What recession could mean for investors

Recently, two US banks failed. Silicon Valley Bank and Signature Bank. Scott Rainey gives his view on financial markets and how Silicon Valley Bank may affect investors.

Recently, two US banks failed. Silicon Valley Bank and Signature Bank.

Silicon Valley Bank was the bank of choice for technology companies in the US. Signature Bank was a regional bank based in New York.

This was big news in New Zealand because four New Zealand companies; Rocket Lab ($62m of $789m), Xero ($8.2m of more than $820m), Comvita ($2.5m) and ikeGPS ($5.3m of $19.6m) all had deposits in Silicon Valley Bank ranging from the equivalent of NZD$2.5m for Comvita to $62m for Rocket Lab.

Initially, that looked like a big problem as US Federal Deposit Insurance is limited to USD$250,000 or approximately NZD$407,000. A few days later, it was still a problem, but not one for deposit makers, with the Federal Deposit Insurance Corporation (FDIC) guaranteeing all deposits, not just up to the USD$250,000 limit.

Silicon Valley Bank was a big bank, the 18th biggest in the US. It has been described as the second biggest banking failure in US history, with the failure of Signature Bank being the third biggest. That seems a bit scary.

However, banks failing in the US isn’t all that uncommon. The US banking sector is very different from ours. It is fragmented and often regional.

In the Great Depression, which started in 1929, approximately 9000 banks failed in the US. This led to the creation of the Federal Deposit Insurance Corporation in 1933 as part of President Franklin Delano Roosevelt’s ‘New Deal’ to help the United States recover from the Great Depression.

During the 1980s and 1990s, more than 1000 banks failed during what was called the Savings & Loan Crisis. The Federal Deposit Insurance Corporation had lots to do then.

In the Global Financial Crisis, 500 banks failed, including the largest failure of all time – Washington Mutual, which had a market capitalisation of $17b. Silicon Valley Bank was $6b, and Signature Bank $4b.

In the seven years leading up to the GFC, a golden time for banking, fuelled by then Federal Reserve Governor Greenspan’s Go for Growth model of Monetary Policy, 25 US banks failed.

Following the massive Fiscal and Monetary policy interventions post Covid when banks had never had access to more or cheaper money, 4 US banks still failed in 2020. The fact that none failed in 2021 and 2022 was, actually, a bit unusual.

Let’s put the two banking failures in context. $6b and $4b are big numbers.

The second and third biggest ever is true in a nominal sense, but let’s not forget that the size of the US economy has grown exponentially over the last 100 years.

The total Gross Domestic Product (GDP) of the US in 1929 was $1.1 trillion dollars. The total GDP of the US in 2021 was $19,427 trillion. That’s growth of 1.77m%.

This also makes $6b 0.003% of the US economy. We don’t mean to be flippant; shareholders in those companies will be upset. At least big shareholders will.

Because Silicon Valley Bank was the 18th largest bank in the US, it was held in underlying funds we manage for clients. Remember, by the way, that our portfolios contain, on average, exposure to somewhere between 6000 and 9000 individual companies. Silicon Valley Bank was one of those thousands.

Based on analysis, the overall exposure to Silicon Valley Bank might be 0.03% to 0.04% of as much as 20% of an average client portfolio. That equates to approximately 0.006% to 0.008% of an average client portfolio.

That’s diversification; investing’s only free lunch.

There has been a lot of media coverage about the R word – Recession – lately. I thought it would be useful to investigate the link between Recessions and markets and what being in Recession might mean for investors.

What is a Recession?

Investopedia defines a Recession as a significant, widespread, and prolonged downturn in economic activity.

Most experts define a Recession as two consecutive quarters of negative economic growth. That means two quarters with a decline in Gross Domestic Product or GDP.

GDP is essentially the sum of all economic activity in an economy, everything it makes or sells.

So, are any developed market economies actually in a recession? Maybe.

In 2022 we experienced a Bear Market, which is a fall in markets from peak to trough of 20% or more, which for most markets occurred in June 2022.

Since 1929, in the US, there have been 15 recessions and 26 Bear Markets. So no, Bear Markets do not predict Recessions.

Recently, Economists from the big 5 (ANZ, ASB, BNZ, Westpac and Kiwibank) all adjusted their predictions to predict that NZ might already have one foot in Recession with a drop in GPD for the December quarter in advance of Stats NZ releasing data for the December 2022 quarter on 16th March 2023.

They were correct; New Zealand has had one quarter of negative growth or a contraction. GDP declined by 0.6% in the December 2022 quarter.

As we ended 2022, I tested John Kenneth Galbraith’s premise that:

“The only function of economic forecasting is to make astrology look respectable.”

My conclusion, tongue firmly in cheek, was that Economists’ predictions for the Official Cash Rate last year were worse than an Astrologist’s prediction for me.

So, while they might be right, based on previous evidence they’re probably not.

Regardless of whether we are or are not in for a Recession, it might be useful to consider what might happen to markets if we do have a Recession.

I reviewed the S&P 500 Index, the largest stock market index in the United States, and analysed returns during a Recession and the year after.

Since World War II, there have been 13 Recessions—defined as two consecutive quarters of negative GDP growth or decline.

Reviewing the data, the S&P 500 somewhat surprisingly rose on average by 1% during actual Recession periods – remembering that Recessions generally don’t last all year. That’s because markets usually peak before the start of Recessions and trough before they end.

The full year returns were somewhat different. About half the time, they were up, and half the time, they were down. The average return was -1.1%, which was skewed by the GFC in 2008 and oil shocks in 1974. Exclude either of those numbers and the average becomes positive, exclude both, and the average return goes to almost 6%.

What is interesting is the following year’s returns. Those are almost all positive and significantly higher than the long-run average return. The overall average return for the S&P 500 since 1945 was 10.9%. The average return, the year after a recession, is 16.9%.

What is more difficult to show is when those second-year returns arrive. On average, the strongest returns occur just after an economy comes out of Recession, which means that trying to time when to get out and, more importantly, when to get back in is risky.

The average return of all 26 years, the year with a Recession in it and the year after, is 8.0% very similar to the long run average of 10%.

Negative returns aren’t pleasant, but they can and do happen over the short term. Over the long term, investors are rewarded for discipline.

Banks, in fact, all types of companies, fail from time to time. It’s not even unusual. That’s why we hold lots of companies so the impact of any one failing won’t be too pronounced.

We neither know whether we will go into Recession or what being in Recession might mean for investors if we do. The combined average returns of the year of a Recession and the year after are close to the long-run average. If you take the median, they exceed it.

Diversification, discipline, and patience are investors’ best friends, and combined, they are rewarded.

By Scott Rainey, Principal & Financial Adviser

21 March 2023

Disclaimer: Information as at 21 March 2023. This article is general information and does not consider your financial situation or goals and does not constitute personalised advice. There are no warranties, expressed or implied, regarding the accuracy or completeness of any information included as part of this article.

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