Should you fear a prolonged recession?
Introduction
2023 started off quite well, with stocks and bonds rallying for several weeks.
Given what transpired last year, this was great news. Unfortunately, the euphoria was short lived.
Late last week, the world was rocked by the biggest banking failure since 2008. In parallel, experts keep warning about a prolonged recession in the U.S. And, as if all of this wasn’t enough, our upcoming transition of client accounts to Charles Schwab is happening in the midst of a banking liquidity crisis and economic downturn.
1. Will SVB’s collapse spread to the entire U.S. banking sector?
2. Should you fear a prolonged recession?
3. Is Charles Schwab a trustworthy custodian?
As always, we do not claim to have definitive answers to all of the issues at hand. We aim to put our years of experience at your disposal to help you navigate these troubled times and prepare for the next cycle.
We hope you enjoy our commentary.
1. It’s ‘Only’ a Liquidity Crisis…
The recent collapse of Silicon Valley Bank (SVB) sent shockwaves through the financial world, causing a retreat in stocks and raising concerns about the overall stability of the US banking sector.
While last week was very difficult for bank stockholders, the US banking system is unlikely to collapse.
In fact, SVB was not the only bank in crisis: crypto-focused Signature Bank was shut down by regulators, while California-based First Republic bank managed to obtain additional liquidity from The Federal Reserve and JP Morgan.
However, unlike the solvency crisis that rocked the financial sector in 2008, this is a more traditional liquidity crisis reminiscent of The Great Depression: too many depositors demanded cash at once, and SVB simply did not have sufficient funds to meet this demand.
Despite the magnitude of SVB’s collapse, it does not pose a systemic risk to the rest of the banking sector or to the economy.
SVB suffered from poor risk management and a very unfavorable macro climate.
Indeed, the Federal Reserve stepped in to ensure that customers will have access to their deposits, and there are no indications that the SVB’s troubles will spill over to other financial institutions.
The blunt reality is that SVB made poor investment decisions: the investment team effectively overexposed the bank to long-duration bonds and failed to preemptively sell off their position before and during the Federal Reserve’s interest rate increases.
As a result, SVB was forced to sell off large chunks of its bond portfolio at a major loss to meet withdrawal demand. At a certain point, the bank simply could not raise enough cash to pay out its depositors.
Thankfully, most U.S. banks balance their investment portfolios much more responsibly.
Nonetheless, the closure of SVB serves as a stark reminder of the importance of maintaining stable and diversified financial systems. Banks that focus too narrowly on a single sector or customer base are vulnerable to sudden shocks and can cause significant disruptions if they fail.
What’s more, the collapse also showcases the importance of diversifying your investments to avoid being overexposed to a single source of risk.
In response to this crisis, the Federal Reserve created the Bank Term Funding Program. This facility offers loans of up to one year to banks that pledge U.S. Treasury securities, mortgage-backed securities, and other collateral at par in exchange for cash.
In effect, banks will be able to access liquidity without incurring the real losses that result from being forced to sell government bonds and mortgage-backed securities at a loss. While these assets are theoretically “low-risk” due to their low credit risks, they are exposed to significant interest rate risk.
Indeed, bond prices move in the opposite direction to interest rates. When interest rates go up, bond prices go down. The longer the bond duration, the sharper the decline.
The Federal Reserve’s new Bank Term Funding Program should prevent future SVB-like liquidity crises.
The Federal Reserve’s new facility will limit the risk of future bank runs.
As the financial sector continues to evolve, regulators must remain vigilant in monitoring potential risks and taking proactive steps to mitigate them before they become systemic.
2. Is a Recession Looming?
Since 2022, the word "recession" seems to be popping up everywhere in the news, causing concern among investors, business owners and households across America. The Federal Reserve's unprecedented rate hikes have cooled the economy and put a sudden stop to the decade-long bull run in stocks, bonds, Private Equity, and other speculative investments.
The Federal Reserve’s rapid rate hikes have had profound impacts on the stock market and the economy.
However, the Fed may be close to the end of its tightening cycle, with peak interest rates expected to reach 5%. Interest rates could even start to decline as early as Q3 2023.
