Gill Capital Partners May 2023 Update
Hello to all of our friends, clients, and partners. We hope this commentary finds you well and that you are settling into springtime. There is a lot to review, including continued troubles within small and regional banks, the debt ceiling “dance,” a significant drop in I-Bond rates, and an update on earnings and other economic data. First, however, we’d like to share the interesting economic factoid of the month.
U.S. households are in excellent shape – the ratio of liabilities to net wealth (shown in the chart below) has declined 50% since 2008 and is currently at levels last seen in the early 1980s. Yes, economic data and higher interest rates point to a period of slower economic growth ahead, but the starting point for U.S. households is very strong.
Regional Banking Issues & First Republic Bank Update
“You're thinking of this place all wrong. As if I had the money back in a safe. The money's not here. Your money's in Joe's house...right next to yours. And in the Kennedy house, and Mrs. Macklin's house, and a hundred others. Why, you're lending them the money to build, and then, they're going to pay it back to you as best they can” – George Bailey – It’s A Wonderful Life
Headlines about bank failures and modern-day bank runs remind us of the famous scene in the classic movie “It’s a Wonderful Life” where George Bailey is trying to calm the crowd and assuage their fears. While the modern-day banking crisis looks different and is happening in near instant fashion with electronic money movement, the cause and effect are the same. Banks take depositors’ money and pay as little as possible, then use that money to make loans at significantly higher rates, with the spread being their profit. If depositors take their money out or if the loans are not good, then the bank can run into problems. Today’s banking issues are being caused by a combination of both of these inputs. Local and regional banks issued billions of dollars in low-interest real estate loans over the past decade, and now fears around the quality and viability of those loans are worrying investors. Concerned depositors are withdrawing funds, which only exacerbates the problems for these banks. Depositors are pulling money out of small and regional banks in favor of mega banks like JPMorgan, Bank of America, and Wells Fargo. Banking concerns percolated to the top of financial headlines again over the past week with the failure of First Republic Bank. This was the third major U.S. bank failure in the past two months and is the second largest bank failure in U.S. history. The assets were taken over by JPMorgan in a deal negotiated by regulators after the stock of First Republic fell over 90% in just a couple of days. JPMorgan acquired the majority of First Republic’s assets, including nearly $200 billion of loans and $100 billion of deposits, marking a financial coup of sorts for JPMorgan shareholders.
Our view – As we said previously, this story is not yet over, even though Jamie Dimon, CEO of JPMorgan Chase, proclaimed earlier this week that it was. His actions remind us of an old school robber baron in true “Mr. Potter” fashion, swooping in to feast on the carcasses of the distressed banks. We do not see this issue as being over and it is certainly far too early to call victory as many banks are feeling the dual pressure of withdrawals and investment write-downs. While the scale and scope of this banking issue remain to be seen, there are a couple of key takeaways:
This will, at the very least, slow the economy, as lending will continue to decrease and lending standards will tighten. Debt and leverage are key components of economic growth, and many banks are pulling back their lending dramatically as their balance sheets have been reduced.
The banking system is now more concentrated than it was prior to this situation, with the top banks becoming much larger and stronger and the local and regional banking system becoming much smaller and fragile.
I Bond Rates Fall
It was announced late last week that Series I-bonds will offer a 4.3% interest rate over the next six-month period, a significant decrease from what we’ve seen over the last year.
Our view – The new rate marks a continued decline in I-bond interest rates, which paid a 6.89% annual return over the six months ending in April. These are down significantly from the peak rate of 9.62% in May of last year. The decline in I-bond rates reflects the continued decline in inflation, and the rush to buy these investments is likely over for now. While rates were very compelling last year, the challenges of purchasing I-bonds, combined with relatively low maximum purchase amounts ($10,000 per person per year) and declining rates, now make these less compelling compared to fixed rate bonds.
Debt Ceiling Update
Negotiations over increasing the debt ceiling are making headlines again. Fears are circulating around the U.S. Treasury credit rating being downgraded, or even an outright default. Janet Yellen, in an effort to motivate lawmakers, painted a bleak picture in her recent letter to leaders of the Senate and the House of Representatives, stating that, “we will be unable to continue to satisfy all of the government’s obligations by early June, and potentially as early as June 1.”
Our view – Similar headlines pop up most years around this topic, and, every time, the government finds a way to raise the debt ceiling. In fact, Congress has increased the debt ceiling 78 separate times since 1960 under many different combinations of republican and democratic controlled congresses and presidencies. This time seems to carry more angst given a razor thin majority in the house. We suspect this will get resolved as it always has, but it might be a bit messier and more protracted, potentially leading to a partial or complete government shutdown like we saw in 2018-2019. Any shutdown will obviously lead to further economic deterioration, but it is too early to speculate on this. While this view into the inner workings of our government is messy, we do not see this as a major reason for concern as we have faith that it will get solved, as it has 78 times before.
Q1 Earnings Update
With two-thirds of the S&P 500 having reported Q1 earnings, we have a pretty good sample for what transpired last quarter and what CEOs see coming. First quarter earnings have so far been better than anticipated, with 54% of the S&P 500 companies beating consensus earnings estimates. Both sales and margins have generally exceeded estimates. Taking a closer look at specific industry performance, financials, utilities and REITs missed their earnings by the most, while energy, consumer staples, technology and materials fared the best. Technology companies saw the greatest improvement in bottom line earnings due to aggressive cost cutting.
Our view – Earnings are one of the few bright spots in the economy right now, with corporate America showing it can adapt to a slower growth environment. Hats off to technology CEOs, who have preserved margins and cash flow in a tough environment with declining or stagnant revenues.
Federal Reserve Update
In a widely anticipated move, the Federal Reserve approved its 10th interest rate increase in just a little over a year, increasing the fed funds rate by 0.25% and taking the target range to 5.0% to 5.25%. This is the highest fed funds rate since August of 2007. Fed chairman Jerome Powell said, “the committee anticipates that some additional policy firming may be appropriate for the Fed to achieve its 2% inflation goal,” and that the Fed “will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”
Our view – This move was widely anticipated and largely priced into interest rate markets. The Federal Reserve is trying to walk a fine line between keeping the door open for future rate hikes while also recognizing the deterioration of economic data. The Federal Reserve has further reiterated that it is their hope that they will keep interest rates at these levels for a protracted period of time. What we heard today is their attempt to counter the market’s narrative that the Federal Reserve will quickly pivot to rate cuts. All else being equal, it will take a continued deterioration in banking and credit to change their position. While we do not want to second guess the Federal Reserve, it seems that they are becoming increasingly out of touch with the current economic reality, which shows declines in real-time economic indicators, declining inflation, and stress in the banking and commercial real estate sectors. For now, the market has priced in today’s increase as the last interest rate hike of this cycle, and the next move is for lower rates later this year. We will continue to keep you updated on this as more information is made available.
As always, please let us know if you have any questions or concerns, or if we can provide assistance with any other financial planning matters including education, taxes, insurance or estate needs.