Windsor Perspective: Q2 2023
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Spring is upon us and like the landscape around us the markets are showing signs of life. It was an interesting start to the year as the markets opened the year strong before stumbling with the unexpected and quick collapse of Silicon Valley Bank. However, the fear of future contagion in the banking industry with more bank failures has seemed to have faded, and the markets have once again begun to bloom.
In this edition of the Windsor Perspective, we review the market performance for Q1 of 2023. In addition, we discuss what happened to Silicon Valley Bank, why we do not think it will spread to other banks and how there may be a silver lining for investors.
If you would like to talk to us further about these topics or about any of your financial planning or investment goals, please do not hesitate to get in touch with us.
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Q1 2023 - Great start to 2023 despite some volatility
The first quarter of 2023 delivered very good performance to start the year. However, it did prove to be volatile, with the collapse of Silicon Valley Bank having a major impact on market performance mid quarter. Although the market started out very strong in both the fixed income markets and equity markets, the news of the demise of Silicon Valley Bank brought the market rally to its knees. Fortunately, as we will discuss below, Silicon Valley does not look to be systemic to the banking industry and the fear that this collapse caused in the markets has subsided. As the concerns of further bank failures diminished, the market was able to stage a nice rally in the last couple of weeks of the quarter.
For Q1 of 2023 (and the year-to-date period), the S&P 500 delivered a solid total return of 7.50%. The fixed income markets followed the same trajectory as equities through the quarter. The pullback in Treasury interest rates sent the fixed income market higher in the last couple weeks of the quarter, with the AGG finishing the quarter up 2.96%. This was a nice quarter overall and a great start to the year for both the equity and fixed income markets.
S&P 500 Index Q1 2023
Source: Bloomberg, Windsor Wealth Management
What happened to Silicon Valley Bank?
The collapse of Silicon Valley Bank was unexpected and very rapid. Although many people had never heard of Silicon Valley Bank, it became a headline name as the bank collapsed in just a matter of days and became the largest bank collapse since 2008. There were a few other banks that also had an issue around the same time, Signature Bank and Credit Suisse for example. But Silicon Valley Bank was the real focus, and the fear was what happened there could spread to other banks. Fortunately, this does not appear to be a systemic issue, and the FDIC rushed in to protect depositors. What this appears to be was a very poorly managed company with inherent flaws in its risk management practices that resulted in a mismatch in deposits and investments. This ultimately led to its demise.
First, a bit of background. Silicon Valley Bank is a regional bank that catered mainly to Venture Capital firms and start-up companies focused on technology and healthcare. It was reported by Silicon Valley Bank themselves that they served roughly half of all venture backed tech and healthcare companies in the US and 44% of the venture-backed technology and health-care companies that went public in 2022. Silicon Valley Bank is not your typical regional bank, as the customer mix is very different. For instance, 56% of its loans at the end of 2022 were to venture capital and private equity firms while 24% were to various tech and health care companies (including 9% of all loans going to early-stage start-ups). These types of companies are inherently risky and rely on the availability of more capital to survive.
More importantly, the mix of their depositors was very different than the average regional bank. As shown below, the average regional bank’s deposits are made up of 49% consumers/retail, a very diverse group of clients. At the same time, 35% of all deposits at regional banks are fully covered by FDIC insurance, with the average account size being $177,000. Contrast that with Silicon Valley Bank, where only 7% of deposits were from consumers/retail clients and only 3% of the deposits were fully FDIC insured as the average account was $1,251,000.
