When shock rippled through the U.S. banking system this month, bonds again proved themselves to investors, according to Ashish Shah, Chief Investment Officer of Public Investing at Goldman Sachs Asset Management.
The turmoil that started with the resolution of Silicon Valley bank is giving way to concerns about tightened lending standards and slower economic growth. That in turn has refocused attention on diversified investments like the 60/40 portfolio that’s split between stocks (60%) and bonds (40%). While that strategy struggled in 2022 as concerns about inflations grew, bonds have rallied this year amid financial sector stress. “You want to be sure to zoom out at times like this and make sure the portfolio is diversified and that you’re always reinvesting if there’s volatility,” Shah said in an interview.
We spoke with Shah about investing strategies, when he expects the turbulence among smaller banks to subside and how recent events may influence policy at the U.S. Federal Reserve.
Do you think we’ve already felt the majority of the impact from the banking turmoil?
No, I think it’s too soon to expect that. It’s not typical of a banking crisis. The losses that have been highlighted by market participants are ones that have taken place in the safe assets and liquid assets for the banks that are in question. The regional banks, in having received an excess of deposits, took the conservative approach and said, “We’re not going to make bad loans or dump this into lending credit. We’re going to buy safe assets like Treasuries and agency mortgages.”
The difference this time around is that that the pace of rate moves is far in excess of what many people expected, including some banks. And that’s creating losses on the balance sheet.
There’s a second dynamic, which is that it’s been a long time since we’ve been in this kind of rate regime. At least as of a few weeks ago ago, we were talking about terminal fed funds rate in the range of 5.5% and potentially higher. A lot has changed in the last 15 to 17 years since we’ve been in that kind of environment, including the advent of social media, the digitalization of financial services and the ability to instantly access your money. The transfer of information is basically accelerated.
I think one of the observations that some of these banks had started making was around the deposit beta – the sensitivity of their deposits to market rates is higher than they expected. The second observation is that the pace of the deposit shift that we experienced both last week and this week has far exceeded what we’ve seen in the past.
It speaks to the pace of everything, including the pace of information and the ability to move money easily in the digital world. Sure, the iPhone was launched in 2007, the year before the global financial crisis, but it had low penetration. Now find me the person in the U.S. who doesn’t have a smartphone. And if you’re banking, find me the person who doesn’t use a banking app. I’m sure they exist but the point is that there’s much more digital availability in a way that there wasn’t during the GFC. That deposit dynamic is new and unique.
How does one position a portfolio at a time like this?
What we’re proving right now is that the 60/40 portfolio is having a comeback. Having duration in a portfolio has become valuable again, and it will continue to be valuable as a diversifier. People’s bonds have gone up in value. I see a lot of green coming from the bond funds. And so it’s paying to be diversified and not jump from one headline to the next, chasing the latest news. So you want to be sure to zoom out at times like this and make sure the portfolio is diversified and that you’re always reinvesting if there’s volatility.
The second thing is that you want to focus your portfolio during times like this on companies that generate free cash flow, whether it’s on the bond side owning investment grade companies or on the equities side, owning companies that generate free cash flow and have high quality because of it. Even if their stock price goes down in this environment, they’re still generating cash and have the ability to support their own stock through buybacks. It’s more difficult if they carry more than a reasonable amount of debt or they don’t have a business model that generates free cash flow. The most challenged types of business models right now are the ones where companies are burning cash, either for capex or from an operating loss perspective because of overleverage.
I also think you can use this period to hunt for innovation that’s on sale. You can find biotech companies that are trading at below cash value and have really interesting R&D. Now they’re going to be burning cash, but we still see opportunities to buy companies at below the value of the IP they have. You have areas of growth like AI that are really going to be transformative over the long haul. They might be slowing down the pace of their investment but they’re still investing. And those investments are going to be really impactful to their valuations coming out of this cycle.
So how do you think this affects the Fed’s deliberations on rates?
The Fed has been tightening to slow the U.S. economy and address inflation. The economy has been growing at a pace that is not consistent with price stability. We’ve seen inflation hit as we had excess liquidity meet strong balance sheets and fiscal spending.
I think what you’re going to see here is that the Fed is going to look at what’s going on and say, “Wait, we’re seeing this substantial tightening of financial conditions. We can’t judge how substantial yet.” A bank doesn’t go from being concerned about a bank run to the next day saying, “Hey, I’m going to make a risky loan.” The environment in we’re in now gets people to kind of sit back and take a pause on taking risk. And the regional banks are really critical to credit creation for businesses, particularly small- to midsized ones. We’re seeing stories in the media about people worrying about making payroll because they have money in these banks. They’re suddenly very nervous about it.
So I have a high conviction level that we’re going to see credit contraction taking place. The pace of that is difficult to gauge. But we’re going to see that continue and the effect will be much tighter credit conditions, far in excess of what a 25-basis-point hike could do. The economy is experiencing the full extent of the tightening, not just through the pricing of credit because of the rate hikes, but also through the availability of credit. That’s a step function, as opposed to happening gradually along with rates. And it’s partly a function of the speed at which those rates have been hiked. The economy wasn’t reflecting that yet. It happened so quickly that banks were adjusting more slowly. The events of the past week are going to cause that to change a lot more rapidly.
I think the Fed is going to have to pivot. At the very least, they’re going to set a higher bar for continuing to raise rates because conditions have clearly tightened. And if this starts to cascade then you might even see the Fed start to ease and it could be a lot faster than people would have expected because it’s entirely possible that if credit contracts because the providers of credit no longer feel like they have the ability to extend credit, then the fed funds rate could be 100 basis points too high, or maybe even 200 basis points too high.
It all depends on how much of the tightness has translated through to the economy. That will be something that the Fed policymakers will have to navigate.
Do you think this meaningfully increases the likelihood of a recession?
I think it becomes much tougher to navigate if you’re the Fed. They’re going to either not ease quickly enough or ease too quickly. The outcomes from here, in my view, are asset-value negative, growth-asset negative. I do think the risk of recession has increased, as has the probability of a more severe recession. We could end up in this vicious cycle where the lack of credit leads to a decline in asset prices, which leads to losses, which leads to a lack of credit. That kind of cycle can be very severe as we’ve seen in past periods. It doesn’t have to happen, but it is very difficult to navigate in terms of policy setting.
Credit destruction can be a long cycle. Equities carry risk, but people don’t like it when they lose money on things that were supposed to be safe. It really causes the system to gunk up and for credit creation to slow.
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