First Quarter of 2023 Reflection and What’s Next for Financial Markets

This time it’s different. No really, it is.

How many times have you heard that about the financial markets? And things end up not so different. Everything pretty much stays the same with a few new attributes or features added in.

“This time it’s different” might be a fitting statement regarding the current state of the financial markets. Let me explain…

We have lived through a decade and a half of extraordinarily accommodative financial markets. If the stock market falls and looks in danger of starting a new bear market… no problem, just lower interest rates. The party goes on as the punchbowl gets refilled.

Investors have learned to buy during the dips knowing everything will be fine. And indeed, that strategy has worked. The US stock market has been a machine. Just throw in your money and the machine spits 12% returns. So simple.

The Fed Responds to Financial Markets Crisis By Printing More Money

In response to nearly every crisis, genuine or perceived, the Federal Reserve has responded by printing more and more cash. This is a concept that I believe is misperceived in how it works – but applicable nonetheless.

In the early 2010s, the Fed printed massive amounts of dollars to turn around and purchase US Treasury Bonds. Inflation continued to be benign. This is because the Fed used the money to take money out of the economy. In fact it was deflationary, taking away the availability of interest payments from Treasury Bonds took cash out of the economy.

Inflation doesn’t occur until money is either lent or spent.

The other result of this policy is credit availability. In a normal environment, businesses have to pay higher rates as their credit deteriorates. They become less likely to repay their debts. 

But in The Go-Go Years of the 2010s, credit did the opposite. It became less expensive to borrow as rates fell. Thank you, Fed, you just prolonged hundreds of money-losing crappy businesses.

The implosion of Silicon Valley Bank and the coming crisis in commercial lending would not have been possible without the leadership of the political class in this country, “Let’s throw some money at the problem. It will go away. Then we’ll take a victory lap.” But I digress.

What’s All This Have to Do With Silicon Valley Bank?

Let’s talk about banking, and in particular, Silicon Valley Bank (SVB).

SVB was like any other bank. They took in deposits and lent them out. They were borrowing short-term and lending long-term. However, because interest rates were so low, many banks had to go long-term to capture extra yield. (Bond investors did this exact same thing.) This actually worked pretty well.

But there’s one problem… inflation.

In order to calm inflation the Fed has no other choice but to raise rates. It is their primary mandate to control inflation. Saving the financial markets is secondary and maybe not even always achievable. In the last six months, interest rates have gone vertical and bank assets have collapsed in value. This requires some explanation.

You see, some of the money banks lend out they also take and invest in US Treasury securities. Uncle Sam guarantees US Treasuries won’t lose money, so that seems appropriate. (As long as they are held to maturity.)

With rates around 1%, SVB had to buy longer-term US Treasuries. That’s fine as long as no one needs their money. But SVB had a run on the bank. The problem is those Treasury Bonds had fallen in value since interest rates had gone up.

Think of it like this. For every 1% increase in interest rates, the value of a 30-year Treasury falls 8-12%. So SVB depositors wanted their money. SVB had to start selling Treasuries, at steep losses.

In the event that your assets and liabilities do not match, your equity may be wiped out. That is what happened at SVB. SVB’s depositors lost confidence and headed for the exits.

Of course, SVB wasn’t required to run their business this way. It chose to do so. 

An old adage is there are over 10,000 banks in the US but only a few hundred bankers. But SVB was encouraged by the system that was overseeing it. The question is how widespread is this, and is it just applicable to Silicon Valley or banks lending to venture capital firms?

I believe SVB is an extreme example. But it does frame the very issues that our financial system will need to address over the next few years. The decline in banks’ equity will weaken the banking system’s ability to handle the higher defaults that will be coming down the road.

In short, The Federal Reserve encouraged excessive risk-taking by banks, individuals, hedge funds, mutual funds, etc. At some point, a 30-year-long asset bubble starts and needs to deflate.

The Next Crisis Du Jour: Should You Be Concerned?

This winter Americans received a reprieve at the gas pump. The average price per gallon fell nearly 40% in six months.

Don’t expect this to last. An energy reckoning is coming. Let me explain…

The energy market has to be looked at from both the supply and demand side. The equilibrium between the two results in price.

