19 March 2023

SVB Took the Wrong Risks. You Don’t Have To.

By Matthew McKee, CFA, CFP® and Arian Colarusso, CFA, CFP®

March 19, 2023

In our 2023 Outlook: Higher Rates Have Raised the Bar, we spoke of the “other shoe to drop”.  The first shoe was rising rates themselves harming asset values, and the second is the knock-on effects of higher rates. Like bank failures.

The Fed’s rate hikes were bound to break something, but few would have predicted how the dominoes would fall to topple Silicon Valley Bank.

Matt Levine provides a thoughtful and nuanced take in Bloomberg Opinion here.

A sign of worse to come? Or is everything going to be ok? Yes.

Investors should buckle up for some short-term market volatility while remaining long-term optimists.

With this new shoe dropping, the markets have reacted decisively into a risk-off, fear-on mood. The 2-year Treasury bill – a liquid, high-quality asset – has rallied sharply. Banks and regulators are now on high-alert for risk. We expect banks to be stingier with capital, tightening lending standards and reigning in credit-money. Company earnings estimates may start falling. Basically, recession.

This is exactly what the Fed’s policy of rising rates is trying to achieve. This possible recession may be mild – if losses and risks are apportioned to those most able to bear them. And on the bright side, it could get inflation back under control.

The recent bank collapses could be seen as isolated failures in risk management under oddly specific circumstances. The themes are clear – banks with outsized depositor exposure to the tech sector overlaid an interest-rate bet that hurt them at the same time.

The Fed’s swift actions to make depositors whole may stem contagion without risking too much moral hazard. After all, depositors shouldn’t have to conduct credit analysis on the banks where they park their money.

It is the equity shareholders in the bank that have justly been zeroed out (not bailed out). And equity shareholders of all other regional banks – even those in relatively good shape – are suffering as well.

 Yet another example of the perils of single-stock risk.

You might have noticed we’ve been pounding the table on “idiosyncratic” or “stock-specific” risk (jargon for: having too much of your wealth in one company’s stock).

It’s often the highest priority risk exposure we tackle when working with clients. We’re seeing it in wealth pictures everywhere.

Very few people believe their stock is vulnerable; it’s difficult to imagine the myriad ways in which something can go wrong.

Individual stocks play their role in certain strategies and situations. It’s important for investors to understand the potency of this risk and manage it with the utmost intentionality.

Here’s a LinkedIn Post by Adrian laying out a “play” concentrated stockholders might want to consider.

What we’re doing for clients

Our concerns in December led us to a more cautious allocation on the margin, as detailed in the 2023 outlook piece.

In balanced portfolios that contain a meaningful amount in bonds, we owned an outsized position in short-term and long-term Treasuries, which have done their duty admirably in the unfolding uncertainty.

Even stock-heavy portfolios (for those with high risk tolerance and long investment horizons) contain a potent dash of diversifiers – high-yield and long-term government bonds. Within stocks, we have leaned into high-quality companies with relatively stable cashflows, and low debts compared to the broader market.

We are actively assessing the unfolding situation and stand ready to make measured moves in response.

Investment nuances aside, we have seen a clear theme among our clients – we are helping them prudently de-risk in various ways. This de-risking usually has little to do with the current environment. It’s more about the long-term strategies that we are more confident can produce a desirable outcome compared to those that are over-indexed to a narrow view of the world.

We help our clients match their risk exposures to their risk capacity and their return opportunities to their goals. We help them uncover their biases and their blind spots so that they have a better shot at enjoying a higher standard of living in more future versions of the world.

What’s next?

It’s certainly been an eventful two weeks. All will be watching how the Fed reacts to the turmoil in this week’s meeting. We expect the committee will hike rates by 25 bps – enough to signal seriousness about the continued inflation fight, but smaller than the 50 bps they might have done before, an acknowledgment that – whoops, we broke something.

A hike of this size should calm market jitters, but the fundamental uncertainties will remain. Long-term investors needn’t overly worry, but everyone, always, should thoughtfully match their risk exposures with their risk capacity. Unlike Silicon Valley Bank.