March 17, 2023
By Steve Blumenthal
“The last two years [are] one of the biggest policy mistakes in the 110-year history of the Fed, by staying so easy when everything was booming,”
– Jeremy Siegel
“My problem with the Fed, overall, is there’s too many academics in the mix,” said Langone. “I think if you had more businesspeople involved or people with business backgrounds, I think you might see a different dialogue and different decisions.”
– Ken Langone, Co-founder of Home Depot
The CPI comes in lower year-over-year but stickier than expected. Moody’s cuts the outlook on U.S. banking system to negative, citing a “rapidly deteriorating operating environment.” Then, BAM—banking crisis… The Fed is in a trap of its own making.
In response to the Silicon Valley Bank collapse, Ray Dalio wrote, “I think that it is a very classic event in the very classic bubble-bursting part of the short-term debt cycle (which lasts about seven years, give or take about three) in which the tight money to curtail credit growth and inflation leads to a self-reinforcing debt-credit contraction that takes place via a domino-falling-like contagion process that continues until central banks create easy money that negates the debt-credit contraction, thus producing more new credit and debt, which creates the seeds for the next big debt problem until these short-term cycles build up the debt assets and liabilities to the point that they are unsustainable and the whole thing collapses in a debt restructuring and debt monetization (which typically happens about once every 75 years, give or take about 25 years).”
The unnerving challenge is that we have now reached the “once every 75 years” point.
More from Dalio: “While in different cycles the sectors that are in bubbles are different—i.e., in 2008 it was heavily in residential real estate and now it’s in negative-cash-flow venture and private equity companies as well as commercial real estate companies that can’t take the hit of higher interest rates and tighter money—the self-reinforcing contraction dynamic is the same. Based on my understanding of this dynamic and what is now happening (which line up), this bank failure is a ‘canary in a coal mine’ early-sign dynamic that will have knock-on effects in the venture world and well beyond it.” (Emphasis mine)
Knock on, indeed. Dalio’s note was published before a handful of other banks joined the crisis. None bigger than the perennial problem child Credit Suisse. Its near-collapse prompted a $54 billion investment from the Swiss National Bank. This isn’t over! Credit Suisse Group’s stock, CS, is down another 10% pre-market, and its default risk has surged. Beneath the surface sits a tangled web of interconnected “counterparty” risk. Which other banks have exposure to Credit Suisse?
A good friend of mine banks at First Republic Bank (fortunately, with cash under the FDIC $250,000 insurance limit… his weekend was a little more peaceful than others). On Tuesday, he called one of the four major banks to open a new account. “Get in line,” they told him, “It will take at least three weeks. Everyone from every small and regional bank is making the same call.”
Wall Street rode to the First Republic Bank’s rescue yesterday as Bank of America, Wells Fargo, JP Morgan, Goldman Sachs, Morgan Stanely, PNC, US Bancorp, State Street, and Bank of NY ponied up $30 billion in deposits to bail it out. I clipped the following tweet flagged by my friend Renè Javier Aninao, Managing Partner at CORBŪ. Note the 120 days.
Treasury Secretary Janet Yellen told senators that government refunds of uninsured deposits will not be extended to every bank that fails, only those that pose a systemic risk to the financial system.
What happens in 120 days? I know at least one person whose money will be long-gone from First Republic Bank to Citi. He won’t be alone.
At 7:40 am this morning, First Republic Bank was trading down 14% pre-market. I just took another look, and the stock is down 32% on the day. Yikes.
Banks make money by paying you X% on your deposit and loaning out the balance with an approximate 10-to-1 leverage. To get a sense of what that looks like, think about it this way: for approximately every dollar on deposit, they are allowed to lend out $10. They pay you 0.50% on your deposit and loan it out for 2.5%. The NIM, or net interest margin, spread in this example is 2%. They make the spread of 2% multiplied by ten, or 20%. Can’t find enough people willing to borrow? The bank invests some of the money in mortgage securities, Treasury bills, notes, and bonds. While this is an oversimplified summary, that’s pretty much what they did. Silicon Valley Bank operated like a highly-leveraged hedge fund. The bank had one big job, and that was to hedge its interest rate risk exposure. Meaning when interest rates go up, the value of their bond holdings goes down. They could have hedged that risk and didn’t.
