Hello, I’m Lisa Shalett, Chief Investment Officer of Morgan Stanley Wealth Management, and today is Wednesday, March 15, and I am recording this as a response to the historic events of the past week and the resulting market volatility. In addition, I want to walk you through some of the implications for portfolio construction advice going forward.
So, what’s happened?
Silicon Valley Bank (SVB), one of the country’s 20 largest banks as of early March, experienced a classic “run on the bank” where depositors attempted significant withdrawals of account balances. This resulted in the FDIC shuttering and taking over Silicon Valley Bank on Friday, March 10.
Concerns about the bank’s liquidity and solvency were originally signaled by management earlier in the week when they announced they were contemplating a dilutive equity issuance to access more capital. This catalyzed a loss of faith among depositors that was exacerbated by the unique inter-relatedness of Silicon Valley Bank’s client base, which consisted primarily of major venture capital and private equity firms and the portfolio companies of tech start-ups that they owned.
It’s worth noting that Silicon Valley Bank was uniquely vulnerable in the current environment for a number of reasons, including how relatively non-diversified its depositors were, and how its account balances were mostly of operating cash, and thus were in continual drawdown mode, not to mention only 7% of the accounts were fully insured by the FDIC [Federal Deposit Insurance Corporation] as defined by the $250,000 threshold. The bank’s vulnerability was an issue that MS & Co. [Morgan Stanley] research analysts identified this past December with their “Underperform” rating.
Now let’s take a minute and consider some of the policy responses to all of this.
First, how did the government and the Federal Reserve respond?
By Sunday night, March 12, the FDIC had agreed to guarantee 100% of all depositor funds, supporting jobs, payrolls and the continuity of these companies as going concerns.
The Fed, for its part, issued a new loan program, called the Bank Term Funding Program, which allows banks and other depository institutions to pledge U.S. Treasuries, agency mortgage-backed securities, and other qualifying assets—at par value—in exchange for a loan with maturities of up to one year. This liquidity source essentially eliminates the need for banks to sell high-quality securities at a loss to meet deposit withdrawal shortfalls. This is a large policy bazooka and should prevent contagion to other banks.
Another issue is that regulators at the Fed have had to admit that oversight of Silicon Valley Bank likely was lighter than ideal because of the 2018 rollback of Dodd-Frank rules, an issue that will likely get revisited by Congress.
Now, how have the markets responded?
The most dramatic market action has been in the U.S. Treasury market, where bonds have rallied aggressively in a risk-off trade, with many suggesting that the Fed could no longer keep raising rates. Consider that since last week, the 2-year Treasury yield has fell from over 5% to close to 4%, before settling at Tuesday’s close of 4.22%. Ten-year yields, the most important for stock valuations, fell from over 4% to around 3.66% as of Tuesday’s close. These dynamics led to a steepening of the 2s/10s curve, something that is typically associated with impending recessions.
Most provocatively, Fed Funds futures priced a new expectation that the Fed would no longer hike toward a terminal rate between 5.5% and 5.75%, which had been discounted only a week ago at [Fed Chair Jerome] Powell’s congressional testimony. But today it has fallen to around 4.9%. That’s close to the level it hit around the October 2022 stock-market low. Further, the bond market is discounting as many as three to four cuts now by next January.
For equities, the S&P 500 has gained about 1.5% since last Friday, but with investors rotating toward a mix of sectors. As you probably saw, investors have pounded the financial services sector, “throwing out the baby with the bath water,” with many regional bank ETFs [exchange-traded funds] and broader bank ETFs down 15 to 30% just in the last 3 days.
Embedded in the financial-sector selloff are investor fears around contagion; a flatter yield curve; lower net interest margins; higher costs of deposits; capital flight to the largest, most well-capitalized banks; lower loan growth and potential asset impairments.
But for the most part, these fears are not well founded. We believe most banks are well prepared to weather a recession if one comes. The issue is very different than in 2008. This is not about systemically bad credit. This is about a mark-to-market risk that some banks face from rising interest rates if they hold interest-sensitive instruments on the asset side of their balance sheet. Most banks know how to manage this.
And so, with all that said, what should we be thinking about as we look ahead?
