Special Market Update - Silicon Valley Bank

Over the past several days there have been significant developments in the financial sector that warrant a direct response from your team at Clearwater Capital Partners.  This morning we convened a full session of our Investment Policy Committee, and we offer this multi-layered response to recent events.  Below we organize our commentary according to three important questions:

Are the Current Banking Problems Symptomatic, or Systemic?

Last week we saw a surge of banking issues involving Silicon Valley Bank (SIVB) and other regional institutions.  In the case of SIVB, the problems were the result of losses suffered in the bank’s investment securities over the past two years.  This led to an unprecedented cascading effect of confidence and deposit withdrawals.

The Silicon Valley Bank collapse marks the worst bank failure since Great Recession as it was the 16th largest bank in the United States.  SIVB depositors pulled out as much as $42 billion on a single day, rendering it insolvent.

The crucial understanding to this situation is that we are witnessing a liquidity crisis, not a credit crisis.  Banking reforms following the Global Financial Crisis have greatly strengthened the U.S. banking system.  While U.S. bank Tier 1 capital ratios, wholesale funding ratios and loan to deposit ratios improved substantially for many US banks since 2008, there are exceptions. 

SIVB was one such exception and represents a unique situation in that the bank was a tech focused bank with a high level of loans plus securities as a percentage of deposits, and very low reliance on stickier retail deposits as a share of its total deposit base.  The bank also had an unusually high degree of longer-term bonds within its bond portfolio.  In other words, the bank was somewhat unique in terms of its business mix and the duration risk its management team opted to build.

Stated very simply, SIVB carved out a distinct and riskier niche when compared to other banks.  When capital shortfalls and liquidity concerns began to swell last week, the bank experienced remarkable deposit outflows and forced asset sales.  Regulators acted swiftly to shut down the bank for inadequate liquidity and insolvency.

Late on Sunday, U.S. regulators adopted policies that effectively guaranteed depositors and the risk of “bank run” contagion appears to have dissipated as the markets digest the highly dynamic headlines related to this liquidity situation.  Treasury Secretary Janet Yellen said Sunday that the federal government will act swiftly to meet the "needs" of depositors who were at risk of losing millions after the bank collapsed last week.

It is important to note that the government’s actions do not represent a bailout of SIVB’s shareholders or bank management.  These actions do, however, underscore the determination of regulators to prevent SIVB’s liquidity problems spilling over into a broader “bank run” on deposits elsewhere.

Accordingly, we do not believe the SIVB crisis indicates a systemic risk for the financial sector.  Rather, we see these developments as symptomatic of a long series of policy missteps.  Regulators have kept interest rates abnormally low for a period of at least 15 years which, in turn, created unsustainable conditions in capital markets – most notably a “bubble” relative to bond prices. 

When inflation failed to live up to “transitory” expectations, regulators responded with an exceptionally aggressive monetary policy response in which interest rates rose quite rapidly and the era of free money came to an abrupt end.  Because of the inverse relationship to interest rates, longer duration bond prices have plummeted.    

This is a clear demonstration of the varied and lagged effect of tighter monetary conditions we have written so much about on our analysis and commentary over many months.  While there could be continued volatility within the financial sector in the days and weeks ahead, we regard what we are observing today as symptomatic of policy excesses and not a fundamental collapse of our banking system. 

Why is Charles Schwab’s Stock Declining?

The value of Charles Schwab’s stock price has fallen nearly 35% in the last several weeks.  It is believed that the pressures currently impacting regional banks (described above) largely explain the recent weakness.  Although Schwab is best known for its brokerage and investing services, the company also offers banking and lending services to its customers.  It also derives meaningful earnings from its money market operations.  As investors reallocate cash from these lower yielding money market instruments to higher yielding opportunities, it is believed Charles Schwab earnings could suffer as a result. 

Schwab put out a statement Monday morning reassuring investors of its financial strength and emphasizing the company’s diversified business mix.  The company also observed that it has “capital well in excess of regulatory requirements,  a high quality and relatively small loan book, and a conservative investment portfolio that is 80% comprised of securities backed by the U.S. Treasury and various government agencies.”

