ASX Market Update 13th March 2023
Global Market Commentary
Well, what a wild ride the last 48 hours of trading was last week. No sooner had we heard of a bank in the US called ‘Silicon Valley Bank (SVB)’ for the first time, for only hours later it was to be considered bankrupt. SVB were the US’s 16th largest bank and luckily enough its downfall seems to be unique and not a contagion event and I’ll quickly explain why without going too in depth.
Chart: SVB Financial Group as at 10/03/23
SVB seems to be like no other bank whereby most of its depositors were start up tech companies. In fact, in their earnings call only last week they boasted they had attracted almost half of all start ups in the valley in 2022. They also only had a mere 37,500 customers on their books. So, you have a situation of high exposure to one sector which is also not spread across many customers. In fact, 93% of its deposits were above the insured $250,000 limit.
So, during 2020/21 there were a lot of tech startups created due to favourable financial conditions such as rates near 0% and lots of cash needing to be invested. And we all saw the growth in the NASDAQ during this time. Hence these tech companies needed to park large amounts of cash they were receiving into a bank like any company or customer would. A lot of these deposits went to SVB and in fact during that time their deposits grew by over 100%. Now you may think great, the bank has lots of deposits all it fine and it was until you hear what they did with all that money.
Most banks when they receive our money will either invest it in very low risk government bonds or use it to loan money to other entities and generally balance that well. In SVB’s case they didn’t do much of the lending side and mostly invested a lot of those deposits into US Treasuries & Mortgage bonds. Again fine until we have the situation we have had played out over the last 12 months. Now key thing here to remember is as rates and yields rise the price or value of bonds fall. They are inversely correlated. So SVB invested a lot of money into bonds when rates were low and then over the last 12 months the value of those investments have fallen substantially, especially in mortgage bonds where the yield curve was much steeper. This means the value of their book held many unrealized losses. Now I’m not going into how they classify those investments as ‘available for sale’ or ‘held to maturity’ because we could be here all day but basically as soon as you started selling some of those assets a lot of those losses start having to be realized and you need sufficient capital to cover those losses. This is what brought SVB unstuck.
So why did SVB start having to sell some of these bonds? Well in simple terms they had a run on the bank. They had a natural run off of deposits in the last 6 months as those tech startups started to burn cash. Also many of these tech startups are managed by Venture Capitalist companies. Well, they worked out that SVB was a going concern due to their investment books unrealized losses and that if things got worse then it would be a big problem, so VCs told them to pull their money out. Now silicon valley is a tight nit community so word gets around quickly, thus it had a snowball effect amongst almost all their depositors and we get to where we are today. On Thursday I had heard they had $16bill worth of realized losses to cover with only $11bill of capital. They also tried to raise capital but also failed in doing so. However, on Friday I also heard a further $42bill was withdrawn from their deposits in one day so that loss figure was much larger by then and by Friday afternoon, in the US, the authorities had stepped in to take control. Now thankfully its being said that depositors will get most, if not all their money back. However, shareholders and creditors are likely to get nothing.
This is a very basic summary of events that lead to SVBs demise and there are a few more intricacies that are important but for the sake of keeping it simple this is where we will leave it. Many are pointing fingers at the Fed as to whom it blame for lifting rates so aggressively and hence creating these losses but to me that had a small hand to play. Most of this sounds of a lot of mismanagement from not diversifying their investments more from just bonds and loaning more money out to having literally no interest rate hedges in place on those investments. Not to mention not having a risk manager for the last 8 months and having such a high concentration in one sector in terms of its depositors.
What are the consequences of the SVB collapse? At this stage they look limited and only directly related to SVB and I don’t see any contagion effect. You will hear a lot about unrealized losses on bank balance sheets this week and moving forward. They will use very large numbers to scare and intimidate you, however they hold very little value without context and when compared to bank HQLA (High Quality Liquid Assets) and LCRs (Liquid Cover Ratio). The large banks will carry high unrealized losses but have adequate capital. There is a small chance that confidence is lost in these smaller regional banks and a run could occur there if more skeletons come out of the closet, but as I said earlier it seems as if SVBs situation was unique. This does not seem like the precursor to another GFC type event. I do think it will provide an opportunity to enter in US Bank stocks, maybe as soon as this week. The whole sector has been hammered and a lot of it is based on fear. Exposure to that on the ASX is limited but Betashares has a global bank ETF, BNKS which 40% is weighted towards to US. This could be an option without direct investment. Markets are likely to be volatile this week as more information emerges from the collapse but the key is to keep a cool head and remain rational.