First, regarding the Fed’s policy path, it looks like the Fed is increasingly between a rock and a hard place, having to trade off market stability risk for credibility on inflation. This is not a good set of choices, but the problems with SVB are partially of the Fed’s own making.
Despite market enthusiasm for the Fed to pause its rate-hiking campaign, the data on inflation suggests that would be a very bad idea. Tuesday’s CPI [consumer price index] report in fact revealed that headline inflation came down as expected but revealed core inflation that was worse than hoped—and is still running at 5.5% year over year. Critically, services inflation accelerated in the month and has not yet peaked, arguing that excess demand in the economy is still visible.
Considering that, we expect the Fed will in fact raise 25 bps [basis points] next week and continue to signal that they are data-driven and thus, not necessarily done.
As for the economy, the Silicon Valley Bank crisis may be a canary in the coalmine. We believe that odds of a recession, rather than a soft landing, have now increased. Consumer psychology is a fragile thing, and bank runs can be very anxiety-producing. Should conservatism be the response of the banks to this crisis, then slower lending, less risk-taking and weaker access to capital could hasten the cash-burn process and insolvency of unprofitable start-ups. It could also lead to consumption pulling back and savings rising, while the labor market could begin to show signs of cracking.
Finally, as for the investment implications, the GIC remains highly convicted that 2023 consensus earnings estimates for the S&P 500 remain too high. While interest rates have pulled back and thus, stock valuations relative to bonds have improved a bit, absolute price/earnings ratios are too high, at nearly 18x on consensus forward earnings estimates of $220/share versus our forecast of $195.
In U.S. stocks, we continue to focus on quality yield, growth at a reasonable price, and earnings achievability—attributes that we are finding today among healthcare companies, select semiconductors and software makers, financials, energy and materials and miners.
With yield curves bear-flattening, we are more open to taking some duration risk and are leaning more towards the benchmark given our forecast of the coming equity market volatility. Real assets like gold remain a decent hedge for a recession or stagflationary scenario.
Thanks as always for listening, and if you have any questions about what’s been going on, or want more details about our views on the economy and portfolio and investment strategies, please reach out to your Morgan Stanley Financial Advisor.
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Asset Class Risk Considerations
Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.
Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.
Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market. Investors should be careful to consider these risks alongside their individual circumstances, objectives and risk tolerance before investing in high-yield bonds. High yield bonds should comprise only a limited portion of a balanced portfolio.
Treasury Inflation Protection Securities’ (TIPS) coupon payments and underlying principal are automatically increased to compensate for inflation by tracking the consumer price index (CPI). While the real rate of return is guaranteed, TIPS tend to offer a low return. Because the return of TIPS is linked to inflation, TIPS may significantly underperform versus conventional U.S. Treasuries in times of low inflation.
The majority of $25 and $1000 par preferred securities are “callable” meaning that the issuer may retire the securities at specific prices and dates prior to maturity. Interest/dividend payments on certain preferred issues may be deferred by the issuer for periods of up to 5 to 10 years, depending on the particular issue. The investor would still have income tax liability even though payments would not have been received. Price quoted is per $25 or $1,000 share, unless otherwise specified. Current yield is calculated by multiplying the coupon by par value divided by the market price.
Some $25 or $1000 par preferred securities are QDI (Qualified Dividend Income) eligible. Information on QDI eligibility is obtained from third party sources. The dividend income on QDI eligible preferreds qualifies for a reduced tax rate. Many traditional ‘dividend paying’ perpetual preferred securities (traditional preferreds with no maturity date) are QDI eligible. In order to qualify for the preferential tax treatment all qualifying preferred securities must be held by investors for a minimum period – 91 days during a 180 day window period, beginning 90 days before the ex-dividend date.
Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision.
Duration, the most commonly used measure of bond risk, quantifies the effect of changes in interest rates on the price of a bond or bond portfolio. The longer the duration, the more sensitive the bond or portfolio would be to changes in interest rates. Generally, if interest rates rise, bond prices fall and vice versa. Longer-term bonds carry a longer or higher duration than shorter-term bonds; as such, they would be affected by changing interest rates for a greater period of time if interest rates were to increase. Consequently, the price of a long-term bond would drop significantly as compared to the price of a short-term bond.
