HSB Trust Newsletter Spring 2023

Spring 2021

SPRING 2023

Successful Retirement

For Women Page 5

This Isn’t Credit Risk We’re Witnessing, It’s Interest Rate Risk Page 1 Brooks R. Smith, CFA Senior Vice President Trust Portfolio Manager

Non-deposit investment products are not FDIC insured and are not guaranteed by the bank or any government agency. Non-deposit investment products are subject to investment risk and may go down in value. All rights reserved. Happy State Bank, a Division of Centennial Bank ©2023.

This Isn’t Credit Risk We’re Witnessing, It’s Interest Rate Risk As I’m wrapping up this essay on Wednesday morning May 3rd, the Fed is scheduled to announce its decision on interest rates this afternoon. Year-to-date, the S&P 500 is up over 8% and market participants widely assume that another 25-basis point increase to interest rates is already baked-in-the-cake. I like cake, but let’s take a few moments to review where I think the Fed is taking the U.S. economy, and then what I’m recommending for portfolios.

The U.S. is in a weird economic post pandemic conundrum with a very strong employment market where consumers want to travel and eat out, but businesses can’t hire enough workers. And this is keeping wage inflation rising and prices sticky (at least until consumers’ savings run out). So, in his effort to fight inflation, Federal Reserve Chairman, Jerome Powell has already increased interest rates at the fastest pace in over 40-years and is telegraphing that even after raising them from 0% up to 5%, he’ll keep rates higher for longer; thus, due to this much tighter monetary policy the U.S. economy is undergoing a Regime Change.

Subsequent to the Great Recession (aka The Financial Crisis), the last decade’s paradigm was one of historically loose monetary and fiscal policies characterized by low interest rates coupled simultaneously with an over-abundant supply of both QE money and fiscal stimulus.

Under that scenario, investors were rewarded by taking big stock market risks owning hyper-growth, long duration stocks with huge projected revenue streams, but little-to-no earnings per share… valuations be damned. On the flipside, investors were also enticed to assume more risk-taking in their bond portfolios predominantly by increasing the interest rate sensitivity via ownership of longer duration holdings (insert the name of SVB right here). However, due to the Fed’s focus on killing inflation over the last twelve months, each of those said investment strategies has experienced reversion toward their means.

During the last few weeks, we’ve witnessed three bank failures. Each bank catered to very wealthy clients, and each failure was directly related to the Fed tightening monetary policy by raising rates and shrinking the money supply. Even though the Fed is describing each failure being the result of unique circumstances, there is less than a spurious correlation as to why… and that reason is poor risk management. Trying to create hyper-growth and increase income, these banks all broke the rule of “Finance 101” by creating big asset/ liability mismatches done by borrowing short-term at floating rates (that have risen) and lending long-term (at lower fixed rates). These strategies worked fantastic, until they didn’t. These banks were partying like it was 1999, but oops that party is over - out of time.

Bottom line, this isn’t credit risk we’re witnessing, rather it’s interest rate risk playing out… and a big 500 basis point shock to interest rates creates great risk (especially when you’re not prepared for it).

It’s important to note, the Fed believes this current banking situation is under control where there is little potential for any contagion. So, by the Fed positioning each of these three bank failures as “one-off” events, it allows them to continue with a tighter monetary policy.

Let’s look closer.

Silicon Valley Bank (SVB) ultimately failed due to a huge asset / liability mismatch after its senior management intentionally made a huge 1 | Spring 2023

bet that interest rates would stay close to zero for many more years.

With this belief, SVB structured an extremely long duration bond portfolio that fell hard when interest rates rose (because that’s what happens with extremely interest rate sensitive portfolios). To state this differently, bond prices fall when interest rates rise. For example, in SVB’s effort to grow quicker, they chased yield by stretching the duration of their bond portfolio. When the Fed unexpectedly turned hawkish and started tightening monetary policy, the market value of SVB’s assets plunged and became worth less than the bank’s liabilities.

Due to social media posts, deposit clients became acutely aware this was happening (in real time) and simply began moving billions in deposits creating an electronic bank-run that cascaded into insolvency for SVB in just a few short days.

First Republic Bank (FRB) is considered the second biggest bank failure in U.S. history. A reason it failed is because they were making thousands of jumbo real estate loans at below market rates to entice more than their fair share of elite clients. Again, when interest rates jumped, the bank’s loan book and investment portfolio became less valuable. This prompted the bank’s affluent deposit clients to start making large cash withdrawals because most of these deposits were well above the FDIC’s maximum insurance guarantee of $250,000.

Another one bites the dust.

