Key Points

• Contagion Contained. March was marked by a banking crisis that developed rapidly and seemingly disappeared almost as quickly. Within just a couple weeks the second and third largest bank failures in history occurred and the bank regulators in partnership with the bank industry ringfenced other problematic regional banks. The good news is that by the end of the month, much of the market had moved on from the banking turbulence.
• Indecent Exposure. Not surprisingly, much of the performance for any given asset class in March, and the first quarter, was determined by its exposure to the banking industry. Small cap stocks and value stocks have heavier weights to the financial sector, and more specifically to the banking industry, and therefore trailed the broader market.
• Is the Dollar Done? Just a month after posting its best monthly return since last fall, a rebellion against the US dollar by several trading partners reignited the debate about the demise of the US dollar as the world’s reserve currency. But an examination of the composition of current foreign currency reserves and the factors needed to be a reserve currency, show quite clearly that there is no alternative to the dollar any time soon.
• Broad-Based Rally. Despite the bank failures, another rate hike by the Fed, and weakening economic activity, most major asset classes booked solid gains in March and all major asset classes were positive for the first quarter of 2023. The S&P 500 was up +3.5% and +7.0% for March and Q1, while the Bloomberg Aggregate Bond Index gained +2.5% and +3.0% for March and Q1.

Market Summary

Asset Class Total Returns

Source: Bloomberg, as of March 31, 2023. Performance figures are index total returns: US Bonds (Barclays US Aggregate Bond TR), US High Yield (Barclays US HY 2% Issuer-Capped TR), International Bonds (Barclays Global Aggregate ex USD TR), Large Caps (S&P 500 TR), Small Caps (Russell 2000 TR), Developed Markets (MSCI EAFE NR USD), Emerging Markets (MSCI EM NR USD), Real Estate (FTSE NAREIT All Equity REITS TR).

The 2023 market roller coaster continued through March. After solid gains in January, most asset classes fell in February, only to rally back nicely in March. Even the rally in March wasn’t without a heavy dose of volatility from trouble in the banking industry, the Federal Reserve’s ninth rate hike in the past year, and a lot of underwhelming economic data.

Within the US equity market, the Financials sector took a direct hit from the collapse of a few banks before regulators and the broader banking industry quickly stepped in to ringfence the troubled banks. Still, the financial sector finished March down nearly -10%. That was in stark contrast to the Technology and Communications Services sectors which were both up more than +10% for the month. In the end, the S&P 500 Index finished the month up +3.7% and up +7.5% for the first quarter. But with the large discrepancy between sector performance, Large Cap companies performed much better than Small Caps and Growth-oriented companies easily outperformed Value-oriented companies. Smaller companies and value-oriented companies comprise the majority of financial and banking stocks. Non-US markets slightly underperformed the S&P 500 in March, but still had healthy returns, with Emerging Markets (+3.0%) outpacing Developed Markets (+2.5%).

The trouble with the US regional banks stemmed from mismanagement, but also from the lagged effects of the Fed’s yearlong aggressive rate hikes. Mike Loewengart, Head of Portfolio Construction for Morgan Stanley Portfolio Solutions, summed it up succinctly:

Many banks loaded up on low-yielding long-term Treasuries before the Fed’s tightening cycle began a year ago. As the Fed raised rates aggressively, the value of those lower-yielding Treasuries dropped as more high-yielding Treasuries became available. That left many banks holding assets that were worth far less than what they paid for them—a problem both in terms of satisfying regulations for how much cash they needed to have on hand, and in terms of being able to pay depositors in the event many of them wanted to withdraw their money at the same time—as was the case with Silicon Valley Bank.

The Fed’s monetary policy obviously also has a significant impact on bonds. And with several economic reports released in March showing signs of inflation slowing, in conjunction with the banking turmoil, investors’ hopes were lifted that the Fed will limit its campaign to curb inflation sooner than previously expected. The bank failures led to bond prices jumping in March as investors fled to safe havens and then in the final week of the month the Fed’s most closely followed inflation gauge, the Core Personal-Consumption Expenditures Price Index, slowed more than expected. Earlier in March, the February Consumer Price Index (CPI) report showed that headline consumer inflation fell to 6.0% year-over-year, the eighth consecutive monthly decline and well below the 8.9% peak in June. Bond yields move in the opposite direction of prices, and March saw the 2-year US Treasury yield plunge -79 basis points (bps, or -0.79 percentage points) to 4.03%, the largest monthly decline since a -95 bps drop in January 2008. The benchmark 10-year US Treasury yield fell -45 bps to 3.47%, its largest monthly decline since August 2018. In the end, the Bloomberg Aggregate Bond Index gained +2.5% in March on the way to a +3.0% total return for the first quarter.