Principal is returned on a monthly basis over the life of a mortgage-backed security. Principal prepayment can significantly affect the monthly income stream and the maturity of any type of MBS, including standard MBS, CMOs and Lottery Bonds. Yields and average lives are estimated based on prepayment assumptions and are subject to change based on actual prepayment of the mortgages in the underlying pools. The level of predictability of an MBS/CMO’s average life, and its market price, depends on the type of MBS/CMO class purchased and interest rate movements. In general, as interest rates fall, prepayment speeds are likely to increase, thus shortening the MBS/CMO’s average life and likely causing its market price to rise. Conversely, as interest rates rise, prepayment speeds are likely to decrease, thus lengthening average life and likely causing the MBS/CMO’s market price to fall. Some MBS/CMOs may have “original issue discount” (OID). OID occurs if the MBS/CMO’s original issue price is below its stated redemption price at maturity, and results in “imputed interest” that must be reported annually for tax purposes, resulting in a tax liability even though interest was not received. Investors are urged to consult their tax advisors for more information.
Physical precious metals are non-regulated products. Precious metals are speculative investments, which may experience short-term and long-term price volatility. The value of precious metals investments may fluctuate and may appreciate or decline, depending on market conditions. If sold in a declining market, the price you receive may be less than your original investment. Unlike bonds and stocks, precious metals do not make interest or dividend payments. Therefore, precious metals may not be appropriate for investors who require current income. Precious metals are commodities that should be safely stored, which may impose additional costs on the investor. The Securities Investor Protection Corporation (“SIPC”) provides certain protection for customers’ cash and securities in the event of a brokerage firm’s bankruptcy, other financial difficulties, or if customers’ assets are missing. SIPC insurance does not apply to precious metals or other commodities.
An investment in an exchange-traded fund involves risks similar to those of investing in a broadly based portfolio of equity securities traded on an exchange in the relevant securities market, such as market fluctuations caused by such factors as economic and political developments, changes in interest rates and perceived trends in stock and bond prices. Investing in an international ETF also involves certain risks and considerations not typically associated with investing in an ETF that invests in the securities of U.S. issues, such as political, currency, economic and market risks. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economics. ETFs investing in physical commodities and commodity or currency futures have special tax considerations. Physical commodities may be treated as collectibles subject to a maximum 28% long-term capital gains rates, while futures are marked-to-market and may be subject to a blended 60% long- and 40% short-term capital gains tax rate. Rolling futures positions may create taxable events. For specifics and a greater explanation of possible risks with ETFs¸ along with the ETF’s investment objectives, charges and expenses, please consult a copy of the ETF’s prospectus. Investing in sectors may be more volatile than diversifying across many industries. The investment return and principal value of ETF investments will fluctuate, so an investor’s ETF shares (Creation Units), if or when sold, may be worth more or less than the original cost. ETFs are redeemable only in Creation Unit size through an Authorized Participant and are not individually redeemable from an ETF.
Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. Technology stocks may be especially volatile. Risks applicable to companies in the energy and natural resources sectors include commodity pricing risk, supply and demand risk, depletion risk and exploration risk. Health care sector stocks are subject to government regulation, as well as government approval of products and services, which can significantly impact price and availability, and which can also be significantly affected by rapid obsolescence and patent expirations.
The returns on a portfolio consisting primarily of environmental, social, and governance-aware investments (ESG) may be lower or higher than a portfolio that is more diversified or where decisions are based solely on investment considerations. Because ESG criteria exclude some investments, investors may not be able to take advantage of the same opportunities or market trends as investors that do not use such criteria.
Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.
Growth investing does not guarantee a profit or eliminate risk. The stocks of these companies can have relatively high valuations. Because of these high valuations, an investment in a growth stock can be more risky than an investment in a company with more modest growth expectations.
Value investing does not guarantee a profit or eliminate risk. Not all companies whose stocks are considered to be value stocks are able to turn their business around or successfully employ corrective strategies which would result in stock prices that do not rise as initially expected.
Rebalancing does not protect against a loss in declining financial markets. There may be a potential tax implication with a rebalancing strategy. Investors should consult with their tax advisor before implementing such a strategy.
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