Experts believe interest rates will peak at 5%, stabilize then decrease starting in Q3 2023.
Whether we reach this peak depends largely on inflation, the biggest drivers of which are supply chain disruptions, imbalances in the labor market, and the global energy crisis. If inflation remains higher than expected, the Fed will continue raising rates for longer than anticipated. In turn, this would extend the economic slowdown and could cause an outright recession.
Despite its immediate and painful effects, recessions can be healthy. They act as a corrective force that blows out speculative excesses and sobers up the "get rich quick" crowd. During hard times, investors and businesses focus on fundamentals and current cash-flows, rather than hype and promises of future profits.
In the long run, a recession can help create a more stable and sustainable economy.
A recession is part and parcel of the business cycle – the question is how long will it last?
It's important to keep in mind that the current economic situation is not necessarily indicative of a full-blown recession. In fact, we may be experiencing a cyclical slowdown or a natural correction in the market. Nonetheless, businesses and investors must be cautious and prepare for potential economic downturns by building up cash reserves, reducing debt, and diversifying their portfolios.
While the current correction is uncomfortable, investors must remember that the S&P 500 more than doubled over the past 10 years.
In conclusion, while the current economic climate may be cause for concern, it's important to keep a long-term perspective. The Fed's tightening cycle is nearing its peak, but the ultimate outcome will depend on factors such as inflation and labor supply.
3. Why Charles Schwab?
We have decided to transition our clients' assets over from TD Ameritrade to Charles Schwab. This decision is the result of internal consensus, comprehensive risk analysis, and thorough due diligence.
Charles Schwab has over 30 years of experience as a custodian for more than 13,000 independent wealth managers. With more than $7.4 trillion of investors’ assets held in custody and $3 trillion of Assets under Management, Charles Schwab is the 8th largest U.S. bank by assets, and one of the largest asset managers in the world.
Also, since Charles Schwab acquired TD Ameritrade in 2020, this transition makes even more sense.
However, recent news has caused concerns about Schwab's stability as a custodian, leading to fears of a banking crisis and a sharp decline in Schwab's stock price.
Despite a sharp decline in its stock price, Charles Schwab’s stock has performed strongly over the past decade.
It is undeniable that Charles Schwab is a major player in the global financial industry. However, with only six months left before we transition our client accounts over to Charles Schwab, questions are beginning to swirl around the health of our new planned custodian.
Despite these concerns, Schwab has reassured investors by noting that more than 80% of its deposits are insured by the US government and that they have access to significant liquidity.
In a recent statement, the firm’s CEO stated that "Schwab has a broad base of high-quality customers across multiple lines of business, 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”.
We remain confident in Schwab as a partner and custodian for our clients' assets. We have carefully evaluated their financial stability and commitment to their clients, and believe they are a strong and reliable choice for the long-term security of your assets.
Of course, we will continue to monitor Schwab's financial performance and take proactive measures to ensure the safety and security of your assets. We understand the importance of trust and transparency in the financial industry, and we are committed to upholding the highest standards of ethical and responsible conduct.
In conclusion, while recent news may have caused concerns about Schwab's stability, we remain confident in our decision to transition our clients' assets to this custodian. Schwab's reassurances regarding deposit insurance and liquidity provide added protection for our clients' assets, and we will continue to monitor their financial performance to ensure the long-term security of your investments.
The Takeaways
Last week’s events are a painful reminder that the turbulent macro conditions are not yet behind us. We expect continued volatility until the Federal Reserve reverses course and macroeconomic conditions stabilize.
However, no matter what the current market conditions or future outlook may be, healthy balance and diversification in your portfolio are critical to long-term success.
If reading the news provokes anxiety or stress, we suggest disconnecting and spending some much deserved time with family and friends. Keep in mind that stock market investing is a long-term commitment, and history proves that staying invested is always the best option. Please call us if you have any questions or concerns.
Anders Storvik
Client Advisor-Partner
*Brent Forrest & Associates, LLC dba Wela Financial Advisory( Wela) is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies .Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.
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