Chart: S&P 500 Index as at 10/03/23
I was going to lead with the next segment, but due to the SVB situation I thought it was important to cover that first. Basically, my thinking moving forward has changed regarding the US economy. I have been reading a lot of research regarding this, this week and it has slightly altered my view. To cut to the chase my thinking has moved from no recession but a slowdown in the US to an unavoidable shallow recession starting in Q2/Q3 this year. If anything, I am logical and rational and when presented with new information we have to consider it. This is what has happened and I am not one to be stubborn for the sake of pride in this game. We must remain nimble and flexible otherwise markets will turn against us.
The thesis behind this has to do with the construction industry and its very high and tight correlation with the rest of the labor market in the US. Up until now the construction industry has remained resilient and job losses have not occurred; however I believe this is about to change, and change quickly. Building approvals lead everything else in the sector. These have been falling fast for the better part of a year. Generally, construction activity peaks 5-6 months after approvals fall 20% or more. It seems construction peaked last month, around 10 months after the falls, this lag can simply be put down to the pandemic delaying everything via lack of supplies and labor and thus pushing start dates out. So once construction peaks, jobs start being lost, and they are lost quickly. On average construction will shed 600-800k jobs from the industry and then another 2-3 million associated jobs will be lost as well. This is where the recession starts and leads the economy lower. This is the era we are headed into this year. Further evidence can be found in constructions job ads falling by 49% last month according to the jolts data.
Now I believe it will be shallow due to the current strength of the jobs market, savings & wages. During the GFC the unemployment rate peaked at 10%, but also started closer to 5%. This time around we were at 3.4% unemployed and thus I feel it will peak around the 5-6% mark. This is obviously going to impact consumer spending and pull the US into recession. I believe even if the actual data doesn’t confirm a technical recession the conditions will be recession like.
NFP data on Friday night showed a large beat on the underlying number seeing 311k jobs added to economy in Feb. However the unemployment rate ticked up from 3.4% to 3.6% and wages growth was much slower at +0.2% vs the +0.3% expected. I didn’t expect the NFP to reflect job losses in the construction sector this early but this coming month or next is when we start to see it.
Chart: US Government Bonds 10 YR Yield as at 10/03/23
Finally let’s touch on the Fed, Powell and all things rates and inflation. Its hard to read the situation at the moment. Normally I would say the jobs data was strong enough to get a 25bps rise from the Fed this month, but not the 50bps some were expecting. However, given the scenario with SVB and potential similar problems with other regional banks it may be enough to get the Fed to pause. The bond markets may be thinking the same way as we have seen the 10yr yield retreat 30bps in the last two session and the 2yr 48bps. Powell may think a pause is warranted in order to allow institutions to sure up balance sheets and bring yields in, thus bond prices up, and unrealized losses on those portfolios down. We have seen those yields come in already, as stated above, but if a pause was announced I am sure there would be significant downside to come.
Back home I also believe there is a strong chance the RBA pauses in April. Economic conditions have deteriorated here also and if monthly CPI data comes in soft again then the RBA has all the excuses it needs to pause. We may get another 15bps lift to close out the current cycle to bring the official rate to 3.75% and stop my eye twitching looking at the 3.60%.
S&P/ASX 200
*Chart: S&P/ASX 200 as at 10/03/23
The chart above tells you all you need to see. After the events in the US we saw a savage -2.3% sell off on Friday to end the week which was looking soft already. After knocking on the door of old highs in late January the XJO has experienced five weeks of losses pushing us below that upward trend we have been straddling since October. Without a significant bounce next week there is a real risk the XJO trends down to the longer-term support between 6600-6700. Given that our earnings outlook is still somewhat positive this would represent an excellent entry opportunity across many sectors. It would put us around 13x forward PE and close to a 5% forecast yield.
Earnings
The February earnings season just passed us by and I would have to admit it was more disappointing than positive. Earnings misses outweighed beats and if you missed consensus then on average you were sold off 4% on the day vs the 2% 5yr average. Also if that miss came with a earnings downgrade you were sold off 10%+ on the day. This tells us that the market was slightly too optimistic going in and was caught out. Forward earnings for FY23 have been slightly revised down by most analysts with many seeing around 5% growth for the year. Remember a while ago that was around +9% and I said it was too optimistic and thus this has turned out to be true. Below is a quick few stat from the earnings season that I thought was relevant:
· Profits fell 30% on aggregate.
· 5% growth in dividends
· +11% in sales & +15% in expenses
· 84% reported a rise in expenses
· $207bill in cash holdings
· 88% firms paid a dividend with 53% lifting, 12% maintain & 22% cutting
· 87% of companies reported a profit with only 41% lifting them
· The best sectors were Insurance, Staples & Healthcare. The worst were resources.