Looking forward, for now, the March banking turmoil appears contained and not systematic in nature. However, they are likely to result in further tightening of bank lending standards, which has the potential to slow economic growth, thereby increasing the risk of recession. On the other hand, the slowing economic activity may be welcomed as it takes the pressure off the Fed, and other central banks, to reduce inflation. It remains to be seen if the market is still treating “bad news as good news” or whether we’ve moved on to the “bad news is bad news” part of the business cycle. With the markets still facing a wall of worry with regards to the banking system, the Fed’s path for monetary policy, and the potential for more slowing in economic activity – not to mention the geopolitical issues with Russia/Ukraine, US-China tensions, and a rebellion towards the US dollar – we continue to believe well diversified portfolios with an emphasis on quality for both bonds and equity allocations is appropriate.

Source: Bloomberg, as of March 31, 2023.
Price Returns for Equity, Total Returns for Bonds.
* The term basis points (bps) refers to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 0.01%. Bond prices and bond yields are inversely related. As the price of a bond goes up, the yield decreases.

Quick Takes

CONTAGION CONTAINED

Following the failures of Silicon Valley Bank (“SVB”) and Signature Bank on March 10th and 12th respectively, bank stocks sold off sharply. On March 13, the KBW Bank Index closed 4.3 standard deviations below its 50-day moving average, which is an oversold reading that has only been hit on just three prior occasions since 1993. The failures of SVB and Signature Bank were the second and third largest US bank failures in history and the first since October 2020. With combined assets of $319 billion, 2023 already ranks as the second largest year for US bank failures as measured by assets impacted, trailing only the $374 billion in assets impacted by US bank failures in 2008. Despite the scale of the bank failures, markets appear to have accepted the government’s response to ringfence the troubled institutions. As seen below, the SPDR Regional Bank ETF remains well into bear market territory, down -25% year-to-date – with the vast majority of the decline coming after the bank failures. However, the SPDR Financial Sector ETF is only down -6.0% in the first quarter, showing that investors don’t seem to be too concerned the issues will reach beyond the smaller regional banks. The broad US market, as proxied by the SPDR S&P 500 ETF, is up +7.0% in the first quarter, showing the market has essentially moved past any true concern that there will be any contagion outside of the financial sector from the banking turmoil.

The Latter Half of February is Seasonally One of the Weakest Times of The Year
S&P 500 Index Returns In February (1950 – 2022)

Sources: Bloomberg, Bespoke Investment Group, FDIC.

INDECENT EXPOSURE

March was a volatile ride, as markets digested news of several failures and the government’s response to those –and several other—banks. How did the banking malaise impact investors’ portfolios? Not surprisingly, that depends largely on what asset class exposures were in the portfolio. As demonstrated in the chart above, the performance discrepancy grew significantly between the broader equity universe relative to the Financial sector, and more narrowly, the Banking industry within the Financial sector, in the back half of March. As a result, much of a portfolio’s performance at the end of March can be explained by the exposure to financials and banking. Small cap stocks were the only major equity asset class to finish in the red for March, with the Russell 2000 Index dropping -5.0%. In contrast, the large cap S&P 500 Index finished March up +3.5%. Examining the makeup of the Russell 2000 and S&P 500 helps explain that big discrepancy. Financial stocks make up about 14.5% of the S&P 500 but a heftier 17.6% of the Russell 2000. More importantly, bank stocks only comprise 4% of the S&P 500 but are nearly 10% of the Russell 2000. The discrepancies are even greater with regard to factor styles. Large cap growth was the top-performing equity group in March. Not coincidentally, it has virtually no bank stocks (just 0.1%) and only a modest weight to financial stocks (7.3%). In stark contrast, large cap value is more than a fifth (22.1%) in financial stocks and 7.7% in bank stocks. More than anything else, those exposures contributed to the Russell 1000 Growth Index outperforming the Russell 1000 Value Index in March, with returns of +6.8% and -0.5% respectively. That was the largest month of outperformance of large growth over large value since June of 2021. However, investors should look past short-term volatility and not chase the large growth outperformance. Almost all the March outperformance by large growth came in the week of the bank failures. In the week ending March 17th large growth outperformed large value by +5.8%. Large value outperformed the final week of March and was ahead in the first three days of April.

Financials and Banking Exposure by Index
Percent (%) of total market cap as of 2/28/2023

Source: Bloomberg. The S&P 500 Index is proxied by the holdings of the SPDR S&P 500 ETF Trust (SPY), the Russell 2000 Index by the iShares Russell 2000 ETF (IWM), the Russell 1000 Value Index by the iShares Russell 1000 Value ETF (IWD), and the Russell 1000 Growth Index by the iShares Russell 1000 Growth ETF (IWF).