If you invested 10x levered into 2.5% yielding Treasury bonds, the Fed drives the Fed Funds rate from 0% to 4.75% in record time, and Treasury yields go from 2.5% to 4%, left unhedged, the value of your assets gets crushed. Since the start of the year, 1- to 3-year Treasury exposure is down 5%, 5- to 7-year Treasury exposure is down 7.5%, 10-year Treasury exposure is down 14%, and 20-year Treasury exposure is down 40%.
Suppose you are a bank with $1 million in customer deposits. You pay depositors 0.50% and agree that they can access their money at a moment’s notice. You lend and invest $10 million in the form of car, mortgage, and business loans. And you invest some of that money in Treasuries if you can’t find enough interested borrowers. If your loan/investment book loses 10%, the asset side of your bank balance sheet is down $1 million dollars ($10 million times 10%)—essentially wiping out your depositors’ money.
On a daily basis, the executives at SVB, Signature, First Republic Bank, and all banks, for that matter, know the liability-to-asset ratio.
Talk about self-preservation! Take a look at the following selling of SVB stock. Where is the Fiduciary responsibility? “What’s really gonna melt your butter”—do you think the executives didn’t know what their assets-to-liability ratios looked like before this crisis? If you want to fix the problem, put some teeth in it—send a banker or two to jail.
Holy cow! You can’t make this stuff up!
Inflation is the Kryptonite to Fed Policy
Way before we hit crisis this week, I’ve been writing that “inflation is the kryptonite to Fed policy.” Inflation means the Fed must raise rates to fight it. Otherwise, everyone in the system loses (from low-wage earnings to high). Think of inflation as a hidden tax. The current crisis is of the Fed’s own making. Jeremy Siegel is right, “The last two years [are] one of the biggest policy mistakes in the 110-year history of the Fed, by staying so easy when everything was booming,” Ken Langone is right, “My problem with the Fed, overall, is there’s too many academics in the mix… I think if you had more businesspeople involved or people with business backgrounds, I think you might see a different dialogue and different decisions.”
Here’s the chart I shared with you last week:
Last week’s On My Radar was titled, “Cracks, Something Will Break!” When I reread the piece Saturday morning, I got a little frustrated with myself as thought it should have been titled, “Cracked, Something Broke.”
Capital will move where it’s treated best. It just may take three weeks to open that new bank account. Think about what that may do to the deposit (liabilities) to asset ratios. Discussing this with my wife, Susan, this morning, I explained the above, and she went right to the salient point: “Should we move any money from the banks we bank with?” Everyone is asking this same question. The Fed and Treasury are trying to prevent a crisis. What might capital exodus do to healthy regional banks? It will put them out of business. I don’t believe this is over. Stay tuned.
Grab a coffee and find your favorite chair. I believe the soft vs. hard landing debate is now settled. It’s going to be a hard landing, folks.
Below you’ll find more from Dalio’s LinkedIn post. He talks about the current crisis in terms of how it fits into the “every 75 years” big debt cycle challenges we are now facing. Pretty great big-picture summary—please think about sharing it with your children. You’ll also find my summary notes covering JP Morgan’s WallachBeth Annual Symposium presentation. JP Morgan is with me in the hard-landing camp. They shared some interesting insights. I also share more than a few random tweets this week as the content kept coming.
Each week’s OMR is broken into sections. Feel free to read them one at a time or all in one sitting. Here are this week’s sections:
- More From Ray Dalio’s LinkedIn Post
- Conference Notes: JPMorgan (hard landing ahead)
- Random Tweets
- Trade Signals: Something Broke
- Personal Note: March Madness and Savannah
(Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.)
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Let’s start with Dalio’s conclusion – but do read the short missive that follows:
“While in this Observations I have been focusing on the money/credit/debt/market/economic dynamic, let’s remember that it is being accompanied by the internal conflict dynamic (most importantly the 2024 US elections that are coming up) and the external conflict dynamic (most importantly the US-China conflict and the US-NATO-Russia conflict, though others like that with Iran are notable). All of these conflicts affect each other. This setup implies to me that there is a significant risk that there will be 1) bad financial and economic conditions at a time of 2) bad internal conflict and 3) bad international conflicts—with the world being leveraged long. In a nutshell, it looks to me like the next two years will be a very risky time.”
To put this in context and think about how this will likely play out, I find it useful to go to my archetypical debt cycles dynamic that I cover more comprehensively in my book Principles for Navigating Big Debt Crises than I can cover here. I am linking to the PDF version available for free here and will summarize in this Observations.
