Last quarter we anticipated continued volatility in the markets going forward, and our thrill seekers were not disappointed. The first quarter brought multiple ups and downs as we continue on the monetary policy adjustment roller coaster. Add in a banking panic and we officially have our first down payment on the costs of the federal government’s and the Federal Reserve’s fiscal and monetary experimentations of the past few years.
The policies enacted since the pandemic first brought on the worst inflation in 40 years. Then, to fight inflation as the worser evil, the belated monetary tightening over the past year has been drastic and is starting to take its toll. The Fed has signaled that it may have another rate hike in them before they hit the pause button and monitor the effects this takes on the wider economy.
It is not surprising that the first areas to see the effects of this change in the cost of borrowing are the real estate and banking sectors. Home sales, for example, are down by double digit margins on year-over-year basis. We’ve also now seen multiple banks experience trouble including Silicon Valley Bank, Signature Bank, First Republic Bank, Credit Suisse, Deutsche Bank, among a few others. Interestingly, it has so far not been the loan portfolios that have had the most trouble. It has been the banks’ management of their interest rate risk through their portfolios that has caused the most problems. It is not hard to chalk this up to a classic example of certain regulation from the last crisis (Dodd-Frank capital rules) that sowed the seeds for this crisis. As a result of the 2008 financial crisis, regulators decided they could define safe capital. Naturally, they included US Treasuries in the definition of safe assets. They failed, however, to consider interest rate risk in this equation. As a result, banks were encouraged to take on interest rate risk, and the regional bank regulators do not seem to have been giving interest rate risk much attention either. What is truly amazing is that this was occurring even during the most aggressive interest rate hike cycle in decades.
There is also evidence that bank regulators were more focused on political social policy instead of the nuts and bolts of financial safety and soundness. Did this lead them to overlook certain risks as long as the banks towed the correct political line? It certainly seems this is a good possibility and will need further investigation.
The result of the turmoil in the banking sector is likely to be a credit tightening cycle as banks focus on lending to only the safest of opportunities. This likewise has contributed to a number of economists increasing their forecasts for a recession in the US economy.
While some took the buoyant job numbers earlier in the quarter as solace that we may avoid a hard landing from the monetary policy adjustments, it is becoming harder and harder to argue that the economy will be able to weather this cycle without a recession.
Overall, the events of this quarter do not change our outlook much. We still anticipate a slow down in the economy and continued volatility going forward. With that, we will be maintaining our focus on value and recession-resistant areas of the economy within our own portfolios. As we see the Fed hit the pause button on rate hikes, we will be making adjustments to our fixed income allocations, and the duration within those, to coincide with our view of a more stable (and possibly even declining within 12-18 months) interest rate environment.