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The Credit Squeeze, Banking Crisis & Resulting Economic Headwinds

The impact of the banking crisis is still unfolding despite assurances from the Federal Reserve and the Big Banks that the banking system remains strong and resilient. With over 100 banks in similar situations as SVB the mismanagement of "duration" risk is clearly widespread among many regional banks. In addition to the current "risks" that have the headlights focused on them are the significant commercial paper "risk" that regional banks hold and will need to be refinanced in the coming years. These are valued in the trillions of dollars. A significant portion of this debt was financed when interest rates were around zero. As this debt rolls over and needs to be refinanced there is a high probability this will occur in a market with higher than zero interest rates, lower property values and less liquidity in the short term, due to the banking failures and call for tighter regulation of regional banks.

COVID accelerated a comprehensive change in employee remote work arrangements. While the trend has generally moved towards a hybrid approach of remote and in-office work arrangements, companies are down-sizing their office space requirements as they consolidate use with shared employee spaces. This trend will impact demand for commercial office space. The commercial real estate market is struggling as a result. Before the pandemic, office space occupancy was close to 95% whereas last December it was at 47%.. Lower rental income equates to declining values. An office building in San Francisco for example that sold for $397 million in 2019 was on the market in December 2022 for $155 million.

Regional banks carry significant risk exposure to commercial paper and commercial real estate companies that are in a market downturn and this will be or should be a forward looking concern to investors and depositors. Columbia Property Trust’s default on a $1.7 billion floating-rate loan, and Brookfield Asset Management’s default on $750+ million in debt in Los Angeles are early warning signs. Commercial real estate leases can span several years so it will take approximately a couple of years for this to unfold during which millions of leases will expire. Companies renegotiating their leases will have the upper hand. They may lease less space or no space attall. Either way, this trend will impact the value of commercial real-estate if rental occupancy and rates decline. This in turn will impact the value of commercial loans on regional banks books and impact their capital ratios.

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Navigating The SVB Collapse and The 2023 Global Banking Crisis

Banks are meant to be in the business of managing risk and mitigating for exactly these types of scenarios. Instead of hedging that risk one must assume that it considered that risk to be an outlier. In either case, one would be right in questioning the judgement of management. As depositors withdrew funds, SVB had to sell its portfolio of bonds and mortgage backed securities for a loss of approximately $1.8bn. When SVB announced this fact to the market - a market that was already on edge - along with the need to raise additional capital, large Silicon Valley VC's began pulling their funds out of the bank which combined with dire messaging amplified through the megaphone of Twitter turned into a stampede. Over $40 billion dollars was withdrawn in 3 days causing the second largest banking failure in US history and new management - that is, the FDIC - to step in.

Other notable banking failures in the last week include Silvergate Capital and Signature Bank who had too much risk exposure to the centralized brokerage companies and counter-parties that failed in the crypto markets. Likewise, in these instances, proper risk management would have contained, hedged or managed these positions and the potential risk of outright catastrophic loss.

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Will the Fourth Industrial Revolution Kill Inflation?

Inflation was up 0.5% in January and the CPI was up for 6.4% from the same period last year. Both numbers were higher than expected and have predictably caused the Federal Reserve to reflect and take a more hawkish stance. Shelter, Food and Energy remain the primary culprits boosting inflation numbers, of which shelter represents approximately 50%. While the markets anticipate a decline in shelter costs over the year this has proved stubbornly resilient to date. The next meaningful economic data announcements this month include "retail sales", the "monthly jobs report" and the consumer price index report for February.

You may be wondering why this article is titled "Will the Fourth Industrial Revolution Kill Inflation" and that is because we are on the cusp of paradigm shifting innovations which will unleash a "productivity revolution" unlike anything that has come before it. The combination of AI, Robotics and Quantum Computing to mention just a few will reinvent what is possible. The current Quantum Computer in development at Google is purported to be 158 million times faster than the fastest supercomputer on the planet. That is an unfathomable leap. AI (Artificial Intelligence) is expected to double in its capacity every 6 months. At the most rudimentary level, these technologies combined with advanced micro-devices that have the potential to monitor every item and point on any supply chain, will not only address "supply chain" imbalances but altogether drive logistical, material and sustainable efficiencies across entire industries. By addressing supply chain issues, one of the main contributors of inflation, we will see these technologies contribute powerful disinflationary forces.

However, while we are on the cusp of this 4th industrial revolution which has the potential to dwarf every previous industrial revolution combined, the current impact is in its infancy. Over time, the combination of the technologies mentioned, and many others have the power for generating exponential innovation and one of these changes will be a generative global disinflationary economic impact.

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Is the Economy Slowing? Realistic Interest Benchmark Forecasts May Signal the Beginning of a Reset

The end of "hope" may be a net positive when it comes to market expectations in a bear market. Up until recently the markets have been relying on a constant drip of an illusory - any moment now - "Fed Turnabout Cocktail". Each time the Federal Reserve dissappoints with renewed commitment to its hawkish policy, the markets pout. Volatility is the ineivtable result with almost daily commentary about the latest thoughts of the members of the Federal Reserve and upcoming economic indicators.

The markets have now - at last - factored in benchmark rates of between 4.9-5.4% which is closer to what the Federal Reserve has indicated as potentially possible. While markets and media talk about a pending recession in lock step with Federal Reserve policy, some argue that we are already in a recession. The markets are now factoring in or discounting the future on a more realistic basis which means a greater acceptance of what is likely and less hopeful about any imminent Federal Reserve policy turnabout. 

Federal reserve actions are slow to filter into the economy but as we mentioned in our previous article, there are signs of demand slowing appearing in the economy. Container prices which are seen as a more current indicator of economic demand have dropped from sky high prices of around $20,000 during the peak COVID era to the low $2-3,000 range today. Job openings are down substantially. Residentail real estate prices are falling. Commodity prices from lumber to copper are down from their recent highs. If it takes 260 hours for the world's largest supertankers to turn around, how much time does it take for the worlds largest economy?

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Recent Trends in GDP and Consumer Demand

The Fed Reserve and inflation have been primary market talking points. Today we will take a look at recent trends in GDP and consumer demand. While the Fed is doing all it can - with its tools - to put the breaks on consumer demand and inflation, the data - across multiple key indicators - shows clear signs that the economy is starting to slow.

After two consecutive negative GDP growth quarters, The GDPNow forecast for the the third quarter of 2022 has been falling steadily since August when it was projected at 2.5% to sub 0.3% as of last week, Tuesday. We will have a better estimate of GDP for the third quarter by the end of October. The trend and forecast shows consecutive declining growth.

The trend in slowing growth is also reflected by declining activity in inbound containers at major US ports. This is considered a coincident demand indicator and reflective of immediate shifting trends in consumer demand. Global commodity and food prices are showing some signs of price easing but remain high year over year. Jonathan Golub, Credit Suisse;s chief U.S. equity strategist maintains that: "Futures indicate that Food and Energy prices should fall -5.7% and -11.8% by year end 2023, while Goods inflation has declined from 12.3% to 7.0% since February,” he wrote. “Over the past year, Services and Rents are up less than Headline CPI (5.5% and 5.8% vs. 8.5%).”

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Phone: 925-906-9800
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