How the Machine Works
Because one man’s debts are another man’s assets and most people are levered long (i.e., they are holding assets financed by debt), when interest rates rise and money becomes tight, assets fall in value, which hurts debtors, creditors, asset holders, and financial intermediaries, which causes a self-reinforcing contraction and contagion because when money is needed, other assets are sold and when creditors are hurt, they curtail lending. Those financial intermediaries (most importantly banks) that are most leveraged long to the asset bubble that is bursting are particularly affected. It is classic that coming out of an extended period of very low real interest rates and abundant credit, there is an enormous amount of leveraged long holding of assets that are going down due to higher interest rates and tighter money, which is producing this classic dynamic of dominos falling.
Because a) we are in the early stage of the contraction phase of this cycle and b) the amount of leveraged long holding of assets is large, it is likely that this bank failure will be followed by many more problems before the contraction phase of the cycle runs its course. Before the contraction phase of the cycle ends, history and logic have shown that there will be 1) forced sales of assets at very low prices that require big losses to be reported and cause further contractions in lending, 2) equity dilution, i.e., selling at prices that are at significant discounts to conservative estimates of the present values of their future cash flows, 3) attractive acquisition prices for strong synergistic companies to buy distressed ones, 4) credit problems being a negative for markets and the economy, and eventually 5) the Fed easing and bank regulators providing money, credit, and guarantees because the problem becomes system-threatening. At this turning point into the contraction, it is too early for the Fed to ease, but I will be watching closely what it does as the trade-offs become tough. Looking backward rather than ahead, tightening rather than easing seems appropriate. Looking ahead, it’s likely that it won’t be long before the problems pick up, which will eventually lead the Fed and bank regulators to act in a protective way. So I think we are approaching the turning point from the strong tightening phase into the contraction phase of the short-term credit/debt cycle.
Now that we’ve looked at the archetypical cycle and what will likely happen, let’s look beyond the immediate problem to what I believe will eventually be the much bigger longer-term problem.
How do these cycles go? When debts are in a country’s own currency, debt crises and the debt contagions that result from them can and will eventually be contained by central banks creating enough money and credit to fill in the funding gaps. For example, in this case, with the Fed guaranteeing all depositors against loss and indicating that it will go beyond that to protect others, not only did it come up with more credit, but it also signaled that it would probably act similarly in other cases.
That begs the question: at what cost is money and credit being created?
That brings us to the much bigger longer-term problem, which is that the US central government has large outstanding debts and is selling more debt than there is demand for, and central banks are monetizing the debt. Controlling the problems is financed by the central bank printing money and buying the debt. With debt assets and debt liabilities so large, it is very difficult to keep real interest rates high enough for the lender-creditors without making them too high for the borrower-debtors.
The really big problem will come when there is too much of this money printing to provide creditors with adequate real returns, which will lead them to start selling their debt assets, which will substantially worsen the supply/demand balance. With the enormous size of US debt assets and liabilities outstanding, plus lots more to come, there is a high risk that the supply of government debt will be much larger than the demand for it, which will cause too-high real interest rates for the markets and the economy, leading to debt and economic pain that will eventually lead the Federal Reserve to switch from raising interest rates and selling debt (QT) to lowering interest rates and buying debt (QE). This will lead real rates to fall, which will lead to a high risk that there will be more selling of debt assets because of the bad real returns that these debt assets are providing. While people are now not thinking about the next interest rate cut and QE of the Fed, we should because the timing of these is probably less than about a year away and that will have big effects. I think that there is a good chance that it will produce a big decline in the value of money. So, it looks likely to me that the financial/economic picture over the next year or two will be tough.
While in this Observations I have been focusing on the money/credit/debt/market/economic dynamic, let’s remember that it is being accompanied by the internal conflict dynamic (most importantly the 2024 US elections that are coming up) and the external conflict dynamic (most importantly the US-China conflict and the US-NATO-Russia conflict, though others like that with Iran are notable). All of these conflicts affect each other. This setup implies to me that there is a significant risk that there will be 1) bad financial and economic conditions at a time of 2) bad internal conflict and 3) bad international conflicts—with the world being leveraged long. In a nutshell, it looks to me like the next two years will be a very risky time.
Please understand that I’m not sure of anything. That’s why I believe that the key to good investing lies in achieving balance of uncorrelated good return streams so that one’s portfolio has little or no bias to go up and down as conditions get better and worse. As I have stated repeatedly, this risk reduction can be done without reducing expected returns. So that’s what I think and what I recommend doing.
(Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.)
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Following are my bullet point highlights:
The economy and where we are today:
- Inflation has peaked and is starting to slow. Sees 4% inflation this summer. Longer run, inflation stays above 2%.
- Unfortunately, the way markets have shaped up over the course of February is a little reminiscent of how things were in 2022.
- But optimistic that 2023 will be different than 2022 for one key reason.
- Historically, market cycles and economic cycles do not always tightly aligned. Meaning markets are forward-looking and tend to bottom before the worst of the economic pain occurs, and earnings decline.
- So while 2023 could still be a pretty painful year from the perspective of what’s going to happen in the economy.
- When the economy starts to roll over, it rolls over in a very specific order. And right now, things are following that script. Hope goes down the drain; housing falls, output declines, profits decline, employment, and right now, we see that housing has rolled over, manufacturing has rolled over, and profits are weaker. Employment is still very strong, but again, included is always the last shoe to drop.
- It takes about six months, on average, to see the unemployment rate go from its bottom to the point where we head into recession. And even when we head into a recession, typically, the unemployment rate is still rising.
SB here: The Fed is uber-focused on unemployment. It is the last shoe to drop. A lagging, not leading indicator.
- The unemployment rate is down at 3.4%. The lowest we’ve seen since 1969.
- They expect it to rise to 5% or 6%, which is somewhat in line with the long-term unemployment averages.
- The other side of this is wage growth has been very strong. The workers are the consumers; the consumers are the workers, so if you’re putting more money into the hands of the worker, and they consume, that potentially has some inflationary implications.
- That is why the Federal Reserve is concerned about how many jobs they are adding to the economy. Many of them are in services which gives the Fed concern that if we keep going up and the demand for services is strong, inflation is going to have a harder time coming down.
- JPM believes we’ve seen a lot of the associated market sell-off, maybe not all, but we did have a pretty dramatic reset in valuations last year. (SB here: Yes, but still high and not a good entry point.)
- Valuations are better but still a bit expensive
International stock market:
- A declining dollar is good for international stocks
- Overall fundamentals look good
- Expects yields to be lower over the course of the year.
- The good news is that with the higher rates, we finally have income back in bonds.
- Regarding the high-yield bond market, yields are not too bad, but yields are not yet good enough.
- Favor higher quality over high-yield bonds
On Government Debt:
- The interest burden on debt is becoming a real issue
Bottom line: JP Morgan has a harder landing view on the economy than Goldman presented. Goldman felt the banking system was rock solid. That changed last week.
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With all that is going on in the banking crisis, Tuesday AM, I got a call from my long-time mentor John Ray. John helped me land my first job at age 22 on a Merrill Lynch Options Arbitrage trade desk. John ran money at the Delaware Funds Group. He said, “take a look at Credit Suisse.” CS closed at $2.54 on Monday, March 13. The stock peaked at $51.88 in 2007. Dropped to $13.02 at the Great Financial Crisis low in March 2009. It rallied to $42.12 by the end of 2009. It’s been a steady decline to its low this month.
“Price leads the news,” John said. Adding, “there is never just one cockroach.”
In that same direction, click on the next photo to access the Reuters article (this was prior to the Swisse National Banking $54 billion rescue… they may need more):
This is where the Credit Suisse and banking crisis starts to come into visibility. It has to do with something called counterparty risk.
“Rehypothecation” occurs when a lender uses an asset supplied as collateral on a debt by a borrower and applies its value to cover its own obligations. In order to do so, the lender may have access to a variety of assets promised as collateral, including tangible assets and various securities. This innovative cycle of leveraging another party’s assets as collateral generates a type of derivative that can expound positive results or bankrupt companies quickly should the strategy fail. Source: Investopedia
As the great Warren Buffett once said, “In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
Never just one cockroach…
This from Mohamed El-Erian, to which I agree:
The Fed has opened up its window and buying bonds at par, not at fair market value, but at par. A backdoor bailout of troubled losses? Losses due to the very spike in interest rates the Fed created. Are we next going to socialize the bank’s current market-to-market losses? I hope NOT.
