Wentz Weekly Insights
Interest Rate Concerns Turn to Contagion Fears with a Rush to Safe Haven Assets

It was expected to be a week focused on Federal Reserve Chairman Jerome Powell’s testimony to Congress on Tuesday and Wednesday as well as the employment report Friday morning, but all eyes quickly turned to the banking sector toward the end of the week after the 15th largest U.S. bank (by assets), SVB Financial – parent of Silicon Valley Bank, failed on Friday and was taken over by the FDIC over the weekend (as well as Signature Bank). The situation caused a broader selloff in stocks and a rush of money into safe haven assets like shorter term treasuries. For the week, stocks fell nearly 5% and back to levels where they started the year, while Treasury yields plummeted – the 2-year yield seeing the second largest two-day decline ever, falling a full percentage point to 4.10% while the 10-year yield fell 50 basis points to 3.50%.
First, Powell’s testimony provided a more detailed picture of the Chairman’s current assessment of the economy and the inflation picture. In a quick summary, Powell said policy rates may go higher, the Fed may get rates higher faster, and that rates may stay that high longer than what it previously expected. Powell talked about the much stronger than expected economic data from January, saying it reflects an unseasonably warm January, but even if you take out the warm weather, inflation is running higher than expected. Powell reiterated that history has warned us against prematurely loosening policy and reminded us the full effects of recent rate increases has yet to be felt. He emphasized the Fed’s next moves will depend on the “totality of the data” adding there is no preset course for policy or rate increases.
The comments were signifnact to the markets because it triggered a re-pricing of rate expectations; with futures market pricing showing investors see a 70% probability the Fed will raise rates 50 basis points (one basis points equals 1/100 of one percent, i.e. 0.01%), well higher than less than 20% probability prior to his testimony. This caused stocks to move lower and Treasury and bond yields to move higher, the yield most sensitive to Fed policy, the 2-year note, moved over 5% for the first time since 2007 and moved the 10-year yield back over 4%. The yield curve itself inverted further, with the spread between the two at 100 basis points, the most since 1981 (to understand what an ‘inverted yield curve’ means, refer back to this newsletter).
Then the employment report Friday showed more jobs were added to the economy in February than what was expected (the consensus was we would see a hotter reading), but investors took notice that the rate of wage growth decelerated, rising just 0.2% in the month and up 4.6% over the past 12 months, lower than expected and slowing from prior months pace. The unemployment rate increased, but a welcoming sign was more people entered the labor force. Markets were little moved by the new data.
What they were moved by on Friday though, was the collapse of Silicon Valley Bank (SVB). To understand how we got here it is important to understand SVB’s business. SVB is the 15th largest U.S. bank by assets and its customer base is highly concentrated in venture capital, start-up, and smaller technology companies (hence its name), all of which saw explosive growth during the pandemic years. Over the past year, these businesses (SVB’s customers) saw growth slow tremendously as the pandemic induced spending wore off and their own customers slowed spending on many of these technologies over worries of slower economic growth and to improve financials. As a result, these businesses were burning through cash, or looking for higher interest on their cash (via money market options) versus keeping them in deposits and earnings basically nothing, and this resulted in shrinking deposits at SVB.
Banks make money by taking in customer deposits, paying a small interest on these, and lending that money out to others at a higher interest rate. They keep a significant amount of funds in short term securities for liquidity. SVB actually kept its security portfolio in longer maturing investments than peers. That means as interest rates rise, the value of its portfolio fell more than if it were to hold shorter maturing securities. It also had very little in place to hedge against rising rates. To raise liquidity to support its deposits, it was forced to sell its +$20 billion securities portfolio for a $2 billion loss, and to cover the loss it attempted to sell more stock, which failed. It then looked to sell itself to another bank and again, received no interest. Its customers noticed and began withdrawing its deposits at a rapid rate, leading to the FDIC closing down the bank. It was the second largest bank failure in U.S. history and the largest since the Financial Crisis.
Over the weekend, the FDIC, Federal Reserve, and U.S. Treasury issued a joint statement announcing that it created a program that would make funding available that would insure all deposits (those that were insured under FDIC AND those that are uninsured) at these troubled banks. The concern is whether this is a idiosyncratic risk, where it is confined to just SVB and others like itself, or if this leads to contagion and is just the first domino to fall.
While it will not lead to a financial crisis like 2007-2009, it is a liquidity event and will have multiple lingering effects on the economy and markets. Banking and depositing your cash is about confidence, and if there is a lack of confidence that your money is safe in a bank, people are going to want their money out. Not only that, but banks are going to now tighten their credit standards, which means less business/lending activity and a further tightening in financial conditions. This could expose cracks in the economy and could very well lead to a further slowdown in economic activity.
How did the markets react? Volatility spiked, stocks fell dramatically, with banking stocks particularly down nearly 20%, and bond prices surged as yields fell (remember when rates fall, bond prices rise, and vice versa). There was a rush out of risk assets like stocks and junk bonds and into safe haven assets like short term Treasury securities which led the 2-year Treasury note’s yield dramatically lower by 100 bps to 4.10% (the rate most sensitive to Fed moves, suggesting a cut in rates later this year), the 10-year down 50 bps to 3.50%, and erased the expectation for any rate increase at the Fed’s meeting next week.
What will be most interesting is what we see out of next week’s Fed meeting – what will be policymakers’ new view on future rate moves (the updated summary of economic projections and “dot plot”) and Powell’s assessment of the situation and expectation for future moves. After moving its expectation for the first rate cut to 2024 over the past month, markets are now expected a rate cut in September this year. It was just Thursday that market’s expectation on the peak policy rate was 5.7%, but after SVB’s collapse that expectation fell to 5.1% which would equal just one more rate increase from current levels.

