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  • Mar 15, 2023

Silicon Valley Bank Failure: Investor Questions Answered

Speaker: Lisa Shalett
Silicon Valley Bank Failure: Investor Questions Answered


Hello, I’m Lisa Shalett, Chief Investment Officer of Morgan Stanley Wealth Management, and today is Wednesday, March 15, and I am recording this as a response to the historic events of the past week and the resulting market volatility. In addition, I want to walk you through some of the implications for portfolio construction advice going forward.

So, what’s happened?

Silicon Valley Bank (SVB), one of the country’s 20 largest banks as of early March, experienced a classic “run on the bank” where depositors attempted significant withdrawals of account balances. This resulted in the FDIC shuttering and taking over Silicon Valley Bank on Friday, March 10.

Concerns about the bank’s liquidity and solvency were originally signaled by management earlier in the week when they announced they were contemplating a dilutive equity issuance to access more capital.  This catalyzed a loss of faith among depositors that was exacerbated by the unique inter-relatedness of Silicon Valley Bank’s client base, which consisted primarily of major venture capital and private equity firms and the portfolio companies of tech start-ups that they owned.

It’s worth noting that Silicon Valley Bank was uniquely vulnerable in the current environment for a number of reasons, including how relatively non-diversified its depositors were, and how its account balances were mostly of operating cash, and thus were in continual drawdown mode, not to mention only 7% of the accounts were fully insured by the FDIC [Federal Deposit Insurance Corporation] as defined by the $250,000 threshold. The bank’s vulnerability was an issue that MS & Co. [Morgan Stanley] research analysts identified this past December with their “Underperform” rating.

Now let’s take a minute and consider some of the policy responses to all of this.

First, how did the government and the Federal Reserve respond?

By Sunday night, March 12, the FDIC had agreed to guarantee 100% of all depositor funds, supporting jobs, payrolls and the continuity of these companies as going concerns.

The Fed, for its part, issued a new loan program, called the Bank Term Funding Program, which allows banks and other depository institutions to pledge U.S. Treasuries, agency mortgage-backed securities, and other qualifying assets—at par value—in exchange for a loan with maturities of up to one year. This liquidity source essentially eliminates the need for banks to sell high-quality securities at a loss to meet deposit withdrawal shortfalls. This is a large policy bazooka and should prevent contagion to other banks.

Another issue is that regulators at the Fed have had to admit that oversight of Silicon Valley Bank likely was lighter than ideal because of the 2018 rollback of Dodd-Frank rules, an issue that will likely get revisited by Congress.

Now, how have the markets responded?

The most dramatic market action has been in the U.S. Treasury market, where bonds have rallied aggressively in a risk-off trade, with many suggesting that the Fed could no longer keep raising rates.  Consider that since last week, the 2-year Treasury yield has fell from over 5% to close to 4%, before settling at Tuesday’s close of 4.22%. Ten-year yields, the most important for stock valuations, fell from over 4% to around 3.66% as of Tuesday’s close. These dynamics led to a steepening of the 2s/10s curve, something that is typically associated with impending recessions.

Most provocatively, Fed Funds futures priced a new expectation that the Fed would no longer hike toward a terminal rate between 5.5% and 5.75%, which had been discounted only a week ago at [Fed Chair Jerome] Powell’s congressional testimony. But today it has fallen to around 4.9%. That’s close to the level it hit around the October 2022 stock-market low.  Further, the bond market is discounting as many as three to four cuts now by next January.

For equities, the S&P 500 has gained about 1.5% since last Friday, but with investors rotating toward a mix of sectors. As you probably saw, investors have pounded the financial services sector, “throwing out the baby with the bath water,” with many regional bank ETFs [exchange-traded funds] and broader bank ETFs down 15 to 30% just in the last 3 days.

Embedded in the financial-sector selloff are investor fears around contagion; a flatter yield curve; lower net interest margins; higher costs of deposits; capital flight to the largest, most well-capitalized banks; lower loan growth and potential asset impairments.

But for the most part, these fears are not well founded. We believe most banks are well prepared to weather a recession if one comes. The issue is very different than in 2008. This is not about systemically bad credit. This is about a mark-to-market risk that some banks face from rising interest rates if they hold interest-sensitive instruments on the asset side of their balance sheet. Most banks know how to manage this.

And so, with all that said, what should we be thinking about as we look ahead?

First, regarding the Fed’s policy path, it looks like the Fed is increasingly between a rock and a hard place, having to trade off market stability risk for credibility on inflation. This is not a good set of choices, but the problems with SVB are partially of the Fed’s own making.

Despite market enthusiasm for the Fed to pause its rate-hiking campaign, the data on inflation suggests that would be a very bad idea. Tuesday’s CPI [consumer price index] report in fact revealed that headline inflation came down as expected but revealed core inflation that was worse than hoped—and is still running at 5.5% year over year. Critically, services inflation accelerated in the month and has not yet peaked, arguing that excess demand in the economy is still visible.

Considering that, we expect the Fed will in fact raise 25 bps [basis points] next week and continue to signal that they are data-driven and thus, not necessarily done. 

As for the economy, the Silicon Valley Bank crisis may be a canary in the coalmine. We believe that odds of a recession, rather than a soft landing, have now increased. Consumer psychology is a fragile thing, and bank runs can be very anxiety-producing. Should conservatism be the response of the banks to this crisis, then slower lending, less risk-taking and weaker access to capital could hasten the cash-burn process and insolvency of unprofitable start-ups. It could also lead to consumption pulling back and savings rising, while the labor market could begin to show signs of cracking.

Finally, as for the investment implications, the GIC remains highly convicted that 2023 consensus earnings estimates for the S&P 500 remain too high. While interest rates have pulled back and thus, stock valuations relative to bonds have improved a bit, absolute price/earnings ratios are too high, at nearly 18x on consensus forward earnings estimates of $220/share versus our forecast of $195.

In U.S. stocks, we continue to focus on quality yield, growth at a reasonable price, and earnings achievability—attributes that we are finding today among healthcare companies, select semiconductors and software makers, financials, energy and materials and miners.

With yield curves bear-flattening, we are more open to taking some duration risk and are leaning more towards the benchmark given our forecast of the coming equity market volatility. Real assets like gold remain a decent hedge for a recession or stagflationary scenario.

Thanks as always for listening, and if you have any questions about what’s been going on, or want more details about our views on the economy and portfolio and investment strategies, please reach out to your Morgan Stanley Financial Advisor.

What happened to Silicon Valley Bank? And what does it all mean for the banking industry, the economy, the Fed’s tightening path and investment strategies? Listen to learn more.

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