In a picture, the current state looks like this:
I love Rosey’s wit and blunt way:
Inflation is of the Fed’s own creation – the result of zero interest rate policy held in place for far too long, plus QE ($120 billion monthly bond-buying program) and direct helicopter money injections into the economy courtesy of our legislators. Supply chain, ok, yes. But the big inflation guns came from central bankers everywhere. Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
I clipped this next chart prior to the emergency measures taken this week. Important nonetheless. Hard landing and recession ahead – M2 is in free fall:
Hard landing ahead:
Coming next to a theatre near you:
Remember that 10x leverage ratio I wrote about above? In case you were curious:
“No Head Fakes” – More from Rosey March 16, 2023 Tweet:
Danielle with some bite. Needed in my view:
Where does the Fed go from here?
Ok, I hit you with a lot. The big picture for me remains the same. Hard landing ahead. My best guess, we are in recession within six months. Sell rallies, raise cash. Be in a position to take advantage of a good buying opportunity. Bottom in the 3,000 to 3,200 range. Median PE “Fair Value” based on the median PE over the last 59 years puts the S&P 500 Index at ~ 2,900.
I could be wrong. It won’t be the first time. Yet, if I’m wrong and we indeed have bottomed, forward 10-year returns are somewhere in the -2% to +3% annualized zone. At 2,900, we are looking at coming 10-year annualized returns in the high single-digit area. Keep the seat belt buckled. Find better return potential investments than the cap-weighted S&P 500 Index funds. Get ready to act when there is pure fear in the streets. Not there yet.
An idea – what can you do?
In the what you can do about it category: Current high yield spreads are nearing 5%. We have a distressed debt fund with a seasoned team that has been positive every year except once in the last 20 years. They have done a great job at hedging their downside risk and, overall, have achieved a steady return stream. The reason it is getting interesting to us is that when high-yield credit spreads were 8% or higher, the returns achieved were in the mid to high teens. Another one of our managers underwrites a very short-term form of chapter 11 bankruptcy insurance protection. His clients are anyone selling goods to a buyer. If you make shoes and sell them to Macy’s and Macy files for bankruptcy before they pay you (generally paid to you in 60-90 days after they received them), your business is in trouble. Maybe sunk. So you’ve got to guarantee your investors, your bank, and your suppliers that you won’t go under if Macy’s files for Chapter 11 bankruptcy protection. So you are willing to give up 3% of your margins to buy 3-month protection. The current environment means the fund can charge a higher premium, say 4%, for the three months of risk. Of course, the investment is not without risk; everything has risk. But 90 days is a very short window of time, and a good credit team should have a good sense of the available money to pay the receivable. My point is not to make a recommendation; my point is to say that there are ways to protect and grow your wealth. A good advisor can find them for you. Or create your own network to find them. And, of course, there are no guarantees on anything in the investment business. Diversify your bets and control your risk exposure so no one thing you allocate to can blow up your ship.
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I do love the pure passion that exists in college sports. Few tournaments give us the joy of a last-minute winning shot or the heartbreak experienced by an opponent and their fans. There is just so much heart in college sports. That passion is now on display as March Madness gets underway. In Thursday’s game between the No. 13 seed, Furman, and Virginia, seeded No. 4, Virginia led 50-38 with just under 11 minutes to go. Then Furman went on an improbable run late in the game to upset Virginia in a 68-67 win. Northern Kentucky fell just short in its upset bid against Houston, but its band director had plenty of fun, striking up “My Own Worst Enemy” as the No. 1–seeded Cougars struggled to pull away. No. 15 seed, Princeton, upset No. 2-seed Arizona. One of the rare times a 15-seed upset a number 2–seed in NCAA Tournament history.
And as long-time readers know, I am an over-the-top Penn State fan. Last night, my Nittany Lions topped Texas A&M. Penn State has struggled for many years to reach basketball’s elite level and has a lot of work to do to get there. But this coach seems to have the Ted Lasso touch, and the team is playing as one, and I sure hope he stays in Happy Valley.
For my many Aggie friends, the next round of drinks is on me. I know you bleed maroon and white. I have just one humble, small (well, maybe not so small) ask: Join me as Penn State faces Texas on Saturday. The Lions are going to need all the love we can get. I love how sports can bring us together, whichever side of the bench we find ourselves on.
Enjoy the tournament. Hope your favorite team wins (unless they are facing my Lions)!
I’m traveling next Tuesday to Savannah, Georgia. I was invited by Skyway Capital to join them as they sponsor the Korn Ferry Tours Club Car Championship Pro/Am on Wednesday. It is a practice day for the pros and great fun for us amateurs.
Last but not least, HAPPY ST. PATTY’S DAY!
Wishing you a fun night, a good beer, and a great week,
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
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