The Big Stories of 2023
What a year!
The year 2023 has been quite an eventful one in the world of finance, wholly apart from all the chaos surrounding Elon Musk and the two Sams (Bankman-Fried and Altman). Here are a few of the bigger stories that I have been following this past year:
Inflation, the economy and public opinion. Inflation has been a big story for several years now, but the inflation story took a dramatic turn in 2023. This was the year in which US inflation returned to low single digit levels and the economy powered ahead notwithstanding the Fed’s aggressive interest rate hikes, which many had predicted would throw the US economy into recession by the end of the year. Instead of recession, we seem to have achieved a more Goldilocks-like outcome, with the economy not too hot and not too cold, but just about right. This isn’t how many Americans view the current state of the economy, however, which raises some interesting questions about the apparent disconnect between the economic data and public opinion.
Let’s begin our discussion by looking at the data.
The annualized rate of change in the Consumer Price Index (CPI), the most commonly cited measure of US inflation, was 1.4% in January 2021 and increased to 7% by the end of the year. CPI inflation peaked at 9.1% in June of 2022, fell to 6.5% in December 2022 and to 3.1% by November 2023. Other measures of inflation showed similar trends, with more or less month to month variability depending on the metric. The Fed’s preferred inflation measure, core PCE (headline PCE less food and energy) was 3.2% (annualized) for the month of November but only 1.9% for the six months through November, a tad below the Fed’s 2% target.
If 2021 and 2022 were the years of raging inflation, then 2023 was the year in which the trend finally reversed. Many prices are still increasing of course—’disinflation’ is not the same thing as ‘deflation’, and changes in the price of individual goods and services are not the same thing as changes in the overall price index—but the rate of US inflation has clearly declined, and by a large amount.
There is still a lot we don’t fully understand about the causes of the global surge in inflation following the covid shutdowns, or its recent reversal for that matter. Supply chain disruptions, fiscal stimulus and geopolitical events all played a big role in driving up prices, but the rate of inflation did not really begin to decline until after the Fed and other central banks began raising interest rates (discussed further below). The outlook for future inflation remains uncertain, however, and the Fed has wisely avoided taking any premature victory laps.
But whatever the causes of the rise and fall of inflation, the US economy seems to be stronger now than it has been in many years. Real GDP grew at an annualized rate of 4.9% in Q3, up from 2.1% in the prior quarter. The US unemployment rate remains extremely low at 3.7%. Wage growth has recently been well in excess of the inflation rate, with nominal hourly earnings in November up by four times the change in CPI. Consumer spending remains strong despite the depletion of household savings following the end of covid stimulus payments. And the decades-long increase in US income inequality, which spiked during covid, finally reversed course this past year (albeit modestly), as a result of long overdue wage gains concentrated among the lowest earners. And so it seems that the US economy is doing quite well on most fronts, at least according to the data.
This is not the public perception, however, at least not according to recent polling results. In a CBS News poll taken in early December, only 34% of respondents described the state of the US economy as ‘good’ and 62% described it as ‘bad’. Over one-fifth of respondents (22%) said that the US economy today was in worse shape than at any time in recent history, including during the covid pandemic years, the great recession of 2008-9 and the gas shortage/high inflation years of the 1970s. A plurality (27%) said that inflation was the single most important problem now facing the country, of greater concern than immigration, the state of democracy or gun violence. And a sizable majority of poll respondents specifically disapproved of President Biden’s ‘handling’ of the economy, with 70% critical of his performance on the inflation front.
How can we explain this apparent disconnect between public opinion and the current state of the economy, as reflected in the economic data? The reasons are no doubt manifold, but it would seem that many people equate inflation with the overall state of the economy. The impact of price inflation is felt by all of us, rich and poor alike, in ways that high unemployment is not. Many people also understand the term ‘inflation’ to refer to the current level of prices rather than the rate of change in prices, and seem to react viscerally to increased prices without considering to what extent their own wages may have increased, taking some of the sting out of the price hikes. All of these factors seem to be reflected in the CBS poll, where 76% of respondents said in December 2023 that that their personal income ‘is not keeping up with inflation’, an observation which may have been true a year or two ago but is unlikely to accurately reflect the current state of affairs.
And so I suppose we should not expect the general public to understand the varied and complex causes of inflation or to have informed views on the appropriate policy responses. After all, this is something on which even the experts don’t always agree. But what are we to make of the fact that 60% of respondents in the CBS poll said that inflation was ‘controlled’ by the president and a large majority (including 56% of Republicans and 80% of Democrats) apparently believe that price controls, not interest rate hikes, are the preferred policy response to fight inflation? Many Americans apparently equate inflation with the price of gasoline, which they also believe to be under the direct control of the president, and don’t seem to remember what happened the last time a US president (Nixon) imposed price controls at the pump.
