- The failures of two banks serving esoteric corners of the economy (crypto and Silicon Valley) highlight rising financial stress in the economy.
- Now that all bank deposits are effectively backstopped by the government the problems that sank these two banks are not an issue for the broader US banking system.
- But there are potential risks in the nonbank sector, which is likely active in the same space as Silvergate and Silicon Valley Bank. – and no one is talking about this. Are they next?
- Only 11 companies report in coming week – but they include key bellwethers Dollar General, Adobe Inc. and Federal Express.
- Equities will be volatile in coming days. But assuming there is not another blowup around the corner, we expect equities will remain in the trading range of the past nine months – albeit in the lower rather than upper half. Another drop will require either a more hawkish Fed or new signs of financial stress.
- The financial services ETF XLF is down 9% last week, and bank ETFs KRE and KBWB are down 15%. We suggest aggressive investors add to positions – but only as a short-term trade.
What We Learned Last Week
As of writing, it appears the Silicon Valley Bank situation has been resolved with little disruption to uninsured depositors or to the broader banking system at least near term. Our latest update is here. We caution this is an evolving situation, and as we discuss below, one that calls into question the ability of bank regulators to monitor and prevent these kinds of crises.
We have been warning of growing stress among lower-income consumers for the past six months, but admittedly the financial sector was off our radar.
The failure of Silicon Valley Bank and Silvergate Capital, both at the crossroads of the most esoteric and yet widely followed corners of the economy (crypto and Silicon Valley) within days, was a jolting wakeup call.
Whether this was a failure of regulatory oversight, outright fraud by bank management or plain bad luck is too early to say. Clearly, the regulatory establishment lacks the tools to anticipate or prevent these kinds of failures. And that has implications for equities and credit spreads.
Crisis Highlights Dodd-Frank Blind Spots
Whatever the role of regulatory oversight was, it is patently obvious that the Dodd-Frank legislation passed after the financial crisis utterly failed to anticipate or prevent foreseeable crises from happening. Then again, Barney Frank, one of the chief architects of the legislation, was also the chief cheerleader pushing Fannie Mae and Freddie Mac into their disastrous foray into subprime mortgages. So a reasonable person might have concluded that Dodd-Frank would be short on vision. Indeed, it has turned out to be nothing more than a full employment act for accountants and lawyers tasked with filling out reams of paperwork and checking boxes on checklists.
For all that busywork, Dodd-Frank failed to produce the kind of institutional initiative where regulators viewed Silvergate and Silicon Valley Bank as a window into highly stressed corners of the financial markets. Rather, they blindly followed standard operating procedures that said those banks were too small to merit that kind of attention.
Remember the summer of 2007 when two Bear Stearns mortgage hedge funds collapsed? Disturbing as that was, markets soon dismissed them as unfortunate but idiosyncratic cases of mismanagement. Little did we know then that those failures were just the tip of a very large, systemic iceberg.
It is said history does not repeat but rhymes. We cannot help but observe that the rhyming scheme we saw last week is depressingly familiar.
What About Nonbank Exposures?
We agree with the many commentators saying the problems that sank Silvergate and SVB are not an issue for any major bank or the vast majority of the 4000+ FCIC-insured smaller US banks, especially now that deposits will be backstopped.
But the nonbank finance sector has boomed since the financial crisis, in no small part because of the onerous (and mostly noneconomic) regulatory requirements of Dodd-Frank. We must assume that nonbanks have been active in the same space as Silvergate and Silicon Valley Bank. No one knows what kinds of risks they are running, if they will be subject to runs, or whether they pose systemic risks.
Meanwhile, the bank regulatory establishment is only beginning to think about talking about doing something to learn more about what is happening in the nonbank sector. Talk is a long way from action. If a crisis is brewing in the nonbank sector, bank regulators will not be the first to know about it. And they will not be the first to know how to deal with it.
We understand that regulators are human and that no regulatory framework will ever be perfect. But no question, whatever credibility the regulatory establishment managed to gain over the past 15 years has taken a severe hit.
Markets Will Recover
If there is yet another blowup in coming days, all bets are off about what happens with markets.
That said, our base case now is that we get through this immediate crisis, and markets will soon move on as they did after the Bear Stearns mortgage funds collapsed. But we expect uncertainty and equity volatility will remain elevated.
In this latter scenario, we expect equities to continuing trading in the range of the past nine months, but in the lower rather than upper half where it has been so far in 2023.
And higher equity volatility will pressure credit spreads even if default rates remain low.
Add to Bank Positions
The S&P 500 financial services XLF ETF dropped 9% to 32.93. The large and regional bank ETFs – KBWB and KRE, respectively – are down about 15%. All will rebound if, as we expect, this crisis passes – although not to pre-crisis levels. We suggest aggressive investors add to positions. Given ongoing uncertainties we view this as a short term trading position.
More Mixed Earnings
Earnings reports last week were mostly good. Several companies reported solid earnings and outlooks, including Ciena (CIEN) – network equipment; and Casy’s General Stores and BJ Wholesalers (BJ) – consumer staples retailers. Oracle (ORCL) beat on earnings but offered a disappointing outlook.
RV manufacturer Thor Industries (THO) reported weak results and collapsing demand. Clearly, the better-heeled consumers of this kind of big-ticket purchase are pulling back big time. However, at the other end of the consumer discretionary sector, Dick’s Sporting Goods (DKS) reported blowout earnings and outlook.
The generally good tone especially among the consumer staple retailers surprises us. Perhaps they have manged their inventories particularly well for their target clientele.
The Week Ahead
Only 11 companies report next week, but they include a variety of key players.
- Following other homebuilders, Lennar (LEN) will likely report solid profits despite a soft housing market.
- Adobe Inc. results will likely reflect a weak consumer and strong corporate demand.
- Consumers are cautious, but Five Below (FIVE) will probably show they are still buying gadgets and fashion accessories.
- Dollar General (DG) will update us on what lower-income consumers are buying.
- The challenge with FedEx (FDX) will be sorting out the firm-specific and macro factors driving its performance.
- Home furnishing retailer William Sonoma (WSM) will likely be struggling due to the slow housing market.
 The Fed’s stress tests of major banks focused on recession risk with little attention paid to interest rate risk – as if the experience of the thrift crisis during the 1980s had been excised from institutional memory.
Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.
Photo Credit: depositphotos.com