J.P. Morgan stepped-in to buy FRB last weekend. One man’s trash is another man’s treasure… and this is a sweet deal for JPM because they acquired one of America’s most envied banks, not only because of its very rich depositors, but also because FRB is viewed as being one of the very best in customer service resulting in an excellent client experience.

Econometric Models and VAR. In a competitive business environment, risk-takers can get too aggressive when trying to gain a strategic advantage, and this is what happened at SVB and FRB. The question is, after more than a decade of very accommodative and loose monetary and fiscal policies, how many more chickens will come home to roost? Therein lies the rub because the Fed thinks it has this banking issue “ring-fenced”, but at this point… it’s a known unknown. “Black Swan” events occur on your blind side, so let’s take a quick look over that shoulder remembering that since rates have moved up so quickly and so substantially (from 0% to 5%), and since the market will need more time to fully digest this move, it’s a low probability that these three bank failures are a three-and-done market stress litany of events.

It’s at this point in the monetary tightening cycle that the Fed’s policy becomes more art, than science. Because these bank failures have created a scenario where cash deposits are now leaving their traditional home to chase the safety of Treasury Bills paying higher yields… if we

extrapolate that out and assume bank deposits are on a 10% downward trajectory, then due to a high correlation between deposits and lending, we might also expect (with a high degree of certainty) that banks’ lending to consumers and businesses will follow suit by decreasing at this same 10% rate. This means banks will now have less money to lend.

Additionally, banks’ credit standards are becoming increasingly more stringent and simultaneously more expensive to finance debt… and all this is due to the new regime’s higher interest rates. Is it becoming easier to see how the economy is beginning to slow faster?

To help the Fed make monetary policy decisions, they employ sophisticated multi-factor econometric computer models that can measure any scenario’s input they wish to create. However, there is “Model Risk” associated with this process where “Model Risk” has at least two problematic issues. The first involves which factors they ultimately decide to model. The second is the variability of sample weights assigned to the factors chosen. The old computer adage of “Garbage In – Garbage Out” is relevant in this example. For instance, in SVB’s case, did the Fed run a scenario that modeled what happens to a bank’s “hold-to-maturity” bond portfolio and ultimately a balance sheet when (and if) interest rates were to increase by 500 bps in less than a year? And due to over a decade of both loose monetary and fiscal policies, did the Fed run their model under different scenarios assuming very poor risk management using a big asset/liability mismatch as one of their multi-factors? We don’t know, but three banks failed. We’ll need to assume that the models were run.

Risk management is a process, not an activity. Risk governance is senior management’s responsibility. At the individual business enterprise level, companies run tests known as “Variance at Risk” (i.e., VAR). VAR is a probability-based model (like the Fed’s), measuring potential loss expressed either as a percentage, or in units of currency.

VAR is most widely used to measure the loss from market risk over a specified time-period. It’s a safe bet that the banks we’re discussing were all using VAR-based risk measures. It’s also safe to assume that all three used inputs to their VAR scenarios that modeled an extreme rise in interest rates due to a much tighter Fed. Lastly, it’s even safer to assume that VAR picked up the risk, but these banks’ own internal biases chose to ignore it. In financial circles, this information bias is known as a “Psychological Trap”. And I truly believe that’s what happened in all three cases. The rest is history.

the Fed believes the banks are strong… this provides a long runway for the Fed to continue its wood chopping. Don’t fight the Fed is the mantra… because that inflation tree is going to fall. And when this inflation tree starts cracking, it will fall where everyone can hear it.

Now let’s talk about when.

The Fed’s dual mandate is to pursue price stability while maintaining full employment. These two goals are in direct conflict because to pursue the Fed’s target 2% inflation rate, the primary monetary policy tool in their tool kit is a velvet interest rate hammer that works to increase and/or decrease GDP-growth from the demand-side of the economic equation. However, rising rates typically works against keeping all of us gainfully employed. In other words, when the Fed raises interest rates to fight inflation, those higher rates work to slow economic development which forces businesses to lay people off. It might be considered circular logic, but this is how modern monetary theory works.

The economy’s best hoped for scenario looks for a “soft-landing” where inflation falls, but very few people get laid-off, and everything quickly goes back to normal. But that’s a low probability scenario because there are just too many moving parts in this highly sophisticated global supply chain driven economy. Again, the likelihood of recession is extremely high.

In my opinion, if the Fed fulfills its promise of keeping interest rates higher for longer: •

And stays determined to lower inflation, then it’s commitment will cause a recession… and every recession sees inflation move lower.

•

When inflation has moved lower back toward the Fed’s long-term target of 2%, and unemployment has risen up over 5%, the Fed will then pivot, but not before.

•

This very much anticipated Fed pivot has a high probability of happening right before the 2024 election. So, they’re setting themselves up for a very well-timed pivot.

Here are several old Wall Street sayings (that are still relevant today): •

Bulls make money, bears make money and pigs get slaughtered.

•

Those who don’t learn from history are doomed to repeat it.

Don’t Fight the Fed.

•

History doesn’t repeat itself, but it often rhymes.

A hawkish Fed’s argument to keep raising interest rates is that the core PCE inflation number (while dropping from 9% one-year ago) is still 4.6% and the Fed wants a 2-handle on it. To say that differently, inflation is higher than the Fed wants it (though there has been significant progress). Additionally, since the labor market is tight, and

•

The market climbs a wall of worry.

But the one most relevant for today’s essay is: •

Don’t fight the Fed.

Spring 2023 | 2

Where Do We Go From Here?

The confines of this article don’t permit space to elaborate all the salient details for causes and remedies, but the answer is “nobody knows”, and this is what makes stocks a risky proposition. The good news is, making a bet that our U.S. economy will succeed has been historically profitable because over the last 100 years, the stock market’s average annual return is about 8% to 10%.

Having said that, there are at least three risks to market valuations right now: •

The looming Debt Ceiling,

•

The disconnect between when the market thinks the Fed will pause (i.e., pivot), and what the Fed is actually telling the public during its press conferences, and

•

Current estimates for earning per share (EPS) for the this year’s fourth quarter are still too high. For example, analysts’ economic projections are for 8% GDP-growth in Q4’23; however, the market is also expecting three interest rate cuts before then. So, there is a complete disconnect between these two arguments making them intellectually inconsistent.

To reiterate, with regard to economic optimism, both consumers’ and CEOs’ outlooks are depressed due to much tighter monetary policy and an M2 money supply that’s been shrunk with the sudden change from QE, to QT (i.e., Quantitative Tightening). Throw on the back of this the three bank failures (with all the FDIC deposit insurance ripple effects), and this becomes a brew with much tighter lending standards, weaker corporate earnings expectations, and lower stock prices. This is the script for a tougher economic environment that the Fed is orchestrating to slow GDP-growth and lower inflation.

The question becomes why is the S&P 500 up over 8% this year? That has a multifaceted answer, but with the Fed tightening monetary policy, it’s primarily because business sales are falling; thus, analysts’ have already lowered their earnings expectations which are subsequently being beaten by 70% of corporate results. Please note, because analysts have lowered the bar that corporate earnings need to jump over, corporations are indeed jumping over it… and this will keep stock prices going up for

a time, but again, this is on the backs of both lower sales and profits.

Another reason stocks are doing well is because investors are simply looking through this slower period attempting to get ahead of a Fed pivot, and an expected better 2024 economy.

Wall Street Analysts still have their consensus corporate earnings per share (EPS) expectations for 2024 set around $243. When we compare that with 2023’s analysts’ expectations for $220, this is roughly a 10% rate of growth for U.S. GDP. If we slap the current market P/E of 18X on these projections, the former grants us only a 6% appreciation for the S&P 500, the latter basically means that the market is fully valued right now. To the contrary, my belief is that once investors hear the tree cracking louder, I see the market trading down toward 3600 and that ends this bear market rally and sets us up for better future returns.

As the global economy slows, I believe we’ll begin seeing more analysts’ lower their EPS expectations both for this year, and next. The disconnect right now is in-the-midst of this choreographed economic slowdown, there is a huge EPS rebound baked into late 2023’s and early 2024’s estimates. In my opinion, there is a high probability that these get recalibrated lower… and that will happen after stock prices have already moved lower, not before.

What Should Investors Do? The answer is… staying fully invested makes perfect sense. But there are new kids-on-the-block with T-Bills and money market rates paying over 4.5%. So, an over-weight allocation to cash can be tactically brilliant as a wait-and-see strategy that creates an opportunistic neutral vantage point. Other tactical adjustments keep a neutral weight in equities and ensure your portfolio’s ballast is fueled by high quality defensive positions with a value-oriented tilt.

It’s worth mentioning that the caveat to this conservative fundamental outlook is this new craze in everything Artificial Intelligence (A.I.). The stock market is chronically inefficient; thus, it can stay disconnected from fundamental reality for months and/or years-at-a-time. Thus, my suggestion to stay fully invested and keeping a neutral weight in equities.

Brooks R. Smith, CFA

Brooks R. Smith, CFA

Senior Vice President & Trust Portfolio Manager Brooks has an entrepreneurial background followed by over thiry years of buy-side experience in wealth management developing client relationships and managing customized discretionary total return investment portfolios. Early in his career, he worked in Tulsa with renowned money manager Fredric E. Russell. After moving to Dallas, he worked with Schwab Institutional, and subsequently spent 18-years as a Portfolio Manager with U.S. Trust / Bank of America Private Wealth Management. In 2018, Brooks became Senior Vice President and Trust Portfolio Manager with Happy State Bank and Trust Company in Addison, Texas.

Brooks is a CFA charterholder and graduated from Oklahoma State University with a B.S. in Finance. He and his wife, Joanna, live in Dallas and are members of The Lutheran Church.

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Meet the Team Tori Cortez Trust Operations Specialist Abilene, TX

Tori was raised in Spearman, Texas and graduated from Perryton High School in 2017. After graduation, she moved to the Amarillo region where she earned her associates in Education at Amarillo College, as well as received her Dental Assistant License. While attending school, Tori began her banking career as a Teller. After graduation she started working in the dental field, where she realized her true passion was in banking.

Tori left the dental field behind and began working for Happy State Bank in December of 2019, where she was a teller at the Buchanan branch. During her time there, she became a Senior Teller and Customer Service Representative.

Tori shifted to the trust department within Happy State Bank in November of 2020, serving as a Trust Operations Specialist. Even though she was working from home due to the COVID-19 pandemic, she continued to learn with the help of her supportive team in the trust department.

In August of 2022, Tori’s husband Luis started attending Physical Therapy School in Abilene, Texas. Luckily, the amazing people at Happy State Bank and Centennial Bank kept Tori on board and she now works from the Happy location in Abilene. During her free time she enjoys photography, spending time with family and friends, and hiking. Luis and Tori don’t have kids yet, but they have one fur baby, a Husky named Bear. Tori looks forward to growing within Happy Trust Company, as well as learning as much as she can from her colleagues.

Shannon Van Campen AVP Trust Officer Addison, TX

Shannon is an original employee of Signature Bank in Dallas, joining the company in November 2008, which was acquired by Happy State Bank & Trust Company in January 2012. She began her start in banking as a teller and customer service representative, before transitioning to Happy Trust Company in August 2015, where she worked as a Trust Administrative Specialist. Shannon was promoted to Trust Officer in April 2018 and to Assistant Vice President in April 2020.

Shannon completed the Texas Trust School and Graduate Trust School courses through Wealth Management and Trust, a Division of Texas Banker’s Association, and is continuing her education by preparing for her CTFA designation.

Shannon currently administers a variety of Trusts, IRAs, and Agency accounts. She enjoys being able to build a relationship with her clients and their families, and to offer possible solutions to accomplish their goals to make their lives a little easier. She believes the trust and investment industry should not just be a transactional one, but one where you have a good, established relationship between the client and administrator.

Shannon is a native Texan, born and raised in Irving, Texas. When she isn’t working, Shannon enjoys lifting weights at the gym, spending time with family and friends, or napping while Netflix plays endlessly in the background.

Spring 2023 | 4

Successful Retirement

For Women

by Laura J. Brown

Summertime is right around the corner. Reminiscing about childhood summers brings fond memories of family vacations and carefree time spent with friends. While raising children, the summer months can feel chaotic with schedule coordination, weekly camps, and balancing your own work responsibilities. Then children grow up, move out on their own, and your retirement looms closer on the horizon.

What is your vision for retirement? Have you thought about how you want to spend not only your summers but all seasons in retirement?

Women who share money management duties with their partner tend to take on a lion’s share of the responsibility for the household finances. Yet only 18% of women feel very confident in their ability to fully retire with a comfortable lifestyle.6,7 Although more women are providing for their families, when it comes to preparing for retirement, they may be leaving their future to chance.

Women and College The reason behind this disparity doesn’t seem to be a lack of education or independence. Today, women are more likely to go to college and graduate than men. So, what keeps them from taking charge of their long-term financial picture?3 One reason may be a lack of confidence. One study found that only 55% of women feel confident in their ability to manage their finances. Women may shy away from discussing money because they don’t want to appear uneducated or naive and hesitate to ask questions as a result.4

jargon of personal finance can be intimidating: 401(k), 403(b), Roth, RMD, fixed, variable. To someone inexperienced in the field of personal finance, it may seem like an entirely different language.5 If you have avoided discussing your long-term financial strategy, now is the time to pick up the reins and retake control. Consider talking with your trusted advisors at Happy State Bank and Trust Company to demystify financial and retirement terms. Don’t be afraid to ask for clarification if the conversation turns to something unfamiliar or move the conversation along for concepts you grasp.

As an example, no one was born knowing the ins and outs of compound interest, but it’s important to understand in order to make informed decisions.

Compound Interest: What’s the Hype?

Insider Language

Compound interest may be one of the greatest secrets of smart investing. And time is the key to making the most of it. If you invested $250,000 in an account earning 6%, at the end of 20 years your account would be worth $801,784. However, if you waited 10 years, then started your investment program, you would end up with only $447,712.

Since Wall Street traditionally has been a male-dominated field, women whose expertise lies in other areas may feel uneasy amidst complex calculations and long-term financial projections. Just the

This is a hypothetical example used for illustrative purposes only.

It does not represent any specific investment or combination of investments.

5 | Spring 2023

Retirement Strategies Preparing for retirement can look a little different for women than it does for men. Although today’s modern families tend to operate differently than the generation before us, women are still more likely to serve as caretakers than men are, meaning they may accumulate less income and benefits due to their time absent from the workforce. Research shows that 31% of women are currently or have been caregivers during their careers. Women who are working also tend to put less money aside for retirement. According to one report, women contribute 30% less to their retirement accounts than men.1,2 These numbers may seem overwhelming, but you can change the statistics. With a little foresight, you can start taking steps now, which may help you in the long run. Here are three steps to consider that may put you ahead of the curve.

1. Talk about money. Nowadays, discussing money is less taboo than it’s been in the past, and it’s crucial to taking control of your financial future. If you’re single, consider writing down your retirement goals and keeping them readily accessible. If you have a partner, make sure you are both on the same page regarding your retirement goals. The more comfortably you can talk about your future, the more confident you may be to make important decisions when they come up.

3. Make room for your future in your budget. Adjust your budget to allow for retirement savings, just as you would for a new home or your dream vacation. Like any of your other financial goals, you may find it beneficial to review your retirement goals on a regular basis to make sure you’re on track.

WA clear vision for retirement will influence your chosen path, strategy, and time horizon. Take some time this summer to vision board your retirement goals and share them with those closest to you.

We recommend using your legal, tax, charitable, and financial advisors to help guide your specific retirement planning needs.

Your trusted advisors at Happy State Bank and Trust Company look forward to working collaboratively and holistically with your advisory team. We value the voices of our female clients and are here to provide a safe space open to questions and discussions about financial and retirement planning.

Retirement may look a little different for women, especially since women live longer on average than men, but with the right strategies – and support – you’ll be able to live the retirement you’ve always dreamed of. As discussed, it’s never too late to plan for retirement, but the sooner you start the better.

2. Be proactive about your retirement. Do you have clear, defined goals for what you want your retirement to look like? And do you know where your retirement accounts stand today? Being proactive with your retirement accounts allows you to create a goaloriented roadmap. It may also help you adapt when necessary and continue your journey regardless of things like relationship status or market fluctuations.

Sources: 1. Transamerica.com, 2021 2.GAO.gov, 2021 3.Brookings.edu, October 8, 2021 4. CNBC.com, June 8, 2022 5. Distributions from 401(k), 403(b), and most other employer-sponsored retirement plans are taxed as ordinary income and, if taken before age 59½, may be subject to a 10% federal income tax penalty. Generally, once you reach age 73, you must begin taking required minimum distributions.

6. HerMoney.com, April 12, 2022 7. TransAmericaCenter.org, 2021

Laura J. Brown, CAP, CTFA

Senior Vice President & Senior Trust Officer Laura J. Brown joined Happy State Bank & Trust Company in 2022 as a senior trust officer and market director for Fort Worth and the Mid-Cities. She previously served as a trust and client advisor with The Northern Trust Company and managed agency and trust relationships utilizing comprehensive wealth management services for ultra-high-net-worth individuals, families and charitable entities.

Laura graduated from Texas Christian University with a Bachelor of Science degree in Advertising/ Public Relations and a minor in Business. While attending TCU, she interned for six months at a public relations firm in London, England, U.K. Laura went on to earn her Master of Business Administration from the University of Dallas in Irving, TX. She holds the Certified Trust & Fiduciary Advisor (CTFA) designation, Chartered Advisor in Philanthropy® (CAP®) designation, is a member of the Tarrant County Bar Association, past board member of the Dallas Estate Planning Council (DEPC), and past president of the DEPC Emerging Professionals. Laura is actively engaged with local community organizations, her children’s schools and her church. In her free time she enjoys traveling and spending time in the outdoors with her family.

Spring 2023 | 6

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