For now, markets will pay attention to the inflation reports this week (CPI Tuesday, PPI Wednesday, inflation expectations Friday) while trying to assess any contagion risks. The cracks we are beginning to see are all a consequence of the Fed’s attempt to kill inflation by raising interest rates at a very fast pace. This is one of the reasons we have been cautious over the past 12 months and why we remain cautious until the uncertainty subsides. Until then, we still favor value and income producing securities and don’t forget money market rates are nearing 5% and offer another safer place to park cash for the time being.

Week in Review:

U.S. stocks got off to a solid start to the week Monday morning with gains as much as 0.8% before fading into the close and finishing barely positive. The big underperformer was small caps with the Russell 2000 falling 1.5%. There was Fed speak over the weekend which included San Francisco’s Daly saying further policy tightening is needed as “disinflation momentum we need is far from certain.”
One of the big events for the week was Federal Reserve Chairman Powell’s semi-annual testimony to Congress and it turned out to be a market moving event based on his comments that were more hawkish that indicated a 50 basis point increase in rates is on the table for March 22, saying the Fed is prepared to speed up the pace of rate increases if warranted as stronger data from January is suggesting the ultimate level of rates will need to go higher than previously expected. Stocks and bonds moved lower as yields moved higher with a steepening of the yield curve as the inversion widened. In addition, the implied rate based on futures markets shows the chance of a 50 bps increase in March rose to nearly 70%, up from around 20% prior to the testimony. Stocks fell 1.53% while the 10-year yield hit 4.00% and 1-year hit 5.20%.
Data Wednesday morning showed ADP payrolls grew more than expected, job openings fell slightly but were still higher than expected, while trade data showed the US trade deficit was relatively unchanged in January, with exports and imports both increasing. Powell had his second day of testimony to Congress in which he reiterated much of what he said Tuesday but stressed the March 22 policy decision will depend on the “totality of the data” adding there is no preset course for policy and rates. Yields rose slightly on the short end while stocks were mixed with the S&P 500 up 0.14%.
Financials and banks, which had their worst day since the start of the pandemic, led a broader decline in stocks on Thursday after a tech and venture capital focused bank, SVB Financial – the parent of Silicon Valley Bank, announced it was selling its bond portfolio at a $1.8 billion loss and raising capital through a new stock offering to shore up liquidity. In addition, Silvergate Capital, a crypto focused bank, said it would begin winding down its operations and liquate by paying its depositors back, both leading markets to increase the risk of contagion. Bond yields fell substantially as investors moved to safe haven assets, while stocks fell across the board as the S&P 500 fell 1.85%. Elsewhere, President Biden released his budget proposal that called for higher spending and higher tax rates for billionaires, capital gains, and share buybacks, which will be dead-on-arrival in the Senate.
Two headlines Friday were the continued efforts of SVB Financial to raise capital, with it failing to raise capital and seeking a buyer to prevent insolvency, while the employment report for February showed more jobs added than expected, but wage growth that rose at a slower pace than expected. The issue with SVB pushed yields much lower – the Fed sensitive 2-year Treasury yield fell to 4.60% while the 10-year Treasury yield fell to 3.70%. Stocks closed the day down another 1.45%.
It was a very volatile week, with stocks falling and bond yields rising on concerns of higher rates, then stocks fell further while yields fell by the end of the week as investors pursued safer investments. Oil fell 3.8% over supply worries and banking fears. The yield curve remained inverted but flattened somewhat over the expectation of rate cuts toward the end of 2023 while the major U.S. stock indices finished as follows: Dow -4.44%, S&P 500 -4.55%, NASDAQ -4.71%, Russell 2000 -8.07%.

