Beware The Ides Of March

Telemus Weekly Market Review March 13th - March 17th, 2023

In Shakespeare’s Julius Caesar, a soothsayer warns the Emperor Caesar to ‘beware the ides of March’. The caution proved to be prophetic as Caesar was ultimately assassinated by a group of Senators on March 15th in the year 44 B.C. Technically the ides refers to the time in March when there is the first full moon. In 2023 the first full moon occurred on March 7th. Thereafter Silicon Valley Bank failed, and contagion spread this past week across regional banks. It led to an eventful week with significant moves across stocks, bonds, and commodities. 

The primary concern impacting markets this past week was a worry of a contagion of bank failures extending beyond just the downfalls of Silicon Valley Bank (SVB) and Signature Bank. While there were some company specific elements that contributed to the downfall of SVB and Signature, banks are sensitive to the risk of having to sell bonds at a loss should be they be faced with deposit outflows. The sharp rise in interest rates has resulted in many bonds sitting on bank balance sheets being currently valued for less than they were initially purchased for. If these bonds had to be sold, and the losses recognized, bank capital levels could be severely impacted. 

Stocks were able to withstand these concerns during the week as the S&P 500 gained 1.4%. Most sectors were positive although the energy and financials sectors experienced disproportionate declines. The energy sector slid -7% as the price of West Texas Crude oil dropped over 10%. Financials were down -6%, as regional bank stocks were more acutely impacted with the KBW Regional Bank index losing -9%.  The week’s winners ended up being many of the largest companies as investors flocked to safety in stocks like Alphabet, Microsoft, and Nvidia; all of which were up over 10%. 

Bonds finished the week with gains of +1.4%, an equal amount to the S&P 500. The key driver was a sharp drop in interest rates. The 2-year Treasury, which had traded at a yield of 5.07% prior to the failure of SVB, finished the week at 3.84%. On Monday, the 2-year Treasury experienced its most significant one day drop in yield since 1987. A countering force that tempered bond gains was wider credit spreads, or investors demanding a higher yield to take on the risk of default in corporate bonds. For example, high yield bond investors are now requiring over a full percentage more in yield versus comparable maturity Treasuries bonds relative to levels prior to SBV’s failure.

Looking back at the past week, markets were anything but orderly. The volatility among Treasury bonds was the highest it’s been since the Great Financial Crisis. The corporate bond market has effectively shut down, with the new issuance calendar empty and trading liquidity drying up. Money quickly fled into money market mutual funds, which now sit on $6.1 trillion of cash balances. Within the equity market, volatility shot higher, as the CBOE Volatility Index (VIX) hit its highest level of volatility since last November. What we find interesting is that the bond market’s reaction of wider corporate bond spreads and sharply lower Treasury yields is an indicator of the market pricing in a greater probability of a recession. Equities did not seem to reflect that with prices broadly higher as losses were more concentrated. 

This coming week not only will the market be reacting to news and evolving conditions around the banking industry, but the Federal Reserve Open Market Committee meets to assess any further interest rate increases. Two weeks ago, the market had been expecting a half of a percent increase in the Federal Reserve’s federal funds rate. By the end of this week, probabilities were roughly 50/50 on either a quarter of a percent or no increase. Concerns of higher rates negatively impacting banks will have to enter the Fed’s decision making on whether they want to prioritize fighting inflation or helping to foster stability among banks. This decision is anything but easy given February’s Consumer Price Index (CPI) released this week that indicated that inflationary trends remain persistent. 

Market movements this past week reflected investors reacting to and repositioning portfolios because of challenges in the banking industry. In markets where there is a more acute shock, such as the present concerns associated with the liquidity of regional banks, passive strategies often leap ahead as they are more broadly diversified and less exposed to outsized movements of any one individual stock. In addition, they can experience immediate asset flows in response to portfolio repositioning. This tendency played out over the past week where exchange traded funds (ETFs), which are predominantly passive strategies, accounted for 41% of equity trading volume. Typically, ETFs account for 20-25% of equity trading volume. 

As portfolios are repositioned via passive vehicles, this often leads to a lack of differentiation in prices as stocks and bonds trade as a group. As the market navigates the direction of inflation, further actions by the Federal Reserve, liquidity of the banking industry, and the direction of economic conditions there will likely be instances where asset prices overshoot to the upside or downside. Should this occur, we expect there to be a greater array of price dislocations in the market. Despite the moves of the past week, we have yet to see outsized movements that compensate investors for what is a higher risk environment. Given the array of risks that remain, we advocate for remaining patient and disciplined in seeking upside potential that is commensurate with the risk. 

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