The quarter began with surprisingly strong employment and economic data.
Following surprisingly robust US employment and retail sales data in January, US Treasury yields spiked sharply. Through early March 2023, investors were increasingly focused on higher-than-expected inflation and the potential for higher-than-expected peak rates. Since the beginning of the year, two-year US treasury yields rose by 65bps to 5.2% and 10-Year US treasury yields rose by 25bps to 4.1%.
Market expectations for peak Fed Funds rates rose to 5.5% vs. the 5.1% median projected by Fed officials.
The swift collapse of Silicon Valley Bank and Signature Bank on March 10th significantly altered investor expectations regarding interest rate trajectory and economic growth.
Both suffered from classic bank-runs driven by mismatched duration of assets and liabilities. Specifically, these banks held significant amounts of long-duration Treasury and mortgage-backed securities which had declined on a mark-to-market basis (as interest rates rose sharply in 2022) while having a large portion of less sticky non-retail deposits.
In SVB’s case, a large portion of these deposits were those of venture capital portfolio companies (many of whom needed cash to fund business operations as valuations declined and the fund-raising market dried up).
SVB’s demise started when it flagged the need for equity capital as it faced rising deposit outflows and incurred realized losses on its bond portfolio upon sales undertaken to raise liquidity. SVB’s largely corporate depositors panicked and quickly withdrew funds setting off the bank run that ultimately led to SVB’s failure and takeover by the Federal Deposit Insurance Corporation (FDIC).
After SVB collapsed, investors and depositors focused on banks’ $620 billion of unrealized losses (which they would not need to realize unless they were forced to sell). Regional banks were especially exposed as they had less oversight from regulators than the larger systemically critical banks.
Investors became increasingly concerned that other regional banks may also suffer swift deposit flight and that they may be forced to sell their bond portfolios at large losses which would wipe out their equity.
The FDIC and Fed swiftly took proactive measures to make all depositors at SVB and Signature whole and created lending facilities so other banks could stave off any potential customer runs.
If the FDIC and regulators had not swiftly acted, the risk of a broad-based financial market panic would have intensified, and significant economic damage may have resulted.
While shares of regional banks remain sharply lower YTD (despite having rallied significantly from lows), the banking situation stabilized and additional bank failures appear unlikely. Bank lending initially declined by record levels in the weeks post-SVB, and customers were rapidly reducing deposit levels (and shifting them from smaller to larger banks). However, in recent weeks, bank lending has stabilized with a resumption in growth, and deposit outflows have stabilized as well.
The unrealized mark-to-market losses on held-to-maturity securities have also declined meaningfully from YE2022 levels as interest rates have fallen swiftly over the past month.
Capital markets have had varied reactions to these banking events.
The Treasury market swiftly reversed course with interest rates falling quickly and bond market participants pricing in Fed Fund rate cuts by H2 2023 vs. the Fed’s expectation of holding rates slightly above 5% through early 2024. The Treasury market is pricing in a scenario in which a deeper recession takes hold sooner than expected.
The equity market has actually rallied 5.7% since the SVB news as equity investors have cheered prospects for a sooner-than-expected end to rate hikes followed by possible pivots to interest rate cuts. Equity markets appear to be pricing in a soft-landing scenario with limited declines in corporate earnings.
Equity markets rallied sharply in USD terms by 8.7% YTD through April 14th (ACWI Index) and are now 20% above early October 2022 lows.
The YTD rally was primarily driven by US (+8.2%) and developed international markets (+11.4%). The strong S&P 500 index performance was largely driven by large gains in technology and internet stocks which benefitted from swiftly falling interest rates. International developed markets’ strong performance was driven by extremely mild European weather (leading to no energy crisis) and optimism surrounding China’s reopening (beneficial to European cyclical and luxury exporters).
Inflation reports were mixed during the quarter. In the US, headline inflation has receded sharply while core inflation still remains stubbornly high (although leading indicators are signaling a deceleration). In Europe, headline inflation has plunged due to falling energy prices. However, core inflation remains at record levels.
The range of forecast outcomes for public equities performance in 2023 remains unusually high given the uncertainties regarding prospects for economic slowdown or recession, magnitude of potential corporate earnings declines, and ultimate trajectory of inflation and interest rates.
Government and investment-grade bonds have appreciated sharply YTD.
The Barclays US Aggregate Index has appreciated by 3.0% YTD as interest rates swiftly fell following the collapse of SVB and Signature Bank as investors increasingly priced in potential for higher recession probabilities.
With inflation having peaked and many leading indicators demonstrating slowing conditions, it appears increasingly likely that central banks are close to ending interest rate hikes. US Treasury bond yields already reflect these expectations to some degree as 2-Year Treasuries have declined by over 100bps and 10-Year Treasuries have declined by over 65bps from early March peak levels.
We see better value among shorter-term maturities (6 month-to-2 years) than mid-to-longer term Treasuries presently.
High-yield bonds and leveraged loans (riskier corporate credit) have performed well YTD.
High yield bonds and leveraged loans are up 4.4% and 4.0% respectively YTD.
Strong high-yield bond performance was largely driven by declines in Treasury base rates whereas strong leveraged loan performance was driven by high current income associated with rising SOFR short-term base rates.
Absolute yields are presently attractive (driven by high base rates) and enhance the prospect for positive returns in 2023 and above-average mid-term returns.
Interestingly, high-yield and leveraged loan markets largely shrugged off the collapse of SVB and Signature Banks and the resultant turmoil among regional bank equities whereas US Treasury yields experienced rapid significant declines as Treasury markets increased bets for an earlier than expected recession followed by faster-than-expected rate cuts.
Hedge funds were flat to up low-single-digits (depending on the index) in Q1.
Credit and convertible arbitrage strategies performed best (+2% to +3%) whereas global macro strategies performed worst (-2.5%).
Private equity buyout fund performance was more resilient than public equities and was down mid-single digits YTD through Q3 2022 (latest data available). However, venture capital funds were down 15.2% YTD during the same time frame.
Private equity and venture capital strategies report performance with a one-quarter lag (as such, latest data is of 9/30/22 valuations). Based on preliminary 12/31 data, PE fund returns were flat to modestly up vs. Q3 2022.
Private credit performed well through Q4 2022 (latest data available given lagged reporting)
The Cliffwater Private Credit Index was up 2.0% in Q4 and 6.2% for full-year 2022 as floating rate loans benefitted from rising rates offset somewhat by valuation markdowns.
The near-term outlook for existing funds is relatively positive. Increases in SOFR base rates has led to unlevered current yields of north of 10%. However, defaults and markdowns may increase and offset some of this return.
Private real estate pricing began to decline in late 2022.
The NCREIF Index was down 3.5% in Q4 2022 but up 5.5% for full-year 2022. Property value declined due to higher cap-rates, driven by surging debt financing costs rather than underlying fundamental NOI weakness.
Transaction volume has declined significantly as cap-rates and borrowing costs have increased and property valuations have declined over the last several months.
Underlying property fundamentals remain strong across industrial and most multi-family sectors but are weaker across office and certain retail property types.
Investors are closely assessing commercial real estate debt maturities (over $1.3 trillion maturing by YE 2024) and potential for elevated loan losses and resultant pullbacks in bank lending over the next 12-18 months.