April 8, 2023 – The “Fed put” is the perceived policy action from the U.S. Federal Reserve to intervene in the financial markets during times of economic distress and market volatility to support asset prices and stabilize the financial system.
After Silicon Valley Bank rapidly fell and entered receivership, other regional banks faced the risk of bank runs and subsequent insolvencies. This downward spiral could have had devastating effects on the capital markets and in turn, the economy.
Therefore, it is not surprising that the Fed sprang into action, implementing the Fed put and easing financial conditions by offering loans to banks and rapidly increasing the size of its balance sheet.
Between March 8th and March 15th, the Fed reversed a year’s worth of quantitative tightening in one week, offering substantial stimulus to the markets. So it is no wonder we saw risk assets rally and bond yields fall.
In last month’s memo, 2008 Redux, we discussed the issues that led to the demise of Silicon Valley Bank and several of its peers:
Silicon Valley Bank failed due to two unique issues that may not carry over to other financial institutions. First, SVB’s deposit base was very risky. Most of its deposits came from Silicon Valley startups, which went through an unprecedented boom over the past several years. During this period, with so much cash coming in the door, its long-term securities portfolio grew from $17 billion to $98 billion over a short period. The bank could not lend the funds as quickly as they came in, so it bought billions of long-term, low-interest-rate mortgage-backed securities and Treasury bonds.
As interest rates rose, SVB’s portfolio of high-duration fixed-income securities suffered devastating mark-to-market losses of more than $15 billion (nearly equal to its entire equity value). The bank’s major mistake was having such a significant portion of its assets in fixed-rate securities, especially with effectively no interest rate hedges. When interest rates rose, the decision to have a much higher concentration of its assets in low-yielding fixed-income securities proved to be its Achilles heel. Each 1% rise in interest rates led to billions of dollars of losses.
If we compare the yields offered by money market funds and those offered by bank chequing and savings accounts, it is not surprising that depositors have been fleeing. The choice between a 4.0%+ interest rate and a 0.0%-0.5% rate is not difficult to make.
Due to the near 5.0% fed funds rate, the appealing yields offered by money market funds have been attracting billions of dollars of funds from investors, to the detriment of banks. What started as a trickle has turned into a flood.
Banks have faced challenges on both sides of their balance sheets. On the liabilities side of the ledger, deposits have fled to the greener pastures offered by money market funds, to the tune of nearly $400 billion.
On the asset side of the balance sheet, banks’ interest-rate-sensitive assets, including Treasury bonds and mortgage-backed securities, have lost value as interest rates have risen.
Both of these stresses on banks are well-known to the market.
However, there is an additional balance sheet risk that is lurking on bank balance sheets, largely unnoticed by investors. Therefore, capital markets participants may be wise to brace themselves for another potential shoe to drop.
The next significant risks faced by banks are the $20 trillion commercial real estate market and the loans backing it.
More often than not, real estate is a leveraged asset class, in which investors utilize debt to fund the majority of the purchase price of real estate assets. Regional banks, many of which have been struggling with mark-to-market losses and deposit flight, provide the bulk of the loans to the real estate industry. Some of these loans are packaged into complex financial products, with many yield-seeking buyers not well informed regarding the quality and composition of the underlying loans.
Real estate values are based on capitalization rates (cap rates), a widely used metric in the industry used by investors to evaluate the potential return on investment for a particular property. As interest rates rise, cap rates increase.
As cap rates increase, real estate values fall.
Ergo, it should come as no surprise that real estate values have fallen precipitously as interest rates have risen.
Over the past year, commercial property values have dropped between -5% for lodging and -25% for office properties. For highly leveraged investors, this market decline could mean the remaining equity value in their real estate investments may be worthless. When real estate values drop below their equity cushion, the loans backing those assets will become impaired.
More than half of the nearly $3 trillion of outstanding commercial mortgages will mature by the end of 2025. Regional banks are on the hook for as much as 70% of these loans.