Supply-side Oil Energy: A Disruption Has Occurred

Historically, oil companies took X amount of their profits and reinvested into new exploration and discovery. Companies record this amount in their financial statements as investments or reserve investments.

The old rule was you want to see an oil company invest enough to replace its reserves used in the prior year. This ensures the supply side of the equation is in balance. You have enough new oil to meet pent-up demand and some in reserve. The result is somewhat stable pricing.

However, over the last decade, this relationship has been disrupted. Energy companies have faced increasing pressure – hostility even – to emphasize green investments over traditional oil and gas assets. As a result, multinationals like Exxon and Chevron have axed their reinvestment programs. The trend started over a decade ago.

The problem is investing and actually bringing assets online is a long-term proposition. A refinery takes 10 years from the planning stage to actual fruition. An oil well is much faster, but again you have to transport the product and refine it. This is what I mean when I talk about lack of investment.

Sectors and industries where there has been a lack of capital investment are the ones you want to invest in, not industries that are swimming in cash and need even more, like electric vehicles. Dollars have flowed into EV technology and it’s still not enough. They need even more. If investment has been scarce, then companies have had to streamline and penny-pinch to survive.

That’s the supply side. It doesn’t look great that the industry hasn’t invested any money in oil and gas. So there will be less of it.

Demand-side Oil Energy: A Post-Covid Explosion

How about demand? Energy demand cratered during Covid and has ramped up ever since.

The International Energy Agency (IEA) raised its forecast for global demand citing the reopening of China’s economy as the main driver. This is just one factor. Demand from emerging countries is set to explode even higher adding several million barrels of demand a year.

Indeed, a report published late last year by the IEA itself projects global oil demand to not peak until the mid-2030s, and to plateau there for decades and not drop until sometime around 2050. In the meantime, the oil industry market trades in relative calm. For now anyway.

Most investors are under-allocated to oil and gas.

For several years I wrote about inflationary pressures being an anchor for securities markets. ESG and EV investments will lead to increased prices for nearly all rare earth metals. These technologies are mining dependent.

The reality is right now there are not enough resources to bring these aggressive policies to fruition. High-interest rates and inflation are indeed an anchor to investment returns.

Our game is finding great businesses that can raise their prices in inflation. These often wield great balance sheets with low debt.

It Really Is Different This Time… Here’s How

Right now I don’t think the masses really get it. It really is different this time.The asset bubble is deflating and will continue to do so for the next decade. It simply must. Our present course is unsustainable. But in that vein, I believe there will be great opportunity.

  • America’s big banks are very well funded. They have better balance sheets today than at any other time in my lifetime.
  • The oil and gas industry is poised for the greatest decade of returns in their existence. Most Americans will miss it. They think the great returns are over. They’re still there, just not where they have been in the past.

Persistent inflation, higher oil prices, and higher interest rates are long-term concepts. Pricing trends tend to run in 30-year cycles. (There’s been research papers written and conjecture on why.)

We just ended the cycle of lower and lower interest rates, low inflation, and low oil prices. That bubble has just burst. We’re at the beginning of a new era.

Indeed, mark my words, it is different this time. The cycle has turned. What has worked in the recent past is behind us and won’t be back for most of our lifetimes.

Steve’s Advice…

So my advice is to ignore the Crisis Du Jour. There are more coming. Treat it as a distraction.

If you want to learn more about these markets, read Goehring & Rozencwajg, a newsletter on natural resource investing. I’d also highly recommend the musings of Horizon Kinetics research. In my view, Murray Stahl and his staff at Horizon Kinetics are among the elite in investment thought and theory. I can’t wait for their quarterly letters – fascinating research indeed!

As of 3/23/2023, my five largest personal holdings are Berkshire Hathaway, Triad Business Bank, Occidental Petroleum, Sprott Resources, and Paramount Global.

CSH’s largest holdings are Berkshire, Paramount, Markel, Meta Platforms, and Cash.

Thank you for your continued trust,

C. Steve Henry
Certified Financial Planner
Registered Investment Advisor