatively safe, but longer-term assets like US Treasuries. It bought Treasuries when interest rates were very low. As interest rates climbed in 2022, bond prices tumbled, and losses mounted for SVB.

When SVB sold a bunch of bonds and realized a large loss last week, customers took notice. When SVB tried to raise fresh capital through a stock offering, investors declined. As herd mentality took hold of the tech crowd that banked at SVB, many demanded their deposits all at once, and the gig was up for SVB.

In addition to customer concentration, SVB depositors tended to keep a lot of money at the bank. At a well-diversified bank, typically half of the deposits are covered by FDIC insurance – the $250,000 deposit guarantee.

In SVB’s case, more than 90% of deposits were above the limit, and therefore uninsured, which made the bank more vulnerable to a run. For Signature Bank, which had niches in the technology sector and the crypto space, nearly 100% of deposits were uninsured.

US Debt Ceiling Developments

The debt ceiling is a cap on the total amount of money that the federal government is authorized to borrow. Congress last agreed to raise this cap to $31 trillion in late 2021.

Lifting the debt limit does not authorize any new spending, it simply allows the government to pay bills already incurred.

Some members of Congress are trying to tie an approval for an increase in the debt ceiling to an agreement for greater fiscal stringency.

In a letter to Congress on Thursday, January 19th, Treasury Secretary Janet Yellen said that the US had reached its debt limit and has begun taking “extraordinary measures” to enable the government to stay current on its bills.

The special measures include suspending investments in government benefits plans, such as the Civil Service Retirement Fund.

The actual moment when the federal government can no longer meet its obligations on time is a function of the Treasury Department’s cash flow, which could change depending on things such as the receipt of tax payments.

Yellen estimates that the government could run out of money, and may have to declare default, sometime in June 2023.

The US has reached inflection points regarding the debt ceiling in the past. In 2011, Congress engaged in a contentious stand-off over spending and the debt that got close to a default situation.

The brinkmanship a decade ago had a negative impact on the financial markets and resulted in a downgrade of America’s credit rating by Standard & Poor’s, one of the main US credit rating agencies.

Last week, Speaker of the House Kevin McCarthy and President Joe Biden held a meeting focused on the debt ceiling issue. The tone following that meeting was constructive, with McCarthy saying “I think, at the end of the day, we can find common ground.”

Given that the government appears to have enough flexibility to stay current on its obligations until June, it’s likely that we’re just at the ‘beginning of the day’ on this issue.

Investors will probably have to suffer through more political posturing, and possibly brinkmanship similar to what occurred in 2011, before the situation is resolved.

The stakes in this political game of chicken are high: Yellen has said that a US debt default would “cause irreparable harm to the US economy, the livelihoods of all Americans, and global financial stability.”

My sense is that cooler heads will prevail in Washington and the US will avert the worst outcome. But if the impasse on the debt ceiling persists into spring and summer, it will become more problematic for financial markets, and more likely cause bouts of volatility and downside for investment portfolios.

RK

Course Correction Under Way for the US Economy

Inflation was a big problem last year and inflation-fighting policies had a big, negative effect on stock and bond prices in 2022. Inflation will continue to be a front-and-center Issue for investors this year. 

Course Correction Needed was the title of the second section of my September newsletter. In that section, I wrote: “Until market participants sense a course correction in the inflation / interest rates / Fed policy dynamic, stocks are likely to struggle”.

I’m pleased to report that a course correction is under way. Inflation gauges are generally improving, longer-term interest rates made a meaningful adjustment, and the Federal Reserve has slowed its pace of short-term interest rate increases.

On February 2, the Fed brought its target for short-term interest rates up to 4.75%, an increase of 0.25 percentage points. This follows a 0.5 percentage point increase in December, and a series of 0.75 percentage point increases last fall and summer.

This indicates we may be approaching the end of the ‘Fed tightening cycle’ that I discussed in my October 2022 newsletter.

Improvements in inflation and a ‘go-slower’ Fed have given a very significant lift to stock and bond prices so far this year. Can this course correction persist in 2023?

The answer is yes, but likely will require the labor market to come off the boil.

The jobs market was hot in 2022. There were 4.5 million new jobs created last year, and millions of job openings remained unfilled.

This supply / demand gap in the labor market was a key factor that drove wages higher, which in turn contributed to inflation.

The hot labor market persisted in January. US employers added 517,000 jobs and the unemployment rate declined to 3.4% – the lowest since 1969. This is good for workers and good for economic growth. But for inflation? Not so much.

We should recognize the improvement in the financial markets in the early weeks of 2023 as a benefit for portfolios.

But we should also realize that the process of course correction is more likely to look like a winding mountain path, with sections of rocky trail and switchbacks, than a straight, paved road back to satisfactory investment results. 

RK

Inflation Watch

Inflation remains a front and center issue for many of us as we start the new year, including consumers, business owners, policy makers and investors. Inflation refers to a broad rise in the prices of goods and services across the economy over time.

For this first letter of 2023, I thought it would be helpful to dig into the inflation issue a bit deeper, and then share some recent good news on the subject.

Price stability is considered a hallmark of a healthy economy. Economists generally consider annual inflation in the range of two percentage points to be a desired inflation target.

There are positive effects of moderate, contained inflation. For instance, it can stimulate spending and spur demand and productivity. But inflation running significantly above target is considered a problem.

The main issue with too-high inflation – a feature of today’s economic environment – is that it is erosive. Inflation erodes the value of income, savings, and investments. It erodes purchasing power for consumers and businesses. In other words, elevated inflation means your dollar will not go as far tomorrow as it does today.

Statistical agencies measure inflation by first determining the current value of a ‘basket’ of various goods and services consumed by households, referred to as a price index, which can be tracked over time to give observers a sense of the path inflation is travelling.

Here’s a picture of how inflation has changed during the past 40 years, as measured by the Consumer Price Index, or CPI, which is calculated by the US Labor Department.

The grey line, labeled ‘Overall’ includes food and energy prices. Since food and energy are considered the most volatile items in the basket, they are excluded from the blue ‘Core’ measure.

Any way you slice it, inflation today is too high for comfort. The most recent CPI reading published in mid-December shows that consumer prices rose 7.1% in November from a year earlier. This is obviously quite far from the 2% target.

The good news is that inflation gauges are now headed in the right direction, and down meaningfully from the high point reached in June 2022 of 9.1%. I expect price indices to show further improvement in the early months of 2023.

Developments in the commodities markets are supportive of this expectation. The recent period of unseasonably warm weather in the northern hemisphere has had a dampening effect on oil and gas prices.

Also, China’s reopening is easing supply chains, which is likely to positively impact goods prices.

And last Friday, January 6th, the US Labor Department provided information that indicates wage growth, a key ingredient in demand for goods and services, seems to be slowing down, too. Wage growth eased to 4.6% from a near 6% annual growth rate at the beginning of 2022.

While a few months of data don’t seal the deal, inflation trends are encouraging.

If inflation continues to moderate, it will give the Federal Reserve, the country’s chief inflation fighter, some room to ease off the pace of interest rate hikes. This, in turn, would mean less pressure on the financial markets, and a backdrop more conducive to stock and bond price gains.

Case in point: following the release of the Labor Department data on Friday, stocks jumped by more than 2% and registered their best day since late November. The bond market got a lift, too, rising by 1% on Friday.

An improving inflation picture in 2023 will go a long way in helping to relieve anxiety associated with the financial markets that has carried over from 2022.

RK