While the Fed put may have placed a floor on the acute stresses in the banking sector and slowed the current banking crisis, there are a couple of problems that will linger over the next several years.
First, it is inarguable that banks must raise their deposit rates to stem the bleeding and slow deposit flight. Raising deposit rates for customers will crush banks’ net interest margins, leading to reduced profitability on a go-forward basis. As a result, look for bank valuations and future share price performance to suffer.
Second, the banks’ balance sheet stress will slow lending, reducing economic growth. March’s banking crisis may have the worst behind it. However, many financial institutions have been hobbled and their lending activity (or lack thereof) will create challenges for the economy, and in turn the stock market.
Moreover, the prevalence of real estate mortgages on bank balance sheets, in a market consisting of rapidly declining real estate values, may prolong the current banking crisis. In addition, a leveraged unwind of the estate loans could portend economic and financial damage well beyond just the banks. Remember, the financial crisis of 2008-2009 was steeped in mortgages.
Nonetheless, for the time being, the Fed put is in effect, interest rates have been dropping, and risk assets have been rallying.
A small handful of large-cap glamour stocks, including Apple, Nvidia, Microsoft, Meta (Facebook), Tesla, Amazon, Alphabet (Google), Salesforce, and AMD, have contributed to more than 100% of the S&P 500’s gains year-to-date. Apple, Microsoft, and Nvidia alone account for nearly 100% of the benchmark’s YTD return. So why own the S&P 500 when you can own the S&P 3? Breadth has been poor, to say the least.
Who would have thought that in a banking crisis, there would be a flight to large-cap tech stocks? Of course, it is not the first investing idea that comes to mind when the economy is on the brink of recession.
Low breadth in the stock market is generally considered to be a negative signal, as it can lead to a scenario in which the market is highly concentrated in a few large-cap stocks or sectors, creating an imbalance in the market and increasing the risk of a sharp correction if those stocks or sectors experience a downturn.
Low breadth can also indicate a lack of investor confidence in the broader market. For example, when investors are uncertain about the overall direction of the stock market or the economy, they may be hesitant to invest in smaller or less established companies.
Another negative consequence of low breadth is that it can lead to a loss of market efficiency. In an efficient market, stock prices reflect all available information and are determined by the collective actions of all investors. However, when the market is highly concentrated in a few stocks or sectors, it can be more difficult for investors to accurately assess the value of individual stocks, leading to greater uncertainty and volatility.
Overall, a low breadth in the stock market is a cause for concern, as it can signal a lack of investor confidence, a concentration of risk in a few large-cap stocks or sectors, and a loss of market efficiency. Investors should therefore monitor market breadth closely and diversify their portfolios to minimize the impact of any potential market downturns.
Nevertheless, stocks in general, and U.S. large-cap equities in particular, stand at a critical and dangerous juncture.
While absolute valuations of U.S. equities are high, their relative valuation compared with bonds is astronomical.
The difference between the S&P 500’s earnings yield and the 10-year Treasury bond yield, known as the equity risk premium (ERP), sits at just 1.6%.
The ERP is the excess return an investor expects to receive from holding stocks over risk-free government bonds. It represents the compensation that investors require for taking on the additional risk associated with investing in stocks.
For example, if the expected rate of return on stocks is 8.0.% and the risk-free rate of return is 4.0%, then the ERP would be 4.0%. This equity risk premium means that investors require a 4.0% excess return for holding stocks instead of risk-free assets.
Historically, the ERP has averaged 3.5% – a reasonable level of additional return that an investor should be compensated for taking equity risk over bonds.
For investors, the current expected return from stocks is implied by their valuation. Specifically, with U.S. stocks trading at approximately 30.0x their ten-year moving average of inflation-adjusted earnings, U.S. equities are expected to return roughly 3.0% to 7.0% over the coming decade.
Moreover, if stocks and bonds do not maintain their lofty valuations, some analysts predict a potential lost decade for the 60/40 portfolio.
