During the quarter, most asset classes posted positive returns, recovering somewhat from a difficult 2022. U.S. stocks, non-U.S. stocks, and insurance-linked securities led the advance with mid-single-digit returns. Bonds and real estate securities turned in more modest gains.
The positive asset class returns across the board may be surprising given the tumultuous headlines during the quarter. In March, the collapse of a top 20 U.S. commercial bank—Silicon Valley Bank (SVB) in California—sent shockwaves across the banking system. In a nutshell, SVB had experienced a massive growth in deposits from its tech-concentrated customer base, had invested a big chunk of those deposits in longer-maturity U.S. Treasuries (1), and then suffered a significant loss on the Treasury investments when interest rates shot up. When the bank’s customers rushed to withdraw their deposits, the bank quickly became insolvent.
Parts of SVB’s difficulties were unique to that bank. But the part about a sharp increase in interest rates causing havoc is not. Consider the following statistics:
94 percent vs. 43 percent: The percentage of “uninsured” deposits at Silicon Valley Bank (94 percent) vs. the percentage of uninsured deposits across the entire banking sector (43 percent) (2).
The Federal Deposit Insurance Corporation (FDIC) insures deposits of up to $250,000 per depositor, per insured bank, for each ownership category. The statistic above means that nearly all of SVB’s deposits were above the FDIC limit, and therefore at risk in the event of a bank failure. One technology company alone, Roku, had over $480 million in cash on deposit at SVB. The high percentage of uninsured deposits made SVB more susceptible to a bank run.
0.24 percent vs. 4.51 percent: The percentage yield on bank savings accounts (0.24 percent) vs. the percentage yield on a representative government money market fund (4.51 percent) (3).
One factor putting stress on all banks, not just SVB, is that bank customers now have a significant incentive to move their money out of traditional bank accounts. Increases in short-term interest rates have led to a significant jump in the annual yield offered by money market funds. Banks have not kept pace in terms of what they offer depositors.
Shortly after SVB’s collapse, federal regulators announced a new program designed to support banks facing deposit withdrawals. The new program seems for now to have calmed down both financial markets and bank withdrawal activity.
Other Facts and Figures
Keeping with the facts and figures theme from above, let’s review some additional topics that may be of interest:
2.3 percent, 2.3 percent, and 2.3 percent: The market’s implied annualized inflation expectation over the next five years, 10 years, and 30 years, respectively. (4)
Yes, it’s a bit of a coincidence that these figures are all the same, but that’s not why I include them in this letter. We have found that the market’s current inflation expectations tend to surprise clients. It is no secret that we are experiencing the first significant bout of inflation in several decades. For context, the current annualized inflation rate is approximately 5 percent, and the annualized inflation rate over the past 20 years has been about 2.5 percent (5). The market currently expects that the Federal Reserve will be successful in getting inflation under control and that it won’t take very long to do so.
November 1, 2023: The market’s current estimate for when the Federal Reserve will begin to cut short-term interest rates. (6)
Like inflation expectations, the market’s consensus for the future path of interest rates can be determined from the relative prices of various securities. And the market is clear on the following point—the current market expectation for the future path of interest rates is down, not up (7).
Half: The approximate portion of the S&P 500’s first quarter return attributable to the performance of Apple and Microsoft alone. (8)
After a rough year for tech stocks last year, the two largest U.S. tech companies bounced back in the first quarter with double-digit percentage gains. The two tech giants currently account for more than 13 percent of the market value of the S&P 500.
57 percent: The cumulative return advantage for U.S. small company “value” stocks over the broad U.S. stock market since 9/30/2020 (9).
Zooming out a bit, a big winner over the past few years has been small company “value” stocks. These are companies that are in the smallest quartile of U.S. public companies by size and trade at relatively low prices in relation to fundamental measures of corporate worth like earnings, sales, book value, etc.
We generally “tilt” U.S. stocks in client portfolios toward small company value stocks because over long holding periods they have tended to outperform the broad market, and we expect the causes of that outperformance to persist. However, small company value stocks can painfully underperform the broader market for years at a time, and their outperformance often occurs in short bursts. Historically, as an investor’s holding period increased, so did the odds of small company value stocks outperforming the broad market. For small company value investors, patience is key.
9 percent: The approximate compound annualized total return for the S&P 500 in the 15-year period ending 2022.
Now let’s zoom out further to a “long” investment horizon, which we tend to think of as at least 10-20 years. Picking the mid-point of 15 years reveals an interesting contradiction. During that period, stock investors have had to deal with the worst financial crisis since the Great Depression, a pandemic that halted the global economy, an inflationary shock, and a total of three bear markets each of which caused stock price declines of greater than -25 percent. Yet the compound annualized return for U.S. stocks over this period was almost 9 percent—close to the 10.1 percent long-term (1926-2022) historical rate of return for stocks.
The next 15 years likely will bring other challenges and setbacks, perhaps beginning with more trouble in the banking system or persistently high inflation. The rough patches are part of the journey. They don’t necessarily define the outcome.
As always, we are grateful for the opportunity to advise you and look forward to our next conversation.
1.Through the sale of U.S. Treasuries, the government can borrow money from investors. Treasuries ultimately mature on a specified date at a specified value but, before then, they fluctuate in value with changes in interest rates. An increase in interest rates causes the value of these investments to decline.
2.Sources: S&P Global Market Intelligence, Brookings Institute, FDIC, and CNN.
3.Sources: Bankrate and Fidelity Investments.
4.From Bloomberg.com. Calculated by finding the difference between nominal Treasury yields-to-maturity and the corresponding yields-to-maturity for Treasury Inflation Protected Securities (TIPS). Data on 4/14/23.
5.Source: Bureau of Labor Statistics and Morningstar.
6.Data from CME Group.
7.One can observe this expectation from the yields available, for instance, on one-year vs. two-year Treasuries. Two-year Treasuries have a lower yield than one-year Treasuries, which implies that the yield available on one-year Treasuries one year from now is expected to be lower than the yield available on one-year Treasuries today.
8.Source: New York Times.
9.Our recommended fund in this category, Bridgeway Omni Small Cap Value, has returned approximately 84 percent cumulatively from 9/30/20 through 3/31/23. Over the same period, the S&P 500 returned approximately 27 percent cumulatively.