I am not at all sure what to make of the views expressed in the CBS poll, which seem to conflict not only with the economic data but also with consumer behavior and the results of consumer confidence surveys. But I can just about hear Milton Friedman rolling over in his grave, and frankly I am inclined to join him.
The Fed and the FDIC: Monetary Policy, Bank Regulation and Supervision. The Federal Reserve had a very active 2023, most notably on the inflation front. The Fed did not began raising rates until March of 2022, after concluding that inflation would not in fact be as ‘transitory’ as it had initially (and not unreasonably) believed. But over the following seventeen months it increased the target fed funds rate from near zero to a range of 5.25-5.5%, where it stands today. This was the most aggressive Fed rate increase since the days of Paul Volcker, a bit of financial history which many Americans today seem not to recall.
The pace of the Fed’s rate hikes came as quite of a shock to the US capital markets, which initially sold off strongly in response, contributing additional financial ‘tightening’ to the first phase of Fed-orchestrated rate hikes. During 2022, the S&P fell 25% peak to trough and the Nasdaq 100 was off by 35% or more, although equity markets subsequently reversed the losses (and more) during 2023. Bond prices also got hammered, with the yield on 10-year UST notes almost doubling from August 2022 (2.6%) to October 2023 (5%), before falling back under 4% more recently in response to widespread speculation that interest rates have now peaked, setting the stage for a series of possible Fed rate cuts next year. Residential mortgage rates more than doubled in response to the Fed rate hikes, from under 3% to over 7%, and corporate credit spreads made a round trip, doubling during 2022 and then completely reversing course in 2023.
The Fed has taken a lot of heat over the past two years, both for its initial delay in raising rates and for the aggressive pace at which it made up for lost time. But the Fed’s rate hikes seem to have had their intended effect on inflation, with relatively little impact on employment or the pace of economic activity, so far at least. However we have yet to see what impact the Fed’s rate hikes, with their ‘long and variable lags’, will have on the pace of economic activity in the coming year. Dark clouds are appearing on the economic horizon, with much of the US manufacturing sector already in recession and some consumer debt default and delinquency rates approaching the levels last seen during the Great Recession. But all things considered, I suspect that Jerome Powell and his colleagues feel a lot better about the outlook for the economy now than they did a year ago.
The Fed is responsible for more than just managing conditions in the real economy, however. It is also charged with maintaining stability in the financial system, and here too it faced significant challenges in 2023. In March, the Fed and other bank regulators were confronted with a deposit run at two regional banks, Silicon Valley Bank and Signature Bank, which had incurred large unrealized losses in their bond portfolios, ironically as a result of investment decisions intended to take advantage of the Fed’s previous accommodative monetary policy. In response, the FDIC with Fed support orchestrated a $250 billion bailout of the two banks’ uninsured deposits, which of course is not how deposit insurance is supposed to work. And to ease the liquidity pressure at other similarly situated banks, the Fed launched a new lending program, the Bank Term Funding Program, which provided eligible banks with one-year term loans secured by their underwater UST bond and agency MBS portfolios, with the bonds valued not at market prices (as under other Fed lending programs) but at face value, traditionally a big “no-no” in the conservative world of central banking. The BTFP took effect too late to save SVB or Signature, but it did extend the life of the troubled First Republic Bank (which was subsequently sold to JP Morgan) and it brought much needed relief to the regional banking sector, which today is still sitting on hundreds of billions of dollars of unrealized losses.
The Fed came in for a great deal of criticism after the failure of SVB, in part as a result of its previous decision not to subject SVB to the enhanced prudential regulatory standards (including more stringent capital and liquidity requirements) applicable to other large banks, despite having the clear legislative authority to do so. And both the Fed and the FDIC were criticized for lapses in their own supervisory activities, weaknesses which the two regulators largely acknowledged in separate reports issued in April. (Read here and here.)
In October, the Fed finalized regulations increasing capital requirements for the largest US banks, already the most highly capitalized banks in the world, a move which bears more than a passing resemblance to Inspector Renault’s call to “round up the usual suspects” after Rick’s shooting of Major Strasser in the film Casa Blanca. [Students, if you have never seen this film, please watch it now. It will change your life!].
And in the wake of its own bailouts of uninsured depositors at SVB and Signature, the FDIC sent to Congress in May an outline of various Options for Deposit Insurance Reform, which as far as I can tell is going absolutely nowhere in the halls of Congress.
