A lot has happened since we last discussed the market’s conditions; rising interest rates and the war in Ukraine have had a great impact on valuations of financial assets globally, with the riskiest ones (tech stocks, crypto…) being the hardest hit. The everything bubble started its inevitable deflation process a few months ago, with very tangible consequences on the housing market as well, as home prices have finally started to fall.
U.S. National Home Price Index (2017-2022)
However, if we look at the US, stocks are still historically expensive, and very expensive if we consider the risks of the current macro environment. In fact, while the S&P 500 and the Nasdaq composite are down roughly 20% and 35% respectively from their all-time highs (as of the day of this article), they are still trading at very high multiples. If we look at the S&P 500 Shiller P/E ratio, it’s still 28x, with the mean being 17x, which means that in order to revert to the mean, the index would need to fall another 40%...
The Shiller Price earnings ratio is based on average inflation-adjusted earnings from the previous 10 years, known as the Cyclically Adjusted PE Ratio.
An old saying on Wall Street goes that “all bubbles are different, but the only thing they have in common is that they eventually blow up”. I firmly believe in this saying, as markets are self-correcting mechanisms in the long run, and capitalism does an excellent job at killing inefficient capital allocations. However, this paradigm doesn’t take into account governments and central banks trying to prevent any significant downturn by re-inflating the bubble.
Why the failure of SVB is so important
As you probably already know, the failure of Silicon Valley Bank has shaken up the entire banking industry in recent weeks, creating turmoil and tension in the financial sector globally. Even though the bank was the 16th largest in the US, the most concerning aspect of this story isn’t the bank failure itself, as it was a result of very poor management, both in the credit business (lending money to risky Venture Capital firms at low rates) and risk management (the bank didn’t take into account duration risk and was forced to sell its bonds at a loss for liquidity). What should be worrying about SVB’s failure is the reaction of the Federal Reserve, the government, and other central banks around the world.
In response to the failure of SVB, the FDIC has expanded deposit insurance to all deposits, not just those up to $250 000 (which is going to be quite expensive for the taxpayer). In addition to that, the Federal Reserve has created a new lending facility for banks and already expanded its balance sheet by approximately $300 billion. They don’t want to call it QE (Quantitative easing), but that’s exactly what it is, as it has erased all the QT (Quantitative tightening) the Fed has done since November. According to JP Morgan, the Fed might end up lending as much as $2 trillion to banks.
With inflation still stubbornly high at 6%, and real rates that are still negative (Fed funds effective rate is 4.5%, 2Year treasuries yield 3.9% vs inflation at 6%), what are the consequences going to be for price stability? Has the Fed just openly declared that it is willing to sacrifice the value of the dollar to prevent any financial institution from failing? What about the moral hazard that is implied in these policies?
Many questions but, unfortunately, the answers seem clear.
Federal Reserve's balance sheet (2018-2023)
US banks have approximately $620 billion of unrealized losses. Their overall equity is $2.2 trillion. Unrealized losses are 28% of equity on average, for smaller banks that number may be higher.
The Fed undid half of all its QT in a week. Quantitative tightening, among with rising interest rates, are the main tools the Fed uses to fight inflation. Apparently, after more than doubling its balance sheet and injecting over $4 trillion into the economy in 2020 (the main driver of inflation in the first place), The Fed is back to expanding the balance sheet even further.
In order to prevent the bubble from bursting, all the Fed can do is inflate it further. Since 2008, zero interest rate policies and QE have created a more fragile economy and much weaker financial institutions. This is because growth has been mainly driven by unproductive debt, both private and public, which can only be sustained as long as the interest payments stay close to zero.
US Government Debt to GDP (2000-2022)
US Private Debt to GDP (2000-2022)
The problem, in the first place, starts with the fact that policy makers don’t accept any form of economic downturn anymore and act to prevent it from happening instead of just supporting the economy countercyclically. We blame our governments and institutions for any sort of economic and financial contraction and expect them to ease the pain. However, economic downturns are essential for the capitalistic system to work properly, as only the best participants “survive” and become more resilient.
No matter how harsh it sounds, that’s how the economic machine is supposed to work, and it’s the only way to obtain the most efficient and productive capital allocation. Instead, policy makers have been sacrificing long-term prosperity for short-term gains (often for political reasons, e.g. I don’t want a stock market crash during my term, let’s pass the problem to the next guy…) for far too long, which is why we are in the current situation: a vicious cycle with a very hard way out. This is the kind of behavior that can transform a small and containable issue into a gigantic monster with systemic implications.
With current public debt to GDP at 130%, private debt to GDP at 150%, 6% inflation, and a bubble bursting, what are the Federal Reserve and government going to do? Are they going to let free markets do their job and intervene only when strictly necessary or are they going to bail everyone out with horrible consequences for the value of the dollar and wealth inequality? Recent actions and interest rate expectations suggest they’re going for the second option, the “easy” one.
Traders are pricing in 100 basis points price cuts before year-end.
It took $700 billion to bail out the financial system in 2008 and over $4 trillion to bail out the economy in 2020. How much will we need for the next bailout?
The new two-tier system
Another issue posed by the government’s response to the failure of SVB is that it has inadvertently created a two-tier system:
Tier 1 Too big to fail banks (e.g., JP Morgan, Citibank, Wells Fargo, Bank of America, etc.)
Tier 2 All the other banks
If you have your money deposited in Tier 1 you are a depositor (guaranteed for any amount), as the government will always be there to bail you out, while if you have over $250 000 in Tier 2, you are an unsecured creditor.
Treasury secretary Yellen testifies before Senate on 2024 budget and confirms the existence of a two-tier system.
This might have huge implications and unexpected consequences in the banking industry, as large depositors now have little incentive to keep their savings at any bank other than the largest five. Large outflows of deposits from regional banks could put them under even more stress while consolidating the position of larger institutions. The result could be less competition in the industry, thus worse rates for consumers, and a system that becomes increasingly fragile. Also, moral hazard at its finest, of course.
Pay attention to gold
Gold has been rallying in the past few days because of uncertainty and higher inflation expectations, as the market is pricing in rate cuts before the end of 2023. As the ultimate store of wealth, it will be interesting to see how gold will perform with the dollar potentially becoming weaker.
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