In times of market uncertainty, investors often turn to sayings such as "those who fail to learn from history are doomed to repeat it" and "history never repeats itself, but it does often rhyme." When it comes to the daily headlines, both quotes are relevant, given the long history of banking crises and market swings.
This is because investors must deal with innumerable challenges throughout their financial lives. In just the last few years, portfolios and financial plans have been tested by the pandemic, the highest inflation rates since the 1980s, global conflicts, political uncertainty, asset bubbles, swiftly shifting monetary policy, and much more. Even when times are otherwise calm, and markets are steadily rising, including from 2009 to 2020, investors and the media always find reasons to be worried. There appears to always be a crisis du jour. So, while it's essential to understand the individual issues, it's more important to maintain a broader perspective based on the lessons of history.
Of the various challenges investors face today, the banking crisis was perhaps the biggest unforeseen event. It's now clear that FDIC-insured banks hold bonds worth hundreds of billions less due to rising interest rates. Banks such as Silicon Valley Bank and Signature Bank had customers concentrated in specific industries, such as tech and crypto, that made them susceptible to liquidity problems and bank runs. In Europe, Credit Suisse may have had strong capital and liquidity ratios, but ongoing issues made it vulnerable to a bank run.
Although modern investors are accustomed to a rapid news cycle, the reality is that the banking crisis will take time to play out. It often takes time for cracks to form, problems to be identified, events to play out, solutions to be implemented, and finally, for the system to stabilize.
Many historical examples underscore this fact. For instance, during the global financial crisis, the housing market had already begun to falter by 2006. Bear Stearns failed in March 2008, but the Lehman collapse occurred in September. During the 1998 Asian currency crisis, the first signs of trouble emerged in Thailand in July 1997, and the hedge fund Long-Term Capital Management was bailed out in September of the following year. In some ways, the COVID-19 pandemic is the exception, given how quickly it reached the U.S. and induced an economic lockdown, but it's also the case that we are still experiencing aftershocks three years later.
So, there are always reasons to be on the edge of one's seat. However, there are reasons for optimism too. The market, economy, and the financial system have been more resilient in 2023 than many expected. The job market has been surprisingly strong despite layoffs concentrated in the tech sector, and inflation has improved markedly across critical areas such as energy and goods. Interest rates rose swiftly early in 2021 and throughout 2022 but have stabilized more recently, with the 10-year Treasury yield ending the first quarter at 3.47%. Even the stock market has improved, with the S&P 500 having gained 7.6% and 7.5% across the last two quarters.
While it is true that markets often turn around when investors least expect it and that long-term investors are often rewarded, it is also true that the long-term is comprised of many short terms. And to experience long-term investment success, it is crucial to be willing to accept and manage short-term risk when others are not. Consequently, it would be naive to believe that we are out of the woods from the fallout of the most recent banking crisis episode and ongoing financial tightening. And to guide investors through the coming months, we highlight five important insights below.
1. Regional bank stocks have struggled as financial conditions have tightened
It's no surprise that bank stocks have struggled across markets. In the U.S., this is due to regional banks as the crisis that began with Silicon Valley Bank and Signature Bank plays out. The FDIC, Treasury Department, and the Fed have stepped in to stabilize the system, as have their European counterparts.
The accompanying chart shows the performance of U.S. and European banks. Perhaps most striking, however, is that the MOVE index of bond market volatility jumped to its highest level since the 2008 financial crisis. Fortunately, the situation has stabilized as the initial bank run has calmed. Ironically, this has allowed interest rates to fall, which will likely reduce the unrealized bond losses at banks that helped create this situation in the first place.
While there are specific circumstances underlying each of these bank failures, financial instability tends to occur when monetary policy and credit conditions tighten. This is partly because many banks had grown accustomed to high levels of liquidity supporting deposits and their aggressive customer acquisition practices. Thus, it will take time for the banking system to stabilize as the world adjusts to tighter financial conditions.
2. Balanced portfolios have benefited from both stocks and bonds this year
Although only a quarter has passed, markets are already performing much better than last year. This is because interest rates have been more stable, and inflation has improved, supporting stocks and bonds, which returned 7.5% and 3.2%, respectively, through the end of the first quarter. A hypothetical 60/40 portfolio generated 5.1% over the same period, underscoring the continued importance of diversification and long-term thinking.
3. Financials have struggled but tech-related sectors have rebounded
While the S&P 500 Financials sector has struggled due to financial stability concerns, many other sectors have offset it. The Information Technology, Communication Services, and Consumer Discretionary sectors have rebounded from last year's losses as interest rates have fallen and the economy has grown more resiliently than expected. Similarly, the Nasdaq gained 17% with dividends in the first quarter. While investors should not focus too much on only three months of returns, this is a reminder of how quickly market sentiment can shift and of the importance of staying diversified across sectors.
4. The Fed is expected to slow its pace of rate hikes or to cut rates
The Fed chose to raise rates despite the ongoing banking crisis, partly as a message about their confidence in the financial system. The Fed's latest projections show that officials expect to keep rates high through the rest of 2023, which starkly contrasts with Fed funds futures, which show implied rate cuts later this year. Either way, this suggests that the Fed is near the end of its rate hike cycle after one of history's sharpest jumps in policy rates.
5. It's important to stay invested and take advantage of attractive valuations
Ultimately, investors should focus on the long run and not overreact to daily headlines. In particular, valuations are still the most attractive in years as investor sentiment slowly improves. The accompanying chart highlights that staying invested, or taking advantage of better market levels, is often rewarded. History shows that waiting for the next pullback often results in missed opportunities both in terms of returns and the length of time investors need to wait.
The bottom line: While ongoing challenges exist, this is always true for investors. As we continue into Q2 of 2023, staying patient and focused, managing short-term risks, and holding dynamically allocated diversified portfolios are the most essential tools in the investor's toolshed.
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Matt Faubion, CFP®
Founder - Wealth Manager
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