Client Investment Letter April 2023

“There is a lot of stuff we can’t control, but it is completely in our power to decide what the definition of a good job is. That’s up to us.” – Mike Rowe


There was an old show on the Discovery Channel called Dirty Jobs where the host, Mike Rowe, traveled around the country making dad jokes while trying his hand at the messiest, most difficult, and most dangerous jobs out there. We never saw the episode where he visited the Federal Reserve and learned about central banking, but clearly Fed Chairman Jerome Powell has one of the trickiest jobs even in normal times, with market participants hanging on his every word to gauge future policy action. During the first quarter, his job became one too hazardous even for Mike Rowe.

First, let’s go back to 2021, when policymakers rushed to pronounce high and accelerating inflation as “transitory.” Even when the data began to clearly suggest otherwise, the Fed dug into this narrative, refusing for too long to course correct. “We think that this is likely to be a temporary phenomenon,” the Fed Chairman told us in May of that year. “The inflation numbers…will moderate as we go forward.”

It wasn’t until November 2021, when it was clear that inflation was becoming embedded, that Chairman Powell proclaimed that the word “transitory” should be retired. The Fed’s repeated mischaracterization of inflation delayed its policy response and later forced it to catch up through one of the most aggressive series of interest-rate hikes ever. This policy error would soon metastasize into something more malicious that could not be seen at the time, as is often the case.

As we only learned this March, the abruptness of the monetary tightening caught some institutions off guard and opened a new front in the battle for financial stability: a global banking panic. Believing that rates would stay near-zero forever, dozens of complacent bank treasurers parked deposits on their balance sheets in long-dated government bonds in order to pick up a little extra yield. As the Fed raised rates from virtually zero to 5.00% in the course of 14 months, these bonds rapidly lost value, which wouldn’t be a problem if held to maturity; there was no credit risk. Accounting rules allowed these underwater bonds to be classified as “held to maturity” and carried on the balance sheet at cost. But when deposits fled, either to cover operating expenses or to invest in higher-yielding alternatives, as was the case first at Silicon Valley Bank, it was forced to sell assets and realize those losses.

The sudden collapse of Silicon Valley Bank, the second-biggest bank failure in U.S. history, plus Signature Bank, has caused depositors to question the financial stability at many other regional banks, setting off a cascading bank run. This is the first bank run in the age of social media and mobile apps making transfers only a click away, which has certainly accelerated the deposit outflow. Days later in Europe, Credit Suisse collapsed, shamefully ending its 167-year ride with Swiss regulators forcing its sale to rival UBS. Investors have since bid up the cost of protecting against the default of many other European banks, a sign of potential financial stress.

We will pause here to mention that we have never owned any banks in your portfolio, nor do we intend to. Further, all of our custodians fully segregate client assets from their own balance sheet in adherence to strict requirements on custody and safekeeping of assets. This means that in the unlikely event of insolvency, these segregated assets are protected against creditors’ claims. One last word of comfort: Though the term “banking crisis” is often used to describe events of the past quarter, this is not comparable to the Great Financial Crisis (intentionally capitalized) as the U.S. banking system was recapitalized in its aftermath and is far healthier today. Further, the losses banks are experiencing today are due to a timing mismatch between their assets and liabilities, not owning bad assets.

The policy response to the sudden loss of confidence by depositors in some U.S. banks was the old playbook of backstops and bailouts. And thus, the Fed is now contending with an intense new challenge for which it is partly to blame: how to reduce inflation, support growth and employment, and manage financial contagion from a systemic banking crisis without creating moral hazard. Surely, somewhere Mike Rowe is smiling that he never dared to set foot in the Eccles Federal Reserve Board Building.

It should be noted that central banking has never been an easy job, and the situation Jerome Powell is facing isn’t unprecedented. Paul Volker’s effort to tame inflation in the 1980s caused a famous double-dip recession from 1980-1982, but persistently high rates to address inflation scares throughout the decade also resulted in the birth of “too big to fail” when Continental Illinois depositors were bailed out in 1984 and kicked off the savings and loan crisis where more than 1,600 banks failed through the early 1990s. For the most part, the economy muddled through the failures, notwithstanding a mild recession in 1990-1991.

As deposits flee small banks, the economic spillover could be a reduction in lending as banks shrink their balance sheets, increasing the risk of a credit contraction that could undermine economic growth. The bond market is skipping a few steps ahead and is now pricing in significant interest rate cuts by the end of this year, a bet that clear economic softness in the months ahead will supersede inflation concerns, even as inflation remains above the Fed’s long-term target of 2%. Cutting rates would support growth while also almost immediately improving the solvency of the regional-bank sector: Estimates are that U.S. banks are sitting on unrealized losses of $2 trillion in hold-to-maturity portfolios, which would be recovered rapidly as rates fell.

Before the rate cuts come though, we expect volatility in the stock market to pick up as economic headwinds develop. To date, the equity markets have been quite resilient – surprisingly the S&P 500 is up year-to-date – as investors are already salivating for more stimulus. But we believe earnings expectations will likely be lowered, and it’s quite likely that valuations contract as well. So, we anticipate a bumpy road ahead as a likely recession and earnings contraction takes hold. We continue to believe that owning reasonably valued, high-quality companies with healthy balance sheets and strong pricing power is the best way to navigate such an environment, especially given the Fed may need to stop tightening before inflation has completely been reigned in.

While there were no major changes to your portfolio in the first quarter, the volatility has already created opportunities, and a couple of new ideas are close to becoming actionable, so stay tuned. The cash we hold in your account has served us well in dampening your portfolio’s volatility, but we aim to deploy it over time as we see great companies get washed out with the broader market. In the meantime, it’s parked in risk-free bonds yielding around 4.5%. We are still positioned quite defensively.

As we turn the page on a tumultuous first quarter, we want to thank you for the ongoing confidence you place in us and to remind you that we are always available should you have any questions or concerns. Rest assured we are working hard to protect and grow your portfolio, in that order. In times like these, our jobs are so rewarding but also both difficult and somewhat intense. We wouldn’t have it any other way.

Mike Rowe, eat your heart out.


Penn Davis McFarland, Inc.
April 2023