Silicon Valley Bank. In my view, SVB may be the most interesting finance story from this past year. Despite what you may have read in the press, the spectacular failure of SVB in the spring of 2023 was not the result of a ‘perfect storm’ of unforeseeable events, as SVB’s former management might like us to believe. It was instead the all too predictable result of a series of investment decisions made by the management of SVB, and approved by its board, which went spectacularly wrong. Two years ago, SVB was a seemingly successful and widely admired bank, particularly among the venture capital and private equity community it served, and today it is the banking industry’s poster child for irresponsible risk management and flawed corporate governance. But how did SVB come to this sad end?
The story is actually quite simple to recount, if somewhat hard to believe. During 2020-21, after the Fed in response to the covid pandemic cut interest rates to zero and drove bond yields back to historical lows, SVB took $120 billion of customer cash—60% of its total assets, 70% of total deposits and 7.5x its total shareholder’s equity—and invested the vast majority of it in long-term UST bonds and agency MBS, gambling that the Fed would hold rates at super-low levels indefinitely. The bet it made was a risky one with asymmetric payoffs not in the bank’s favor. As long as rates stayed constant, SVB stood to pick up around $1 billion (100bp) of incremental annual (after-tax) net interest income, but if (or when) rates moved up or the yield curve inverted, the resulting losses (when recognized) could very easily wipe out all of the bank’s capital. Which is exactly what happened after the Fed began raising rates unexpectedly in March of 2022. Within a year, SVB’s share price had collapsed, the bank failed to complete an emergency capital increase, and its customers attempted to withdraw $140 billion in uninsured deposits from the bank in a single 24-hour period. At which point the regulators stepped in and it was game over for SVB.
In addition to demonstrating incredibly bad judgment (and timing) at the roulette table, SVB operated with what appears to have been a rather lax approach to risk management. It operated for eight months without a chief risk officer; its senior executives did not all work out of the same office or even in the same time zone; it did not regularly test its liquidity lines with the Fed or the FHLB; and it compensated its senior executives based on reported ROE with little apparent regard for the associated risk incurred.
The big unanswered question about SVB, I suppose, is how the bank’s senior management and board got comfortable taking the risks associated with this investment strategy, particularly given the bank’s heavy reliance on uninsured and unstable deposits. I am not privy to the banks’ internal deliberations and so I don’t really have a good answer to this question. But I should point out here that SVB was not alone in pursuing the strategy it did. Many other banks made very similar bets, most likely for the same reasons, albeit in smaller size and with more stable funding bases. These other banks survived when SVB and Signature did not, for which they can probably thank the Fed (see above).
The Magnificent Seven. Following the dismal performance of the stock market in 2022, US share prices recovered strongly in 2023 and are once again at or near all-time highs, at least as measured by market cap-weighted indexes like the S&P 500 and the Nasdaq 100. But the big stock market story for most of 2023 was not the broad recovery of US stocks, but rather the truly astounding share price performance of a handful of large tech companies, now known as the Magnificent Seven. The share prices of these seven companies—Apple, Microsoft, Alphabet (Google), Amazon, Nvidia, Tesla and Meta (Facebook)—increased by an average of 75% through mid-December. The M7 stocks now represent $11 trillion of market cap, accounting for 30% of the total value of the S&P 500, greater than the market caps of all of the publicly traded stocks in the UK, China, France and Japan combined. This is truly a remarkable state of affairs.
Explanations for the exceptional share price performance of the M7 generally cite three factors: strong reported earnings, lower bond yields (recently) and the potentially large future business opportunities for these companies associated with artificial intelligence, of which the most significant (but least understood) factor seems to be the last one. It is true that each of the M7 companies operate quite large businesses, but only three of them rank in the top 10 of the Fortune 100 index of American’s largest firms (ranked by revenues). The average P/E ratio for the M7 stocks is something like 50x (ranging from 30-85x), compared to 20x or so for the other 493 companies in the S&P 500. This large and growing disparity in valuation metrics between the M7 and everyone else has recently attracted a substantial flow of funds into those stocks perceived to offer better value than the M7, the share prices of which have increased markedly over the past few weeks. As of mid-December, however, it was still the case that only 25% or so of the S&P 500 stocks traded within 10% of their all-time highs, a historically low number, so there may well be more room for stocks to run in the new year, particularly if the Fed cuts rates and the economy remains strong,
The US federal debt. If SVB was the most interesting story of 2023, the US federal debt may turn out to be the most consequential one. The growth in the US federal debt over the past two decades represents a profound change in the financial position of the US government, with serious implications for our collective future that may not be well or widely understood. The financing of the US government cannot really be compared sensibly with that of either a private business or a household, despite what the soundbite politicians like to tell us. The US government has taxing power and a central bank with the ability to create an unlimited supply of dollars, and there is no inherent reason why the US government cannot continue to run fiscal deficits in perpetuity as long as the capital markets will continue to fund them and the Fed is prepared to step in from time to time when markets get volatile. But with the US federal debt now at $33 trillion, up $5 trillion in just the past three years, and with interest rates and bond yields having returned to more normal levels after more than a decade of highly accommodative Fed monetary policy, there is ample reason to be concerned. And this is particularly true given the partisan gridlock in DC and the debt ceiling terror tactics adopted by some of our elected representatives.
