The recent collapses of Silvergate, Silicon Valley Bank and Signature Bank, and the federal government’s measures to protect depositors, have attracted investors’ attention—including those with portfolios intended as a source of retirement income.
Most Americans recall the fear, uncertainty and losses of the Great Recession, so there’s plenty of worry to go around.
In times like these, clients may turn to their advisors for help. They want to know their investments are sound, or where they might move their wealth to stem potential market losses. They may want to understand what happened to cause the bank runs that led to their collapses.
And many may be calling their advisors for predictions. Are we heading into a recession? If so, will it look like the last one? During the Great Recession, gross domestic product (GDP) fell by more than 4%.1 Unemployment doubled.2 Homes lost significant value, and household wealth took a major hit; it’s easy to understand investors’ fears.
At the same time, financial professionals know that we can’t predict the future, and the economic and market landscape is complex and intertwined. Talking to clients about current conditions calls for a level-headed, rational approach and an awareness of key facts.
Inflation, interest rates and the “new normal”
Under what economists refer to as “normal” conditions—when interest rates are driven by market conditions—those rates are typically higher than inflation. And that makes sense, since investors generally look for gains that can outpace inflation for their investment to make sense.
The Federal Reserve, aiming to promote maximum employment, stabilize consumer prices and moderate long-term interest rates, uses policy tools much like a driver brakes or accelerates to control a car.
The lower-than-inflation interest rates—which we’ve been experiencing since the end of the Great Recession—were manufactured through quantitative easing by central banks as part of efforts to stimulate the economy in an effort to make up for huge losses.
But pandemic-influenced inflation pushed real interest rates even lower than they had already been in the post-Great Recession years, making inflation now the top issue for the Fed to address. Out-of-control inflation pushes up prices on goods and services, which can push basic expenses out of reach for households.
So, the Fed began very aggressively increasing interest rates, making borrowing more expensive, as a means to counteract inflation. In 2022, there were seven rate increases, including back-to-back 75-point increases in June, July, September and November of 2022. Increases continue in 2023 with a 25-point hike in February.3
In short, inflation rose fast and far, and the Fed raised interest rates to counter inflation’s force on the economy—and these aggressive increases can be hard for an economy to digest.
Illiquidity’s potential effects
Spiking interest rates and the high borrowing costs they cause can lead to Illiquidity, and that can create systemic risk when very large institutions fail to raise the capital they need to meet the needs of depositors and borrowers. Falling asset values can lead to collateral calls, which can force selling—further depressing asset values and increasing downward pressure on financial institutions’ balance sheets.
Markets typically respond by falling, and the probability of recession rises and ultimately, the Fed stops hiking interest rates.
Bank runs, collapses and stemming contagion
A bank run occurs when too many depositors withdraw their funds from accounts out of a fear of bank insolvency. That takes those funds out of use for the bank, limiting its ability to earn by lending and further pushing it toward insolvency. That’s when regulators at the Federal Reserve Board and Federal Deposit Insurance Corporation (FDIC) take steps to close banks and make depositors whole.
What’s important to understand is that, as a lender of choice in the tech startup sector, much of SVB’s lending may have been highly speculative. Due to inflation and interest rate pressures, many bond assets have lost value and put banks in the position of needing to raise capital. SVB shared this information in a press release; rather than calm investor fears, it would appear that many of the bank’s customers lost faith, panicked and withdrew funds in excess of the bank’s liquidity.
Preventing widespread contagion in a case like this is a top priority. Contagion contributed to bank collapses and global finance during the Great Recession—an experience no one wants to repeat. Markets (especially bank stocks) dropped in the wake of SVB’s closure, so the need to shore up confidence in the banking system is urgent. How urgent? The five-year U.S. Treasury yield dropped more than 60 basis points between March 8 and March 15.4
At this time, stemming contagion is a key concern. While the specific banks’ problems may not actually be systemic, the effects impact peoples’ emotional responses. Recent bank closures were related to the tech industry and cryptocurrency markets, specific niches of the economy. The losses may not directly impact other economic areas in concrete ways.
But contagion can result not only from actual market conditions; human confidence plays a key role in markets, too. And evaporating confidence often creates market volatility that can spell trouble. Investors anticipate “more shoes to drop,” and that can lead to a loss of confidence in the larger system—which could mean more bank runs, as well as problems that can cascade into the non-finance economy.
It’s impossible to predict what actually happens next, but a recession isn’t unlikely. Keep in mind, four back-to-back, 75-point interest rate increases are the Fed’s way of stomping the brake—and when you stomp the brake on a car, the force can be felt. Regulators are working to stabilize the situation and rein in extremes, but a hard landing just got a little more likely.
This is a time for vigilance and close monitoring of financial systems. Multiple scenarios remain possible: systemic financial accident, a Fed policy pivot, recession or soft landing.
Addressing client concerns
First, understand that this event is meaningful, and impacts credit markets. Continued high inflation can limit the Fed’s ability for a rescue using monetary easing. On the up side, the Fed is unlikely to continue raising interest rates. On the downside, recession could inch closer. And above all, the situation is fast-moving. Expect volatility in the short term.
Above all, the current situation illustrates the wisdom of diversification in a long-term investment portfolio. And investors who are particularly risk-averse may benefit from a conversation about their risk-control options. We offer unmatched advisor support, as well as resources and tools you can use to inform client conversations.
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