The positives remain the strong health of balance sheets across the board. With cash holdings still high and net debt low. Also more companies are confident in their outlook with only 30% not giving any guidance vs 60% last August. Finally, we will see 70% of the dividends paid out in the last week of March and first week of April. This generally gives our market a boost as a lot of that comes back into stocks.
The ‘Return of the King’
Just as Aragorn’s army had to defend the city of Minas Tirith versus the army of Sauron in the famous last lord of the rings film ‘return of the king’ so too has the popular 60/40 portfolio strategy had to defend against lower bond valuations and higher yields over the last 18 months. At points it has hung on grimly, looking like all hope is lost, never to return, only for Gandalf the white to shine his bright light over the horizon to signal hope and help is on the way. Now if you are totally lost and all I have done prove to you what I nerd I really am then please bear with me. What I am trying to say is for the last 18 months an investment in bonds has been a spectacular fail with bonds being sold off savagely as yields soared higher. However, with peak yields on the horizon and a flight to safety possible then it looks as if this beaten down asset class will reign again.
The 60/40 portfolio strategy (60% equities/40% bonds) has been one of the most popular over the last few decades as yields remained low and bond prices on the bid. During that time, it has performed well, outside the last 18 months, and offered a safety net whilst also reducing portfolio volatility. Now with bond prices looking oversold and with accompanying high yields it may be time to revisit this strategy again. If we see what we think will play out with yields coming down and bond prices rising either due to peak hawkishness or possible recessions across the globe it would make for an attractive strategy. If you can secure 40% of your portfolio, almost risk free, and receive a 3-5% yield whilst doing so then many will consider it. Obviously if growth outperforms again then this strategy will underperform but for an investor looking to preserve capital whilst receiving a decent yield that doesn’t matter so much.
For most of us investing in bonds here in Australia is too hard and has a high barrier to entry with minimum purchases of $100k or more mostly needed. However, there are few ETFs that do this for us and can give us exposure to an array of bonds. Below are three I like to use in client portfolios:
Global X US Treasury Bond ETF (USTB: $9.45)- Gives you exposure to US Treasuries with an effective duration of 6.5 years. It carries a 2.04% dividend yield with a yield to maturity of 4.39%. It is also currency hedged adding that extra protection. Recently listed on the ASX it has a decent fund size of $240mill and distributes quarterly.
Betashares Australian Government Bond ETF (AGVT: $42.53)- Very similar to USTB but in Australian government bonds instead. Slightly longer duration at 8.8 years but with a similar yield of 2.5% and 3.95% yield to maturity. No need for currency hedging here but is unique as it distributes its income on a monthly basis.
VanEck Australian Subordinated Debt ETF (SUBD: $24.78)- A little different to the other two as it invests not in Government Bonds but corporate subordinate debt. Now this may scare a few off as it is tier 2 debt but when you see that its all issued by the top five Australian banks then it should put you more than at ease. This one has a yield of 3% but a running yield of 5%+ with monthly distributions like AGVT. Average duration is 7.5 years.
These investments are a bit boring and won’t provide huge returns, but they have an important place in the investment universe. The above three also are only a few of these types of ETFs out there with CRED, PLUS, XARO, TACT & VAF worth looking at also depending on your targeted sector.
You will be hard pressed to find a more eventful last 48 hours of markets then what we just experienced this week. As I mentioned above expect a rough week for markets as it digests all that is thrown at it. The less we hear from other regional banks about balance sheet stress the better we will be. If we hear of another couple that suffer from similar circumstance then a quick 5-10% move to the downside would be on the cards. However, I expect this to be contained and remain a unique situation to SVB.
On the personal front there isn’t much to report. Our little girl has just turned 4 months old and I can’t believe how quickly that time has passed us by. She is such a happy little girl and gives us virtually no trouble eating and sleeping well. In fact we have been lucky with all our kids being excellent in that way. The two boys are at school and really enjoying their time. I am so very proud with how they conduct themselves at school and how they are excelling in all areas. They are two very intelligent little men, which they certainly don’t get from their father. Footy season starts this week, which I am very excited about. Very keen to see how the Crows improve this season and I have a feeling we may surprise a few. Hope you are all well. Remember feel free to call me anytime if you have concerns about the market or your portfolios. Happy just to chat and help ease your minds. Keep safe and I hope to speak with you all soon. Go Crows!
heath@hlminvestments.com.au
0413 799 315
Important Notice
Any advice in this article should be considered General Advice only and does not consider your personal needs and objectives or your financial circumstances. You should therefore consider these matters yourself before deciding whether the advice is appropriate to you and whether you should act upon it. I am happy to assist you in this process. To do so, I will need to collect personal and financial details from you before providing my recommendations. Please note the author may own shares in the companies mentioned in the above blog.
