Three banks failed last week, but the fallout of Silicon Valley Bank (SVB) was the one that mattered. The other two were tied to the decline of the cryptocurrency industry. SVB was the bank for many small and growing businesses and was hoping to become publicly traded in the future. With the Federal Reserve rising interest rates and investor sentiment declining, the window for new public offerings “IPOs” has closed. This made SVB’s business customers draw down on bank deposits and forced the bank to sell bond holdings of investment grade issues at a loss to cover withdrawals. When investors balked at adding more capital to the bank, a “run on the bank” ensued and in a few days, the bank was taken over by the State of California regulators. Bank runs can occur much faster than in the day of George Bailey from It’s a Wonderful Life.
To stem further losses, the Federal Reserve and the FDIC will cover all depositors accounts. Bond and stock investors in SVB are likely to lose their investments. If the banking sector can avoid another failure over the next week, it will enable confidence to return.
The Federal Reserve has raised short-term interest rates from 0.25% to 4.75% over the past year. While they remain concerned that the rate of inflation is not falling as quickly as hoped, signs are emerging that business credit conditions are quickly tightening. Many corporate bank customers are seeing much higher interest rates and fees. At the same time, banks are challenged with office property losses and narrowing spreads between their lending rates and the interest they pay depositors, referred to as net interest income. This situation suggests that rising cost of borrowing funds for businesses will rise, and the economy will slow.
In the financial markets, Treasury bond yields have fallen dramatically in the wake of the SVB collapse. The 2-year bond yield has dropped from 4.7% to about 4%. The 10-year bond yield also has fallen from about 4% to 3.5%.
The drop in bond yields has supported the stock market overall, but the performance of the segments is dramatic. Smaller companies, financials, and real estate are feeling the most punishment. Larger companies, especially those with the strongest financial resources, are doing well, such as technology and biotechnology.
In client portfolios, we have exposure to Key Bank Preferred Stock, JP Morgan Preferred Stock, and the Preferred Stock ETF that are of concern. Preferred stocks are similar to bonds in that they provide a fixed dividend yield. Our largest financial holding, Royal Bank of Canada (RBC), is down about 5% over the past week. Royal Bank of Canada, a AA- credit rating, higher than JP Morgan. Last week, we sold many positions as the trading patterns were suggesting that a bearish momentum was building.
Despite the chaos in the regional banks and the increased risk of economic decline, the SP500 closed today only -0.16%, well off losses from over 1% earlier in the trading session.
Our investment strategy will be updated in the Client Letter for the 2nd quarter that should be distributed in about two weeks.
