VOO - VOO: It's Going To Get Worse Before It Gets Better

2023-03-11 06:05:14 ET

Summary

• The largest bank failure since the Great Financial Crisis has shaken equity markets.
• This event is a sign of potential instability in financial markets and could prompt the Fed to pivot monetary policy earlier than expected.
• Equities can find a strong footing for a prolonged bull market, but only after we get through what comes next.
• A picture is worth a thousand words, but a chart is worth a thousand pictures.

The week was brutal for equities as the S&P 500 was down 4.84% with the news of SVB Financial Group ( SIVB ) failing and the FDIC intervening to protect depositors. The development has caused financials to dump across the board with the Vanguard Financials ETF ( VFH ) down 9.2% on the week. Regional banks ( IAT ) took the news especially hard, down over 17% on the week.

Normally, financials lead the broad economy and major stock indices. This dramatic move to the downside deserves the attention of all equity investors. Is this an isolated episode (the infamous "contained") or is it the next Lehman moment thereby affecting the entire market?

FDIC-insured institutions fail from time to time, usually without widespread consequences. But in this case, the market has reacted strongly. Rates on U.S. Treasuries have cascaded down and the market implied probability of the next hike in the Fed Funds rate has shifted from 68.3% for 50 basis points to 62% for 25 basis points. The two year hasn't fallen this quickly since September 2008 when Lehman filed for bankruptcy. Clearly the bond market is bracing for a bust.

While SIVB may stay contained (knocking on wood), the reason for this event has the potential to impact other financial institutions. That, in turn, can impact the overall economy. With this much uncertainty, risk assets including the Vanguard S&P 500 ETF ( VOO ) are not looking attractive to me, yet .

Monetary Policy Matters

The failure of SVB is one of the largest in recent history. This follows two years without any bank failures . The last time the U.S. had two consecutive years without bank failures was 2005-06. There were 3 failures in 2007 which cascaded into 25 in 2008 and 140 in 2009. It is interesting that the total assets in this failure, $209B, is greater than the amount of assets in all of 2009, although less than 2008. Sources estimate that 87-93% of the deposits at SVB are uninsured. The depositors include some publicly traded companies. This creates a real issue.

There are problems that are unique to SVB. For example, a high percent of its deposits are from technology companies and venture capital firms. In addition, many of the bank's positions were inadequately hedged. Despite these weaknesses, the source of this problem is the current tightening of monetary policy and the lending practices that preceded it. For banks, rising rates can lead to lower book values as the assets on their balance sheet lose market value. SVB was particularly impacted by this effect because of an inordinately high percentage of its assets are in securities. However, data from the FDIC suggests that the amount of unrealized losses on bank balance sheets is the largest in years.

While this issue does not impact all banks equally, and many banks are much better capitalized and hedged (particularly major banks), this event demonstrates the stress in the financial system and how leverage can result in "black swan" events. To compound the issue, bank depositors are highly incentivized to remove their deposits from banks to earn higher rates of interest in Treasury bonds and bills. While many savings and money market accounts are now offering higher yields, above 4%, the average yield is still far below what is offered by Treasury bills.

This has resulted in the first decline in bank deposits in over 20 years. This is adding to the stress that banks like SVB are experiencing. Banks can stem these outflows of capital by raising their deposit rates to be competitive with Treasury yields. This would have a negative impact on earnings.

Finally, Something Bullish (eventually)

Readers of my work on SA are well familiar with my bearish stance on risk assets. Believe it or not, but this development makes me a little bullish, eventually . This is because problems in the financial sector are going to put the heat on the Federal Reserve to stop tightening monetary policy. The Fed will not compromise the banking system because the implications could lead to a financial crisis.

This is why bonds rallied and rates declined. Besides the Fed stepping down its rate hikes from 75 BPS to 50 BPS, this is the first major sign that the end of monetary tightening is nearing. I suspect that the bear market in equities is not finished until monetary easing begins again. The threat of a banking crisis, illuminated by this week's events, is such a catalyst to prematurely reach that end, regardless of inflation.

Employment remains tight. I've written before that I think this tightness is a mirage leftover by the long term consequences of the pandemic and that with time the employment situation would moderate, at first, and then weaken. We have begun to see some glimpses of this moderation in the data.

Initial jobless claims are now trending higher than the non-pandemic average over the past 5 years. This trend has been developing since the beginning of the year. Ironically, changes in monetary policy can often take a year to be fully in effect and monetary policy began tightening one year ago.

This is also the first time since 2014, with exception of the pandemic-influenced years of 2020-2021, that jobless claims are higher seasonally adjusted than the year previously.

This is positive for risk assets in that material weakness in the economy and fragility in the financial system will pressure the Fed to change policy. It's possible the Fed could conduct emergency liquidity operations or cut interest rates in response to event but my base-case is that this bank failure will be handled and it will appear that things return back to normal until the next event occurs.

Here's the bad news for risk assets. My two most likely scenarios is either:

1. Weakness in the economy and financial system is inevitable and the Fed will reverse policy immediately.
2. The economy and financial system can stave off weakness for a while longer while the Fed maintains a tight monetary stance.

Either scenario will result in further weakness for equities, including the S&P 500, in the near term.

Finally, the technical picture is not supportive. I recently wrote about how the 0.5 Fibonacci retracement was an important level for the S&P 500 to cross and in accordance with my expectations the index has failed to breach it. It has also lost major upward and downward trend lines and the 200 day moving average. In this case, the technical picture is helping to confirm the fundamental outlook.

The Vanguard S&P 500 ETF includes a 13.99% allocation to financials, which have been acutely impacted by the failure of SVB. While I remain underweight financials for these and other reasons, the concern is more about the overall health of the economy and how it will impact all holdings in the fund. I am overweight healthcare and communications but the allocation distribution of VOO is too risky for me given the macro conditions.

Summary

The failure of SVB is a warning sign that stress in the financial system is present and may lead to more issues for financial institutions. This condition is largely the result of interest rates rising quickly impacting bank capital and book value. This event may be an outlier but I view it akin to the tip of an iceberg. You can't see exactly what's underneath but you know it's there.

The effects of monetary tightening is beginning to manifest more obviously with this visible stress in the financial system and trends in employment. This means that a change in monetary policy is nearing, which will be bullish for equities. But in the meantime, there is likely to be more "pain" ahead, as the Fed Chairman likes to say.

For further details see: