The latest bank equity selloff

Regional US bank stocks fell 5% on May 4, 2023, led by those banks most targeted by short sellers in recent weeks. These shares are now down 39% year-to-date, while large banks considered “too big to fail” have outperformed, “only” 17% lower this year (data to 5/4/23). While concerns around unrealized losses on loan portfolios and balance sheet securities are partially to blame, CIO sees the latest decline as a panic that was initiated by meaningful deposit outflows. Markets have been in a short-selling spiral, where weaker, individual banks are targeted, their stocks decline, and headlines trumpet broader concerns about deposits. Targets include banks with relatively homogenous and geographically concentrated deposit bases, and in some cases with lending concentrations in commercial real estate. And as institutions fail, “systemic confidence” is eroded. Rapid declines in regional bank shares have begun to impact consumer confidence and their perception of deposit safety. A Gallup survey released May 4 found that nearly half of participants were either “very worried” or “moderately worried” about the safety of their bank deposits. Meanwhile, short sellers in the equity market appear emboldened by the full wipeout of shareholder value across three major US banks this year. Yet those banks had much higher and more concentrated levels of uninsured retail deposits than typical large banks. More recent stock price declines are in banks with “normal” levels of insured deposits. This indicates that the level of contagion is rising. This is all happening as the country faces a debt-ceiling showdown in June. Political posturing and a likely cliffhanger ending could exacerbate market concerns. New US fiscal restraints are possible as a result of debt ceiling negotiations in the coming month. These could impact the economy negatively at a time when it’s already decelerating.

Impact of the Fed rate hike

The Fed last week made the historic choice to raise rates again in the face of an inverted US yield curve and a shrinking supply of money and credit (apart from a new emergency Fed lending facility). Beginning last year, the US central bank moved from increasing its balance sheet to shrinking it within the space of three months. The Fed abruptly set its sights on attacking inflation after seeing its credibility threatened because of an extended easing cycle that lasted through an economic boom in 2021. The Fed’s economic and balance sheet stimulus during and after the pandemic was too strong and it is possible that the strength of its inflation fighting medicine could be as well. Put simply, recent macroeconomic policy has been reactive and sub-optimal. Just as higher rates attracted capital to move from deposits to money market funds and T-bills, so too have higher rates caused the held-to-maturity values of bank assets to fall precipitously.

Risks for markets and the economy

Markets, the banks and the economy face several incremental risks. Banking turmoil is causing a decline in available credit in the economy. Bank lending is likely to tighten further with negative and imminent repercussions for the real economy. Second, reserves for commercial real estate loans are likely to rise as more heavily exposed banks prepare for restructurings. Third, market attention could soon focus on credit deterioration that can occur in the future. Fourth, greater regulation of small banks is in the mix, even if imminent action from Congress is improbable. And finally, further consolidation in the US banking sector is likely, with smaller regionals across the country teaming up to diversify their localized pools of deposits and loans.

Portfolio considerations

As CIO has said repeatedly, the increase in capital and strong risk management standards following the Global Financial Crisis have sought to make the US and world banking system safer. From a macro level, the data are unambiguous and positive as equity capital surged relative to lending. The nature of the post-Covid recovery – led by stimulus, not private borrowing – also makes a systemic banking/credit crisis far less likely. Even with the jump in small bank commercial real estate lending, broad private credit growth has been negative in real terms overall. Government borrowing for Covid stimulus surged in 2020 and 2021 but has collapsed since then. Further, the US economy’s underlying resilience shouldn’t be forgotten in moments of fear. A decline in inflation is underway helping real consumer incomes rebound. While employment gains could likely fade, CIO believes producers are beginning to make progress on reversing excess inventories across key industries while this consumer demand persists.

Note: Past performance is no guarantee of future results. Real results may vary.