Q1 2023 Insights
Global financial markets extended their recovery during the first quarter of 2023, despite global instability and elevated volatility. January saw a strong rally in risk assets and risk-free bonds as longer-term interest rates receded. In the U.S., some of those gains were pared back in February, and especially March, as the rapid collapse of Silicon Valley Bank (SVB) caught markets off guard.
While the (now) third-largest bank failure in U.S. history was spawned by the confluence of several unique factors, including poor interest rate risk management, as well as a concentrated and particularly flighty deposit base, SVB’s failure turned an indiscriminate spotlight on all financial institutions. Market volatility in the banking sector spiked over the course of the month as the visceral fear of another 2008 led many investors to dump shares of large, high-quality, well-capitalized banks alongside those of small regional banks that were facing a higher risk of deposit flight. In the span of four weeks, the collective share price of U.S. banks plunged 25%.¹
Several institutions² later failed, yet another systemic financial crisis did not materialize, and the rest of the equity market escaped relatively unscathed. The speed at which regulators and larger banking peers acted to restore confidence, mitigate the risk of contagion, and coordinate the absorption of underlying assets and deposits from the failed banks reflects the industry’s willingness to use its collective capital strength to avert the kind of systemic shock investors were fearing.
Markets have since recovered from their initial flight to safety (though bank shares remain a laggard), but the series of events has left many assessing the fallout of the U.S. Federal Reserve’s historically aggressive policy tightening. Will the recent turmoil convince the Fed to ease off and risk a resurgence of inflation, or will it continue to hawkishly raise rates to get inflation back down to its long-term target, despite the added strains it could put on the banking sector?
For their part, markets are predicting an end to the current tightening cycle, with a growing expectation for policy rate cuts in the U.S. before the end of the year. Greater attention to financial stability will also lead many banking institutions to restrain credit extension going forward. This could further slow economic growth in the near term, on top of an already measurable deceleration in the manufacturing, real estate, and service sectors. Despite the negative headlines however, a recession is not guaranteed. Corporate earnings, while certainly under pressure, do not yet indicate a sharp contraction in economic activity.
More important than trying to predict the Fed’s next move, the prudent course of action for investors is to heed the fundamental lesson markets have just offered. The recent mayhem in the banking sector comes on the heels of the significant correction in growth stocks last year and is yet another reminder of the critical role diversification plays in a portfolio. If one business fails and the value of its stock is wiped out (or its convertible bonds in the case of Credit Suisse), it should be nothing more than a scratch to an investment portfolio, not a fatal wound. This is exactly why we seek to avoid large, concentrated positions and exposures in client portfolios. The quest for robust long-term returns must always be paired with disciplined risk management.
With both significant uncertainty and opportunity ahead, we are holding true to our core investment philosophy. We continue to focus on maintaining a well-diversified positioning across all economic sectors, investment styles, capitalization sizes, and market geographies, with a focus on quality and plenty of sources of dry powder to take advantage of temporary market dislocations.
¹ As measured by the total return of the KBW Bank Index between 28 February and 31 March 2023.
² i.e., Signature Bank, Credit Suisse, First Republic Bank