Recent Economic Data

  • Census Bureau data shows new orders for manufactured goods, also known as factory orders, declined 1.6% in January, down a little less than what was expected and follows a 1.7% increase from December. We knew the index for orders would be down because orders for durable goods, which we saw the week prior, showed a large decline and is an input to factory orders and GDP. The decline was due mostly to a drop in transportation equipment (aircraft, which is an extremely volatile category).
  • Trade data shows the U.S. trade deficit was $68.3 billion in January, relatively unchanged from the deficit levels from December. January exports rose $8.5 billion, or 3.4%, to $257.5 billion while imports rose $9.6 billion, or 3.0%, to $325.8 billion. Compared to a year ago, the deficit decreased $19.2 billion, or 22%, as exports picked up pace with a 13.3% increase as the global economy recovered while imports slowed to a 3.5% increase.
  • Consumer credit rose $14.8 billion in January, a little less than expected, with revolving credit increasing at an annual rate of 11.1%, while nonrevolving credit rose at an annual rate of 1.2%. Revolving credit (credit cards, line of credits, etc) is up about 15% over the past 12 months.
  • ADP said its data showed 242,000 new payrolls in the month of February, slightly ahead of consensus expectations of 200,000. Again, there was a decline in employment in small businesses, but another increase in mid and large sized businesses. In fact, small businesses have shed jobs every month since August last year. All industries saw gains except construction and professional services.
  • For the week ended March 4, there were 211,000 jobless claims, a rise of 21k from the prior week and the highest since December, but still very low levels. The four week average of initial jobless claims was 197,000, up just 4k from the prior week. The number of those continuing unemployment claims was 1.718 million, an increase of 69k from the prior week with the four-week average at 1.680 million.
  • The number of job openings on the last day of January was 10.824 million, down about 400k from the end of December, but again higher than what economists had estimated. All of the decline came from leisure and hospitality including bars/restaurants, but the category remains very high, with increases in job openings in professional services and trade (transportation, warehousing, etc). The number of separations was little changed while the number of quits fell about 200k to 3.9 million, still historically high (people confident they can find a better/higher paying job).
  • There were more jobs added in February than expected, but the unemployment rate rose and wages rose at a slower pace than expected which investors welcomed. The establishment survey showed nonfarm payrolls rose 311,000 in February, above the 220,000 expected, while the prior two months of payroll gains was revised down by a combined 34,000. Gains were widespread with the most jobs added in leisure and hospitality, retail, government, and health care, with declines in information and transportation/warehousing. The household survey showed people continue to re-enter the labor force, with the size of the labor force increasing 419k to 166.25 million, which helped move the labor force participation rate to 62.5%, up from 62.4% in January. The number of people employed rose 177k to 160.315 million, while the number unemployed actually rose 242k after months of declines, which caused the unemployment rate to rise to 3.6%, up from 3.4% in January. The underemployment rate (the U-6 rate), increased to 6.8% from 6.6%. Another item to take note of was the average workweek fell 0.1 hours to 34.5 hours, equating to less work or suggesting existing workers are not needed to work as long of days anymore due to the tighter market. The average wage increased just 0.2%, the slowest in months and lower than the 0.3% increase expected. Over the past 12 months, the average wage is up 4.6%, a little lower than the 4.7% rate that was expected.

