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Strategy Update

A Run on the Banks

The month of March began with a quiet announcement from a relatively unknown bank called
Silvergate Bank. The “bank” was as much a cryptocurrency exchange as it was a conventional
bank, and their troubles had been evident since the collapse of various cryptocurrencies in
2022. On March 1st, Silvergate announced they might not have sufficient capital to continue.
The share price collapsed, depositors started to flee, and a week later the bank was insolvent.

The pace of that first decline felt glacial compared to what happened next. The same day
Silvergate officially went bankrupt, Silicon Valley Bank, the country’s most prominent lender to
the private equity and venture capital world, announced it would raise money by selling new
shares of its stock. The need to raise money set off alarm bells, and its depositors started to
withdraw money. The next day, $42 billion left the bank, with $100 billion lined up to leave the day after. Before that could happen, the bank was seized and put under the control of the FDIC.

In the span of just thirty-six hours, the U.S. had suffered its second-largest bank collapse in
history. Within the banking world, a weekend of panic ensued, capped off by Signature Bank,
another prominent lender to the cryptocurrency world, becoming insolvent. In the span of just a few days, three banks had closed, representing the most significant bank panic since 2008.

In the weeks since, the shares of a handful of banks have suffered tremendously, while the entire sector has struggled to regain investor confidence. First Republic Bank, most notably, has
required assistance from other banks and, at times, has seemed on the brink of becoming the
next insolvency. But even as First Republic Bank suffers, the contagion that swept through the bank sector for a week in March seems to have run its course. Many banks have reported their
results for the first quarter of the year that show resilience and allay the worst fears harbored in
March. Yet, with the height of the panic now likely behind us, bank shares have recovered little
meaningful ground, and investors remain skittish. To understand why, one needs to understand
the underlying causes of the bank panic. Given the specific banks that failed, it would be easy
to link the panic to the cryptocurrency collapse, or to the larger decline of the venture capital
industry in 2022. But this analysis misses much of the nuance, and too easily relegates the
problems to a few unique banks.

To fully see the larger problems affecting the entire banking sector, we return to the dominant
economic narrative of the last eighteen months: high inflation and rising interest rates. For banks, rising rates are proving to be a double-edged sword. Higher rates make it increasingly
productive for customers to move their money from checking and savings accounts into
higher-interest Money Market Funds, or short-term Treasury Bonds. This movement, in turn, is
beginning to drain bank deposits. The shift is occurring slowly at most banks, but as highlighted
above, at a few institutions it was cripplingly fast. And all banks now must suffer through
continued outflows or raise rates for their depositors, which hurts profitability.

Rising rates have also exposed poor investment decisions made by some banks in 2020 and
2021. During those years, a number of banks decided to invest some deposits into longer-dated
Treasury Bonds. This decision presumed that interest rates would remain low for a prolonged
period of time, but within a year these bonds sat at a significant loss. Now, as deposits leave,
the most pinched banks are forced to sell these bonds to generate the necessary funds for their
departing customers.

The bank panic may be over, but these larger issues, especially that of declining deposits, will
continue to exact a toll for months to come. And a critical byproduct of this episode will almost
certainly be increased conservatism on the part of most banks. If a bank is worried about
slipping deposits, it will naturally not lend out quite so much money. This will in turn act as
another brake on the economy, since bank lending is one of the key cogs in the machinery of
economic growth. Recessionary expectations have increased through the month of March; this
can be attributed almost entirely to the problems exposed by the bank panic, and the problems
it continues to create. An economy that was already fragile, as a result of rising interest rates,
will now have to contend with a cautious banking sector as well.

Current Strategy

The stock market staged a recovery in January and February, as it appeared that inflation was
more convincingly on the decline. Inflation served as the primary headwind for the market
during a tough year for investors in 2022. Any fresh signs that inflation was moderating
would naturally be received enthusiastically. Then the bank turmoil hit in March, temporarily
wiping out all progress the broader market had made on the year. We saw the beginnings
of an opportunity and made some new stock investments, while increasing the size of some
existing investments. While our investment actions in March do reflect a little risk-taking and
opportunism amidst a panic, we continue to balance our stock exposure with considerable
reserves in money market funds for most clients. This seems prudent given the heightened
chances of a recession some time this year.

Stock prices have recovered since the lows in March, as has our investment portfolio. Yet it
is telling that since the lows of the banking panic, among the best performing sectors in the market are healthcare companies, consumer staples and utilities. Meanwhile, the financial
and industrial sectors are almost unchanged, and shares of many banks and manufacturing
companies are setting new lows daily. The market is being lifted higher by the shares of
companies that are resilient during recessions, to the exclusion of many other companies.
This is not a rally in stocks that speaks to investor confidence in an improving economic

The recovery in the bond market this year has felt more convincing and durable than the
recovery in stocks. Inflation is falling, although not quite as fast as the Federal Reserve might have hoped. But the banking panic and growing economic weakness provide a compelling
argument that central bankers have pushed far enough on interest rates. The Federal Reserve
must now seriously balance the health of the economy and the financial sector against the risk
posed by inflation. Bond investors think the Fed will pivot towards lower interest rates soon, as
economic risks force a more cautious approach. As these expectations of a pivot grow stronger,
longer-dated bonds are rising in price, continuing a rally that began late last year.