LESSONS LEARNED?

The turmoil touched off by the collapse of SVB has undermined much of what the Federal Reserve, political leaders, and investors thought they had learned from the Global Financial Crisis of 2007-09. They assumed complex securities, too-big-to-fail banks, and shadowy, lightly regulated lenders were the problem areas in the system. Now they’re learning that the mundane, ostensibly safe areas—government bonds, smaller banks, and deposits—can also be weak links. By the end of March, much of the early-March banking turbulence had blown over with few additional consequences for the broader economy. However, if the issues aren’t fully contained, broader trouble could develop on a couple of fronts: smaller and regional banks may struggle to survive on their own; or the federal safety net will expand, creating new risks down the road. Between 2007 and 2022 banks boosted their holdings of Treasurys and federally backed mortgage securities to 20% from 12% of total assets, while the uninsured share of domestic deposits rose to 45% from 38%. And according to S&P Global Market, SVB and Signature Bank went to extremes, with uninsured deposits at 94% and 90%, respectively. Suddenly, after the Fed hiked rates by 500 basis points in a year, those seemingly safe Treasurys and government-backed mortgage bonds have lost value unless they are held to maturity and the number of uninsured deposits had expanded to the highest levels since the 1950s-1960s.

Banks’ Uninsured Deposits as % of Total Domestic Deposits
And Dates of New FDIC Insurance Limits

Note: From 2008 to 2010, the FDIC guaranteed all non-interest-bearing accounts. Some deposits categorized as uninsured may be insured because they are held on behalf of multiple beneficiaries.
Source: Federal Deposit Insurance Corp., The Wall Street Journal.

SCARY? YES! PANIC? NO!

The prospect of a banking crisis has many investors and clients wondering if their money is safe. That’s not unusual, especially with the Global Financial Crisis still seared in many people’s minds. Certainly, there has been a rush of depositors at the smaller regional banks to transfer to larger national/global banks and into money-market funds. First, keep in mind that as long as deposits are kept at levels within the amount insured by the Federal Deposit Insurance Corporation (FDIC) limit of $250,000 per depositor, per FDIC-insured bank, for each ownership category. In terms of ownership category, a couple could each have $250,000 in protection at a bank for their individual accounts, and another $250,000 each in a joint account in both of their names. They could have additional protection if they held a revocable trust at the same bank, up to $250,000 per owner per unique beneficiary. Now that’s what is technically covered, but $750,000 or more in various bank deposit accounts is not at all what would be recommended for most long-term investors. Market losses are part of investing and can persist for uncomfortably long stretches, but the vast majority of investors with a time horizon longer than a few years should be invested in a properly diversified portfolio. As shown in the table below, in all nine previous bear markets since 1950, three years after the -20% decline defining a bear market was marked, returns have been positive, by an average of +12.1% annualized. In all but three of the bear markets, returns were positive a year later, by an average of +19.2%.

How the S&P 500 Performs After Closing in a Bear Market

Note: Total Returns with dividends reinvested in the index.
*Returns for periods greater than one year are annualized.
Source: Bloomberg.

IS THE DOLLAR DONE?

The US dollar hit a two-decade high this past September amidst the Federal Reserve’s most aggressive rate hiking cycle in decades. Through March 31, it has fallen back a little a bit over -10%, but even with that pullback, it remains well within a 15-year uptrend that has seen it advance over +45% against the world’s leading trading currencies. Notwithstanding the dollar’s ascendence over that period, and its utter dominance as the global reserve currency, every few years the argument is reignited that it’s standing as the world’s currency standard is about to come to an end. The -10% correction from the 2022 cycle high, in conjunction with some atypical trade deal announcements in recent weeks, served to spark the latest flurry of media attention about a potential demise of the dollar. And there are plenty of signs that the twenty-year slide of the US dollar’s share of world trade may continue.

Against the backdrop of Western sanctions, the Chinese yuan has replaced the US dollar in Russia. As a result, in February the yuan outperformed the dollar for the first time ever in monthly trading volume in Russia. But even with U.S.-China relations at a low point following the Chinese spy balloon fiasco, trade between the world’s two largest economies just hit an all-time high of $690 billion in 2022. By comparison, China’s record trade with Russia was less than a third of the U.S.-China at $190 billion in 2022. Yes, Saudi Arabia and some of the largest economies in South America are also exploring trade arrangements in currencies other than the US dollar. But replacing the dollar would be very difficult.