Deposit Characteristics of Silicon Valley Bank vs Other Large Regional Banks
Source: Windsor Wealth Management, Strategas
So why does the deposit mix matter? The way a bank functions is they take in deposits and then either lend out those deposits as a loan or invest those deposits in risk-free Treasuries (or other lower risk bonds). Many of their customers (tech companies) were doing very well post the Covid pandemic and did not need as many loans. As a matter of fact, the bank’s deposits had tripled between 2020 and 2022. Thus, Silicon Valley Bank had been investing a lot of the deposits into longer duration Treasury Bonds as the demand for loans slowed. Although Treasuries are considered ultra safe, the bank was taking on unrealized risks. The two main risks they exposed themselves to were the impact interest rates would have on the value of the long-duration bond holdings and the stickiness (or lack thereof) of their deposit base. When the Fed began aggressively raising rates in 2022, the market price of their bond holdings began to decline rapidly. If they could hold the bonds to maturity, there would notbe an issue as they would pay out at full value. But if they were to sell them prior to maturity, they would be selling them at a large loss. This is because Silicon Valley Bank started buying these bonds before interest rates had moved up. Thus, as rates went up, the value of these bonds declined. This is where Silicon Valley Bank stumbled. The acceleration in inflation and higher interest rates increased the operating expenses of their clients. Their clients began to access their deposits to help with these rising costs. This forced Silicon Valley Bank to begin selling their Treasury Bond holdings at a loss so they could handle the customer withdrawals. Silicon Valley Bank planned to do a securities offering to raise capital in order to prevent further losses on the sale of their Treasury Bond holdings, but was unsuccessful. For various reasons, this attempt to raise funds created concerns in the venture capital world that there was an issue at the bank, and many venture capital firms recommended the companies they are affiliated with to pull all their money from Silicon Valley Bank. This resulted in a “run on the bank” with companies withdrawing very large sums of money. The more that was taken out, the more Treasury Bonds had to be sold at a loss. This resulted in the bank collapsing.
The root cause of the collapse was poor risk management by the bank and a complete mismatch between short-term deposits and long-term bond investments. The bank also overestimated the loyalty of their business customers to not withdraw their deposits. But the lack of customer diversification leant itself to the ultimate failure. Fortunately, this is not a systemic issue and other banks do not have the same issues Silicon Valley Bank experienced, and this should not become a wider issue.
There may be a silver lining for investors
Although the collapse of Silicon Valley Bank caused near term disruption to the markets, there may actually be a silver lining to this story. The immediate after effect has been that the markets now believe the Fed may soon pause further interest rate hikes, which is much earlier and at a lower rate, than previously anticipated. As shown below on the graph of the expected Fed Funds rate, prior to the Silicon Valley Bank collapse, the market was expecting rates to rise to 5.56% by the end of the year. However, that expectation has since fallen to 4.26% which is below the current Fed Funds rate of 4.83%. In other words, the market is now expecting a rate cut by year end.
Expected Fed Funds Rate December 2023
Source: Windsor Wealth Management, Bloomberg
There is still a 50/50 potential that the Fed will raise rates an additional 25 bps at their May meeting. Assuming inflation continues to trend down, that may be the point the Fed pauses. The reason for the change in sentiment regarding interest rates is due to the collapse of Silicon Valley Bank. This collapse has effectively restricted credit availability to venture capital firms and new start-ups as Silicon Valley Bank was the main bank for those companies. In addition, the ripple effect is all banks will tighten lending standards going forward. Data shows that VC backed start-up companies are a primary job engine, growing employment 930% faster than the rest of the economy. The net effect is credit has now become more expensive and this will ultimately slow job growth, GDP, and ultimately inflation as well. In other words, the collapse of Silicon Valley Bank has accelerated what the Fed was trying to achieve. And an end to rate increases should be viewed positively by the markets.
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In Summary
Despite the volatility, this was a very good start to the year as both the equity and fixed income markets delivered a very good performance in the first quarter. The demise of Silicon Valley Bank has most likely helped the Fed in their fight against inflation, and we could be close to a “pause” on rising interest rates. If inflation can continue its downward trajectory and interest rates eventually top out, this could set up the market for a nice run into the end of the year.
As always, we will be seeking out opportunities for your overall financial plan based on the current economy and our outlook. Together, we will continue to tailor your plan to suit your unique financial objectives and a risk level you are comfortable with. Thank you for your confidence in our team and in Windsor Wealth Management.
Dream boldly. Plan wisely.
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