The Charles Schwab statement can be viewed by clicking the link below:

Charles Schwab’s Perspective on Recent Industry Events

We at Clearwater Capital know of no material similarities between the operating model of Charles Schwab and the regional banks currently experiencing liquidity challenges.  Accordingly, we have no reason to believe our utilization of Charles Schwab as the custodian broker/dealer for some of our firm’s clients would be problematic.  Various Wall Street analysts have released updates to their ratings of the company and remain bullish on the company.  

It is worth noting that along with the protection provided by Securities Investor Protection Corporation (SIPC), Schwab has insurance coverage with Lloyd's of London and other London insurers that provides protection of client securities and cash up to an aggregate of $600 million and is limited to a combined return to any customer from a Trustee, SIPC, and London insurers of $150 million, including cash of up to $1,150,000.

In keeping with our independence as a Registered Investment Advisor and our fiduciary duties, we will continue to monitor all developments and promptly report and findings that could be cause for concern.

What are the Implications of Recent Developments to Clearwater Capital’s Outlook?

The current liquidity crisis in the regional banking sector is not likely to produce a major shift to the trajectory of the U.S. economy.  The circumstances currently surrounding SIVB and other regional banks are nothing like those that caused the meltdown in the banking system in 2008-2009. 

Our base case calls for continued deceleration of economic activity in the U.S as regulators pursue tighter financial conditions in their fight to bring the rate of inflation down to their target level of 2%.  This will likely require a “higher for longer” environment for interest rates with no expectation for a “Fed pivot” coming in 2023.  This perspective was only underscored by Fed Chair Powell’s recent hawkish testimony to Congress.   

While we believe the Federal Reserve remains deeply entrenched in their battle to bring historic rates of inflation under control, it is entirely possible the Fed will choose to not make any changes to the Fed Funds rate at their March meeting given the current instability in the financial sector.  This said, the prospects for a 50 hike to the Fed Funds rate at the March meeting would certainly seem to be off the table.

Beyond the March meeting, we fully expect the Fed will continue to tighten financial conditions.  The rate of inflation remains stubbornly high and we must believe the Fed when it proclaims “they have more work to do.”

Last week U.S. equities had their worst week since September (S&P 500 -4.6%).  All sectors were down with banks the biggest decliners due to the SIVB financial failure.  While Treasuries rallied across the curve (two-year yields recording their largest two-day move since 9/11), the Treasury yield curve recently moved deeper into inverted territory (more than 100 basis points for the first time since September 1981). 

We would observe that a recession has followed seven of the last nine tightening cycles and have started, on average, 14 months following an inversion of the yield curve.  This said, the fixed income market is currently 11 months into this yield curve inversion (Crossmark Global Investments).

Our near-term outlook is decidedly cautious with the view that risks will likely be asymmetrical to the downside until such time as investors perceive a sustainable shift in monetary policy.  Accordingly, we believe volatility will remain elevated over the near to intermediate term, with the possibility equity markets could experience lower lows before a meaningful bull market cycle begins.

Over the past couple of years, we have taken our strategies into a more defensive posture.  Still, we are maintaining our core equity exposure because we believe any attempt to time the market would be ill-advised.  Our view is the looming recession will be, relatively speaking, short and shallow and on the other side of all of this a new bull market cycle will develop.  History teaches the early rallies in a new bull market can be exceptionally strong and it is our intention to be properly positioned for when this shift occurs.

We wish to again acknowledge that these are difficult times.  The distortions coming from many years of easy monetary policies and the unprecedented government response to the global pandemic are real.  Forecasting economic trends and expected returns from portfolio strategies has never been more difficult.  In accordance with our portfolio disciplines, we will remain in a relatively defensive posture until the data begins to suggest a recovery is beginning to form.

Please do not hesitate to contact us with questions or concerns you may have.  As always, thank you for your continued confidence in Clearwater Capital Partners.

John E. Chapman

Chief Executive Office

Chief Investment Strategist

March 13, 2023