Company News

  • Retailers have reported very mixed fourth quarter 2022 earnings results, but one standout was Dick’s Sporting Goods who’s report released last week beat sales and earnings expectations. Its comparable store sales growth was 5.3%, better than the 2.5% increase expected, saying it gained more market share in the quarter. Its guidance for comparable store sales and earnings forecast positive growth with both above analysts’ estimates. The strong business conditions allowed it to nearly double its dividend from $1.96 annually to $4.00 annually.
  • Tesla announced it will cut prices on two of its most expensive models in effort to spark demand. The price of the Model S will start at $89,990, down about 5%, while the Model X will start at $99,990, down about 9%. It was several weeks ago Tesla cut prices on other models to boost demand, which data showed was effective, and to be eligible for federal tax credits. Separately, Tesla is under investigate by regulators tied to an issue where its Model Y steering wheels can become detached.
  • The Department of Justice filed an antitrust lawsuit to block the JetBlue merger with Spirit, alleging the combination would be an adverse development for consumers by raising prices and eliminating competition. The compliant said “JetBlue plans to abandon Spirit’s business model, remove seats from Spirit’s planes, and charge Spirit’s customers higher prices. JetBlue’s plan would eliminate the unique competition that Spirit provides—and about half of all ultra-low-cost airline seats in the industry—and leave tens of millions of travelers to face higher fares and fewer options.”
  • The US Transportation Safety Board is opening a special investigation into the safety practices and culture at Norfolk Southern, this follows a string of derail incidents over the past several weeks. The investigation also comes right after a NS conductor was killed in Cleveland yesterday after being struck by a dump truck.
  • Bloomberg reported Uber is looking at a potential spinoff of its freight logistics unit as either a sale or as a separate publicly traded company. The move would be to further streamline its focus on its ride sharing and food delivery services.
  • Silvergate Capital, a leading crypto-focused bank, said it will begin winding down its operations and liquidate by paying all customers their deposits back, as well as considering how to resolve claims and preserve residual value of its assets. It was a week prior that it warned on its ability to continue as a going concern, key words associated with being close to bankruptcy.
  • Pfizer announced it would acquire global biotech company that focuses on cancer medicines, Seagen, for $229 per share, or approximately $43 billion in an all cash deal. The purchase represents a 33% premium to shares of Seagen prior to the announcement.