A lost decade for a stock and bond allocation, in which an investor’s portfolio generates a zero or negative return, can be devastating for those trying to reach their financial goals. With bond yields well below the rate of inflation, combined with stocks trading at well above average valuations and extremely low stock market breadth, diversification beyond just stocks and bonds is needed now more than ever.
Accelerate manages five alternative ETFs, each with a specific mandate:
- Accelerate Arbitrage Fund (TSX: ARB): SPAC and merger arbitrage
- Accelerate Absolute Return Hedge Fund (TSX: HDGE): Long-short equity
- Accelerate OneChoice Alternative Portfolio ETF (TSX; ONEC): Alternatives portfolio solution
- Accelerate Enhanced Canadian Benchmark Alternative Fund (TSX: ATSX): Buffered index
- Accelerate Carbon-Negative Bitcoin ETF (TSX: ABTC): Eco-friendly bitcoin
ARB gained 0.4% as five merger arbitrage deals held by the Fund closed during the month and more than a dozen SPACs matured.
After a lull in new blank check issues, four SPAC IPOs came to market in March raising an aggregate of $246 million (average deal size of $61.5 million). The Fund participated in three of these SPAC IPOs. As detailed in the latest SPAC memo, IPO: It’s Potentially An Opportunity, we view participating in SPAC IPOs as a low-risk strategy to generate 6.0% to 10.0% annualized returns. Given their attractive risk-reward characteristics, the Fund seeks to allocate to new SPAC IPOs to the full extent possible
The current allocation in ARB is 66% SPACs, 26% strategic M&A, and 9% LBOs.
HDGE gained 0.3% in March in a month featuring mixed factor performance. U.S. multifactor long-short portfolios were generally positive, except for long-short value, which dropped -3.3%. Canadian multifactor long-short portfolios were more challenging, with all significant factors falling except for the trend and operating momentum portfolios.
The Fund’s performance during the month was buoyed by its short position in Signature Bank, which was placed into receivership, making its equity worthless. HDGE has had some notable short positions over the past year, including Carvana (down -91.6%), Opendoor (down -76.9%), Proterra (down -81.6%), and more, but Signature Bank takes the cake as the Fund’s best short ever (down -99.9%). That performance of an equity short is unlikely to be beaten.
Accelerate’s multifactor predictive model is quite good at finding stocks that underperform. The model’s top stock selections, both to outperform and underperform, are published for investors monthly in Top Stocks.
ONEC fell -0.7% as its alternative allocations produced mixed results.
The Fund’s inflation protection bucket gained as gold surged 8.5% and commodities rose 3.6%. After nearly two years of out-of-control inflation, ONEC’s inflation protection portfolio is finally working.
Real assets produced mixed portfolio contributions during the month, with infrastructure adding 2.4% and real estate detracting -3.5%. In addition, the global macro allocation was varied as risk parity gained 4.1% while managed futures dropped -7.3%.
On the private credit side, the mortgage portfolio added a positive performance of 1.6%, while the leveraged loan portfolio was approximately flat.
The absolute return strategies both contributed positively during March, with long-short equity adding 0.4% and arbitrage at 0.3%. On the other hand, the alternative equity strategy fell -2.5%.
ATSX declined -2.5% while its benchmark dropped -0.9%. The Fund’s long-short overlay portfolio declined by -1.6% during the month.
The Canadian multifactor portfolio fell with negative contributions from value (-4.8%), quality (-5.0%), and price momentum (-8.2%). The long-short trend portfolio gained 4.7% while operating momentum was slightly positive.
Have questions about Accelerate’s investment strategies? Click below to book a call with me:
-Julian
Disclaimer: This distribution does not constitute investment, legal or tax advice. Data provided in this distribution should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this distribution is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate Financial Technologies Inc. (“Accelerate”) as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Past performance is not indicative of future results. Visit www.AccelerateShares.com for more information.
