To my clients;

It was an up week for North American stock markets with the Canadian TSX finishing up 0.6%; the U.S. Dow Jones Index finishing up 1.2%; and the U.S. S&P 500 finishing up 1.4%.

I’m back from holiday and, despite the positive returns this week, the overall market environment since my last update three weeks ago has been rather gloomy, with the broader Canadian market down about 5%, and the U.S. market down about 2.0%. Unlike the past 15 months, the driver of this turmoil was not (at least not directly) higher inflation and interest rates, but rather the initial collapse of Silicon Valley Bank and then subsequent fears for other U.S. regional banks following suit. This leads to two questions: 1) What went wrong? and, 2) heaven forbid, might this be (as a couple of clients have asked) the initial salvos of a banking crisis similar to the 2008 financial crisis?

So, let’s keep this simple on both fronts and not lose readers in the details…

What went wrong? Simply put, Silicon Valley Bank (SVB) did a poor job of managing its balance sheet. The bank invested heavily and disproportionately in long-term bonds which, when interest rates rise, suffer a disproportionate loss in comparison to shorter-term bonds. So as the value of the bond portfolio of SVB declined, this meant that the bank had less assets to cover the deposits of its clients which predominantly consisted of very high net worth tech entrepreneurs and companies. Because the client base was very high net worth, it turned out that most depositors held far more than the $250k federally insured deposit maximum with the bank. In fact, about 94% of the total SVB deposit base was uninsured. As the value of SVB’s long-term bond assets declined, this high net-worth and relatively sophisticated clientele began to worry that their uninsured deposits might be at risk and began withdrawing their deposits rapidly. This is a proverbial “run on the bank” and, well, the bank rapidly collapsed.

and

Is this 2008? In a word, NO. The 2008 financial crisis was a result of bad quality debt (largely subprime mortgages) which were packaged, and repackaged, such that these highly risky underwritings permeated and poisoned a significant chunk of the banking system. In the case of SVB, it was not an issue of poor quality assets, but rather a poor mix of good quality assets (again, a disproportionate mix of long-term bonds vs shorter-term bonds). Further, SVB’s situation was exacerbated by the very specific niche of higher-net worth depositors that it served. While the sudden collapse of SVB has certainly caused continuing anxiety in financial markets, including runs on a handful of other banks that investors worried might be similarly positioned, today’s situation is fundamentally very different to the 2008 experience.

The preceding said, I DO believe the SVB collapse and related banking concerns highlight what I’ve been saying for some time: that there are lags to the economic impacts of increased interest rates and that the Federal Reserve has already gone too far in raising interest rates – including this week’s 0.25% interest rate increase. While reading between the lines of Fed Chair Jerome Powell’s Wednesday speech suggests that this will indeed be the last increase of this rate cycle, a mild recession is now a near certainty in my mind. BUT, the much better news, as I’ve also been saying for some time, is that rates are likely to start falling by the end of 2023. And it appears bond markets now agree. In fact, bond markets are now pricing in up to 0.75% in rate cuts by the end of 2023.

I’ll conclude by reiterating what I’ve been communicating with clients during annual reviews: I believe 2023 will be a year of volatility with big economic forces in play. But I continue to believe that with inflation destined to continue declining and the Fed poised to pivot to rate cuts (rather than just pausing), I believe the end result will see the year end better than it is now.

That’s it for this week. All the best,

Nick

Nick Scholte, CIM, FCSI

Senior Portfolio Manager

Scholte Wealth Management
RBC Dominion Securities Inc. │ Tel: 604.257.7569 │ Fax: 604.235.9950
3200-1055 West Georgia │ Vancouver, BC │ V6E 3P3
Toll Free: 1.844.665.9900 │Email: nick.scholte@rbc.com

Visit Our Website: www.nickscholte.ca

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