Other News

  • The inflation picture remains cloudy and the future path of inflation is even more uncertain. Price pressures on goods have eased as consumers shift spending to services over the past 18 months. Used car prices, however, have seen a rebound in prices lately. Used car prices, which were up nearly 40% over a 12 month period the first half of 2022, then fell 7% on a 12 month basis near the end of 2022. But the latest data for February shows used car prices were up 4.3% in the month, the largest monthly increase since 2009. Some are attributing the increase to one time factors like dealers building inventories ahead of the seasonally strong tax refund season, but there are concerns about the rebound in used car prices as they are now up 8% since November, adding to the surprise upside momentum we have seen in overall inflation so far this year.
  • Qin Gang, the new Chinese foreign minister and ex ambassador to the U.S., said relations with the U.S. have left a “rational path” and said “if the U.S. does not hit the brake” it will continue down the wrong path which could lead to conflict and confrontation. Gang reiterated China’s stance on Taiwan that it is an internal affair of China and it considers it part of Chinese territory.
  • President Biden released the White House’s budget proposal last week that included a wish list of tax increases and an increase in spending. The proposal calls for a 25% minimum tax on billionaires, doubling the capital gains tax rate to 39.6% from 20%, raising the tax on share buybacks to 4% from 1%, ending tax breaks for oil companies, PE funds, and real estate, and raising the corporate tax rate to 28% from 21%. Any proposal of the sort is expected to be dead-on-arrival in the Senate. The plan would generate $2 trillion in additional revenue that would be used to offset increased spending across the board.
  • Republicans are working to prepare how to prioritize payments in new legislation should Congress not be able to raise the debt limit in time. Separately, Moody’s chief economist said a failure to raise the debt limit could cripple the US economy quickly.
  • Several Senators introduced a new bill called the Restrict Act last week that would set rules for foreign technology companies and would give the Secretary of Commerce the authority to ban certain services, which would allow the Secretary to ban TikTok, but which the Biden Administration says is for more than just TikTok. The proposal is receiving approval by both Republicans and Democrats.
  • Fed updates:
  • Jerome Powell, in his prepared remarks for his semi-annual testimony to Congress said policy rates may go higher, the Fed may get there faster, and the rate may stay that high longer than what it previously expected as the data has recently indicated. Powell repeated that history has warned us against prematurely loosening policy, as the full effects of tightening have yet to be felt. Regarding the strong economic data seen in January, Powell said it partly reversed the softening trends seen at the end of 2022, but likely reflects unseasonably warm month of January, however at the same time, even if you take out the warm weather in January, it tells us inflation is running higher than expected. There is still little sign of disinflation in services, particularly in the index of core services excluding housing, which is what the Fed has focused on more recently. Regarding the labor market, it remains tight and wages are still above level consistent with Fed’s 2% inflation target which consumer spending continues to rise at a solid pace. In the second day of testimony, Powell stressed his previous message, but did emphasize the March 22 policy decision depends on the “totality of the data” between now and then, adding that there is no preset course for policy and no decision has been made yet but “the ultimate level of interest rates is likely to be higher than previously anticipated.”
  • Richmond Fed President Barkin said on Friday in an interview with the Financial Times that he is still concerned about inflation being too elevated. This occurred even after the SVB bank failure, and is likely the last public comment from a Fed official before the next FOMC meeting March 22.

WFG News

Updates on 2022 Tax Documents

Please note tax documents will not start mailing until January 31. Most retirement accounts will see 1099-R and form 5498 mailed on January 31. Retail accounts will see 1099 and related documents mailed by February 15. Certain accounts with more complex securities may have 1099’s mailed as late as March 15. Please see this email for more details. If there are any questions on tax documents, please reach out to us at 330-650-2700.

Regarding Market Conditions

We understand the volatility in the markets and headlines you see regarding the banking sector may be concerning. We expect further weakness in the markets in the weeks and months ahead as investors digest the collapse of SVB and Signature Bank and the lingering effects on the economy/markets, but do not expect this to lead to a financial crisis or a similar event. However, an event like this will lead to further uncertainty and will have substantial effect on sentiment. We are working diligently to analyze all client portfolios and assessing ways to reduce risks and/or find opportunities. As always and particularly in instances such as this, it is important to not lose sight of your longer-term financial objectives.
If you have any questions or concerns in the meantime, please do not hesitate to reach out.

The Week Ahead

Investors are going to have a lot going on this week with focus on the banking sector and contagion risks after the failure of SVB, but also the wave of economic data this week and the now substantial uncertainty around the Federal Reserve’s next moves and beyond. New inflation data will be released this week with the consumer price index on Tuesday, producer price index on Wednesday, import & export prices on Thursday, and consumer expectations from the consumer sentiment survey on Friday. Other notable data releases include retail sales for February, expected to have fallen 0.3% in the month after rising a much larger than expected 3.0% in January, several housing indicators including the housing market index on Wednesday and housing starts and permits for February on Thursday, new data on the manufacturing sector from the Empire State and Philly Fed manufacturing activity surveys as well as industrial production on Friday, and weekly jobless claims on Thursday. Earnings reports are light with results expected from Lennar, Adobe, Five Below, Dollar General, Signet Jewelers, and FedEx. There are several notable brokerage conferences this week that could bring guidance updates from individual companies as well as investor and analyst day events. Federal Reserve policymakers will go into a quiet period before the FOMC meeting March 22. Also, quadruple witching will occur Friday, when four major options expire, which typically leads to significantly higher volume as traders close positions.