Earlier last week, Federal Reserve Chair Jerome Powell testified in congress, as he often does, sharing the Fed’s intentions concerning the Federal Funds Rate’s path in the future. As we’ve shared in recent months, the Fed is on a quest to rein in inflation by raising interest rates, effectively increasing the cost of borrowing, and reducing the amount of money circulating in the economy. One unfortunate consequence of their rate-raising efforts has been the potential for a recession, the impacts of which have been felt in the financial markets, particularly in the bond market. As rates increase, yields rise, making newly issued bonds more attractive. With higher rates, today is a much more favorable environment for lending money. Where money market accounts used to yield virtually nothing, accounts today are advertising anywhere from 3-4% - amounts unheard of in recent years. This is excellent news for current lenders; however, it’s not great news for previous lenders who have locked in long-term lending rates prior. This is a simplistic version of what led to the collapse of Silicon Valley Bank last week. Silicon Valley Bank (SVB) was a regional bank serving startups in the area. It had previously invested a significant portion of its assets in longer-term debt instruments during a lower-rate environment. As it became clear that the Fed intended to continue raising rates, SVB found itself facing a need to return higher interest rates to its investors and depositors, despite making lower interest rates on its investments. Concerned about the risk to their deposits, customers of the bank begin pulling their funds, leading to a classic bank run. In response, SVB has been forced to sell some of its investments at steep discounts, causing further pain and ultimately leading to its closure over the weekend. While the quick run-up in interest rates played a significant role in the collapse of SVB and a few other banks like it, there are a few differences worth pointing out, particularly in light of concerns regarding the broader banking system. The first is that SVB was uniquely positioned in the startup space. The Federal Deposit Insurance Corporation (FDIC) insures bank accounts up to $250,000. For the average individual, this covers a significant portion of their bank funds, if not all. For instance, Schwab recently released a statement regarding its position, noting that more than 80% of its deposits are fully insured under the $250,000 insured threshold. SVB and the other two banks (Silvergate Bank and Signature Bank), by comparison, had between 2 and 20% of their deposits covered by insurance. These banks are also on the smaller side. SVB had roughly $200 billion in assets compared to JPMorgan’s $3 trillion. Furthermore, SVB had made significant investments in mortgage-backed securities, which have greater interest rate exposure than most investments typically made by banks and are less liquid. Consequently, it was in a riskier position with regard to rate hikes and liquidity needs than a typical bank. Regulators have since rushed in to reassure depositors and the broader markets. SVB, Signature Bank, and Silvergate Bank, which primarily served crypto investors, have all been shut down. The Federal Reserve, Treasury, and FDIC have jointly announced that SVB and Signature Bank depositors will all have access to the full value of their deposits. The hope is that by insuring these deposits, they can reassure other customers of regional banks and prevent further fallout. As things presently stand, we believe this crisis will be short-lived and have minimal impact on markets in the long run. Regulatory agencies moved swiftly to contain the crisis, and markets have responded positively to their interventions. In the longer run, the outlook is potentially more positive. One important lesson to be learned from recent events is how impactful the Federal Reserve is and what the right move is going forward. While tighter monetary policy is needed to combat inflation, a steep path for rates has implications for the broader financial markets. Given the potential for widespread fallout, many economists believe the Fed will respond to recent events by slowly lowering its approach to rate hikes and pace. Markets have reacted positively to this possibility, with most major indices rebounding from early this morning. Of course, the most meaningful question is, what does this mean for Sherwood and our clients? First, we think it’s worth saying – don’t panic. The majority of banks remain we
ll-capitalized. However, it’s also worth remembering that the entire banking system and the economy is a communal endeavor built on our shared trust in the system. We are dependent on each other, and the success and stability of the system will be determined by how confident the public is in the safeguards put in place to protect the average consumer. As it stands, we believe those safeguards will work and that the system is still strong as a whole. In the longer term, we remain cautiously optimistic. Inflation continues to fall, albeit slowly, and while the possibility of a recession remains, we expect it will be shallow if it does occur and has largely been priced into markets. Furthermore, we continue to be confident in our value tilt. In the short-term, we expect growth stocks to experience a large bump because bank stocks are typically included in value indices, which are experiencing the most significant fallout. Looking forward, however, we believe value assets will continue to perform well as investors seek more stable cash flows. On the bond side, we continue to explore opportunities to add yield as fixed income looks more appealing from a risk-reward standpoint. As always, we encourage you to call us if the news is causing you unease. We’re more than happy to discuss these events and any other concerns you may have. We remain grateful for your trust and support and will continue to follow the situation as it evolves.