Quarterly Review and Outlook – 1st Quarter 2023

Written by Clay McDaniel, CFA & John B. Cox, CFA, CAIA on April 3, 2023

Quarterly Review and Outlook – 1st Quarter 2023


Prior to the banking stress in March, the US economy was still running too hot. Not crazy hot, but hot enough to imply that higher interest rates may need to remain elevated for a while. This was already broadly reflected in securities prices, and we entered the year reasonably optimistic about the return outlook for many areas of the market.


Bank failures in this context are a curious thing. They typically cluster in a cooling economy for obvious reasons—less growth means less cash flow to pay debts. This was not the problem here. Two of the failures—Signature Bank and Silvergate Capital—were related to cryptocurrency while the largest of the three—Silicon Valley Bank (SVB)—held only 10% of its assets in risky loans. The central problem at these banks was mostly bad judgement and had little to do with the real economy.


Maybe the government overreacted, but we cannot run the experiment again to find out. Bank runs happen fast, especially now with banking apps on every smart phone. Heading into that fateful week, SVB held around $175 billion in deposits. Customers wired out $42 billion on Thursday, and another $100 billion was scheduled to leave on Friday before the government stepped in. Nearly the entire deposit base was at risk of exiting in under 48 hours.


Recent statements from policymakers imply that all depositors are safe, though current law distinguishes between small banks and larger but ambiguously-defined “systemic” banks. It is admittedly hard to see how any depositor losses will be tolerated when one of the largest beneficiaries of the SVB backstop was Circle, a cryptocurrency firm. But implicit guarantees are not guarantees. Until Congress bridges the gap, depositors should pay close attention to the size of cash balances held at small banks.


It seems likely that banks will tighten lending standards given how quickly deposits fled SVB. From a macro standpoint, this could be seen as a blessing in disguise. The Fed primarily uses one blunt tool to rein in money creation. Tighter credit conditions may substitute for still higher interest rates. A bank crisis might not be the ideal way to slow down a hot economy, but it could do the trick.


On the other hand, small banks are actually not that small in total. They originate about a third of all commercial and industrial loans in the US, and about half of all real estate loans. They have the relationships needed to make loans to small businesses everywhere. A sudden throttling back in these areas could be self-reinforcing as less capital is available to refinance loans already on the books.


The irony is that while small businesses could face additional headwinds, the most obvious beneficiary is the technology sector. These companies rely less on bank lending and saw valuations tumble last year because of higher interest rates. They would welcome lower rates, especially when the cost of slowing down growth is born by others. Venture capital struck the match, begged the government to put out the fire, and now rises from the ashes.


The overall market outlook is not that different than before. The Fed can adjust monetary policy to offset the impact of tighter lending standards. The actions they took in March demonstrate they are focused on the risks to financial stability that inevitably spring from aggressive monetary tightening. Household balance sheets are healthy, wage growth is around normal again, and government investment is only now ramping up from the various bills passed over the last few years.


Since the onset of banking stress in March, the technology-heavy Nasdaq Index has rallied, while the Real Estate Index is down. Large companies have outperformed small companies, especially among banks. These trends could continue if additional cracks form in the banking system or credit markets.


Market valuations are not excessive, and tighter bank credit favors large over small, good balance sheet over bad. That describes companies in the S&P 500. The cap-weighted index is concentrated, so we like diversification into inexpensive areas like energy and industrials that have a low weighting in the index. Many small companies are too cheap to ignore, and we prefer managers that focus on earnings quality and balance sheet strength.


Now is a good time to be a lender. Yields on cash and short-term bonds are unusually high. We are overweight. These yields could fall quickly, so we are also focused on areas where it makes sense to lock in longer-term cash flows. For instance, asset-based lending strategies in private markets offer an attractive multi-year return profile while aiming to protect capital during either a recession or high and rising inflation.


Exceptional returns require investing through the fog of uncertainty. We believe that by embracing all the tools available, we can create resilient portfolios that are in a strong position to take advantage of opportunities during periods like today.


Clay McDaniel, CFA 

Chief Investment Officer

Private Markets  

John B. Cox, CFA, CAIA

Chief Investment Officer

Public Markets


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