The state of the federal debt is much discussed these days, and the ‘debate’ (such as it is) has become even more blatantly partisan than usual as we move into yet another presidential election year. I have very little to add to this discussion from a policy perspective, but I do think that we might all benefit from a bit more historical and financial context to help us evaluate the merits of the various arguments being voiced in Congress and on social media. And so to that end, let’s look at some of the data.
Over the past twenty two years, since George W. Bush took office, the US federal public debt has increased by a factor of over 5x, from under $6 trillion at the beginning of 2001 to over $33 trillion today, a compounded annual growth rate of over 8%. During this period, the federal debt increased about twice as fast as the US economy, with large federal budget deficits incurred under each and every presidential administration, Democratic and Republican. The last time the US government had a budget surplus was back in the late 1990s under Bill Clinton, who is today remembered not so much for his fiscal prudence but rather for what we should perhaps call ‘other events’. The largest percentage increase in the national debt occurred during President Bush’s two terms, when the amount of debt doubled. The largest dollar increase in the debt, $8+ trillion, occurred during Obama’s two terms and again during Trump’s one term. The debt under Biden has increased by another $5 trillion, with one (very long) year still to go.
Compared to our international peers, the US federal debt has historically been low, at least relative to GDP, but this is no longer the case. The US federal debt as a share of GDP was just 55% when George Bush took office and it is 120% today. The size of the US debt relative to GDP now exceeds that of all but a few other developed economies in the world. We aren’t yet on a par with Japan, at 265% of GDP, but we are rapidly approaching the level of Italy (140%), traditionally considered the poster child for irresponsible sovereign finance in western Europe. Before we all freak out about the impending insolvency of the USA, however, we should note that the cost of government debt in Japan is the lowest in the developed world, with 10-year sovereign yen bonds trading at a yield of just 0.65%. And in Italy, the current yield on 10-year sovereign debt (in Euros) at 3.7% is broadly in line with that of the US (3.8% currently but 5% two months ago). And although the US national debt has more than doubled relative to GDP over the past 22 years, the current market yield on 10-year UST debt is about where it was during the entire eight-year term of George W. Bush, when we debt financed two rounds of tax cuts, a war in Iraq and the initial stage of fiscal stimulus during the global financial crisis.
How worried should we be about the big increase in the US federal debt? I am not sure, frankly. The numbers are certainly big and the trends do not seem sustainable. But we have to be a bit cautious about extrapolating recent trends indefinitely into the future. A large share of the increase in sovereign debt here in the US and across the word is attributable to just two major global events: the covid pandemic and the last financial crisis. In both cases, tax revenues plummeted, government spending exploded and the real economy took years to recover—close to a decade after the GFC, when many governments (particularly in Europe) adopted arguably counter-productive ‘austerity’ programs in an attempt to limit the fiscal impact of the banking crisis.
But whatever the reasons for the growing deficits, the US government now has to service $33 trillion of debt, $10 trillion more than before covid hit. Interest payments on the federal debt have doubled in the past year, and now constitute 14% of the federal budget, about equal to what we spend on defense. The average interest rate paid on the federal debt has increased over the past two years from 1.6% to 3%, and will likely increase further as the US Treasury refinances at higher rates whatever remains of the debt incurred in the years of Fed-supported low interest rates during covid and the GFC. As a result of the large post-covid deficits and recently higher interest rates, the volume of US Treasury debt issuance continues to grow, with $2.4 billion issued in the month of November 2023, 60% more than in the same month one year earlier. The capital markets so far seem willing and able to absorb this increased amount of new debt— UST bond yields have fallen substantially over the past few months notwithstanding the big increase in UST issuance —but capital markets are volatile and conditions in the bond market will not always be as benign as they are today.
And so I think we are right to be concerned about the rising US federal debt, but perhaps not for the reasons you might think. What really concerns me about our current situation is not the amount or cost or trajectory of the federal debt per se, but rather the continuing inability or unwillingness of our politicians to address it in any meaningful fashion, or for that matter to agree about almost anything else of real importance. This is not an entirely new problem, of course, but it seems to have gotten worse in recent years as our country has become more rabidly partisan than at any time in recent memory. A large share of our current debt may have been incurred as a result of extraordinary events, most notably covid and the global financial crisis, but we will no doubt experience many more such events in the future. And if we cannot agree on how to deal with the debt we have now, what will we do then?