The 20-year slide in the dollar’s share of global transactions has meant the dollar now represents just under 60% of total foreign currency reserves. That’s only about a -10% decrease over twenty years, and the next closest currency, the euro, is just 21% of world currency reserves. And the euro has been in its own slow decline for more than ten years. The Chinese yuan has risen as a share of the world’s currency reserves but it is still less than 3%. It could grow twenty-fold and still have less share than the US dollar. Reserve currency status is closely correlated with the size of the issuing country’s economy. China’s the second largest economy behind the US, but to become a scalable reserve currency, China would have to end capital controls, unpeg the Yuan from the dollar, develop a much larger bond market, and be willing to run trade deficits. And even if the euro survives long term, there’s really no euro-denominated bond market. India is growing rapidly, but it would need to grow more than 600% to match the US’s GDP today. That could take two to three decades. More than 60 countries peg their currencies to the dollar. The next closest runner-up is the euro with a couple dozen countries pegged to it. The recent rebellion against the US dollar will likely further erode its influence, but there are no feasible alternatives to replace it anytime in the foreseeable future. Stated simply, replacing the US dollar is much easier said than done.

The Dollar Has Been in a 15-Year Bull Market
US Dollar Index (March 2003 through March 2023)

Source: Bloomberg.

A TALE OF TWO HOUSING MARKETS

To say the US housing market is mixed right now is an understatement. On a year-over-year basis, Existing Home Prices, which make up most of the home sales, fell for the first time in 11 years in February. According to the National Association of Realtors, the national median existing-home price declined -0.2% from the prior year to $363,000. But on a monthly basis, sales of previously owned homes rose +14.5% in February to a seasonally adjusted annual rate of 4.58 million, snapping a 12-month streak of declines. And the data isn’t just mixed on an annual versus monthly basis—it also varies geographically. A separate home price index by Black Knight shows we are a nation of two housing markets divided right down the center of the country. In all 12 major housing markets west of Texas, plus Austin, home prices fell in January on an annual basis. In the 37 biggest metro areas east of Colorado, except Austin, home prices rose year-over-year.

A Nation Divided… by Home Prices
Home prices fall in the West, and rise in the East

Source: National Association of Realtors, Black Knight Home Price Index, The Wall Street Journal.

Asset Class Performance

The Importance of Diversification. Diversification mitigates the risk of relying on any single investment and offers a host of long-term benefits, such as lowering portfolio volatility, improving risk-adjusted returns, and helping investments to compound more effectively.

Source: Bloomberg.
Asset‐class performance is presented by using market returns from an exchange‐traded fund (ETF) proxy that best represents its respective broad asset class. Returns shown are net of fund fees for and do not necessarily represent performance of specific mutual funds and/or exchange-traded funds recommended by The Retirement Planning Group. The performance of those funds may be substantially different than the performance of the broad asset classes and to proxy ETFs represented here. U.S. Bonds (iShares Core U.S. Aggregate Bond ETF); High‐Yield Bond (iShares iBoxx $ High Yield Corporate Bond ETF); Intl Bonds (SPDR® Bloomberg Barclays International Corporate Bond ETF); Large Growth (iShares Russell 1000 Growth ETF); Large Value (iShares Russell 1000 Value ETF); Mid Growth (iShares Russell Mid-Cap Growth ETF); Mid Value (iShares Russell Mid-Cap Value ETF); Small Growth (iShares Russell 2000 Growth ETF); Small Value (iShares Russell 2000 Value ETF); Intl Equity (iShares MSCI EAFE ETF); Emg Markets (iShares MSCI Emerging Markets ETF); and Real Estate (iShares U.S. Real Estate ETF). The return displayed as “Allocation” is a weighted average of the ETF proxies shown as represented by: 30% U.S. Bonds, 5% International Bonds, 5% High Yield Bonds, 10% Large Growth, 10% Large Value, 4% Mid Growth, 4% Mid Value, 2% Small Growth, 2% Small Value, 18% International Stock, 7% Emerging Markets, 3% Real Estate.
* The term basis points (bps) refers to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 0.01%. Bond prices and bond yields are inversely related. As the price of a bond goes up, the yield decreases.

Chris Bouffard is CIO of The Retirement Planning Group (TRPG), a Registered Investment Adviser. He has oversight of investments for the advisory services offered through TRPG.

Disclaimer: Information provided is for educational purposes only and does not constitute investment, legal or tax advice. All examples are hypothetical and for illustrative purposes only. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed. Please contact TRPG for more complete information based on your personal circumstances and to obtain personal individual investment advice.