Wealth Insights | Weekly Market Analysis | Economy | Asset Allocation | Equities | Fixed Income
Weekly Market Analysis: Unintended Consequences
Posted on3 Things to Know
Confidence is critical
Confidence is critical to the banking system and the economy’s performance. In the past week we saw what a lack of confidence looks like in internet time. Within days, we saw the failure of two large banking institutions. The speed of information has impacted the speed of depositor actions to the point where regulators had to announce bank closings.
The Fed set the stage for the crisis
The Fed’s abrupt and rapid reversal of monetary policy set the stage for today’s unfolding events. Following record stimulus in 2020 and 2021, the Fed reversed course in 2022 and raised rates 450 basis points, more quickly than ever before while also reducing its bond portfolio. They’ve committed to these policies until their 2% inflation target is in sight. The Fed’s moves have led to the worst combined stock and bond market performance since 1931.
Implications for depositors, regulation
The rates banks will need to pay for deposits will rise while US Treasury rates will fall. Borrowing costs for companies and individuals will rise, as well. Market liquidity will be reduced. There will likely be more banking consolidation and less credit expansion.
Summary
Confidence is the life’s blood of the banking system and is critical to the economy’s performance. This past week, we saw what a lack of confidence looks like in internet time. The Fed’s abrupt and rapid reversal of monetary policy set the stage for the recent tumult. In CIO’s view, the US banking system will stabilize when the US government provides clear and unambiguous support for the system as a whole. The longer it takes for the government to provide clear guidance in support of depositors and the wider banking system, the less safe many depositors will feel. A silver lining amid the current uncertainty is that we are likely in the final stretches of the bear market. Asset markets are now more likely to quickly price the economic weakness to come with the Fed recognizing this as well. Just as asset prices fell in 2022 when economic growth and profits rose, history suggests markets can find a bottom in the trough of an economic contraction.
Portfolio considerations
In CIO’s view, the US economy will likely show an output contraction around midyear. Once labor markets shift to net contraction, the Fed will likely begin to reverse course. CIO is therefore significantly overweight US Treasuries and defensive industries such as large-cap pharmaceuticals along with strong dividend growers in equities markets.
Source: Haver Analytics as of March 10, 2023. Past performance is no guarantee of future results. Real results will vary.
Confidence is critical
Confidence is critical to the banking system and to the economy’s performance. Once a financial institution loses the confidence of its customers, it becomes vulnerable. This past week, we have seen what a lack of confidence looks like in internet time. Within days, we saw the failure of two large banking institutions. Unlike in 2008, the speed of information has impacted the speed of depositor actions to the point where regulators had to act intraday to announce bank closings. This past week, a consortium of US banks deposited $30 billion at First Republic. When there are enough events like bank failures or forced mergers between institutions, depositor and investor anxiety – the antithesis of confidence – can become endemic. We have already seen the price of regional bank shares in the US fall by 30% since March 1. On March 15, bond rating agency Moody’s cut its outlook on the US banking system to negative due to a “rapidly deteriorating operating environment.” Moody’s issued its warning after US regulators had stepped in to ensure the safety of depositors and promised to provide substantial liquidity to banks faced with deposit outflows.
The Fed set the stage for the current crisis
The Fed’s abrupt and rapid reversal of monetary policy set the stage for today’s unfolding events. Following record stimulus in 2020 and 2021, the Fed reversed course in 2022 and raised rates 450 basis points, more quickly than ever before while also reducing its bond portfolio at a rapid pace. They have committed to maintaining these policies until their target of 2% inflation is in sight. This reversal of policy and abandonment of incremental action in 2022 saw the worst combined stock and bond market performance since 1931. The fact that banks have $620 billion in aggregate mark-to-market losses on their securities portfolios is, in part, a reflection of the Fed’s actions. A week ago, the FDIC, Federal Reserve and Treasury Department stepped in to ensure that all depositors of Silicon Valley Bank and Signature Bank – both insured and uninsured – would have “full access to all of their money starting Monday, March 13th.” They implied that all depositors at US banks wouldn’t be subject to default. But are all US bank depositors safe? Of any size? Is there, in fact, unlimited deposit insurance, if only during this period of massive instability? That remains unclear.
Implications for depositors, regulation, and the economy
Regardless of the timing of the end of 2023’s banking emergency, there are several impacts that will extend to the broader economy with delayed, but negative implications. The rates banks will need to pay for deposits will rise while US Treasury rates will fall. Borrowing costs for companies and individuals will rise, as well. Market liquidity will be reduced. The behavior of bank depositors will likely change and their awareness of available rates from other sources will become a part of their “buying process,” as will considerations of relative safety. All this will put pressure on bank profitability over the coming year or longer. And in the meantime, there will likely be more banking consolidation and less credit expansion. There will also be regulatory changes. While US employment gains have been stronger than expected in the early months of 2023, CIO continues to believe the extreme Fed tightening cycle is sure to apply the brakes, and not evenly. Less well-capitalized firms (cash-burning small caps) and industries under secular pressure (such as office real estate) would likely be the first to show cracks.
Portfolio considerations
CIO thinks the US economy will likely show an output contraction around midyear, though precise timing of when it will bottom is difficult. Once labor markets shift to net contraction, the Fed will likely begin to reverse course. CIO is therefore significantly overweight US Treasuries and defensive industries such as large-cap pharmaceuticals along with strong dividend growers in equities markets. A silver lining amidst the present uncertainties is that we’re likely in the final stretches of the bear market. Asset markets are now more likely to quickly price the economic weakness to come with the Fed recognizing this as well. Just as asset prices fell in 2022 when economic growth and profits rose, history suggests markets can find a bottom in the trough of an economic contraction. It might be too soon now, but CIO expects market volatility and a fast-evolving business cycle to present us with potential opportunities to add to equities this year. When CIO does move to add risk – once the Fed has shifted toward easing – the first steps will likely focus on three broad groups of stocks: rate victims, global firms with strong balance sheets, and secular growth themes.
Five Answers to Frequently Asked Questions
Q: How could a healthy banking system have bank failures and runs on deposits?
A: Just because the overall banking system has seen a marked increase in equity and sharp reduction in risky lending since 2008 doesn’t mean every institution was managed prudently. As we discussed in our March 12 CIO Bulletin, there are vast differences between banks that might make some more fundamentally vulnerable in certain circumstances. Some have low levels of retail deposits. Others have made the bulk of their loans to a single industry or geography. Some economists ignore these distinctions and speak only of the aggregate strength or weakness of the banking system.
Importantly, depositor and investor attitudes and anxiety can be a powerful force for the economy, whether there is a rational basis for them or not. Banks work in the economy by meeting credit demand for periods that differ from those providing funding through deposits. If the majority of a bank’s depositors – the lenders to a bank – demand immediate repayment, it would threaten the solvency of nearly any bank.
So-called contagion occurs when investors (in this instance, depositors) fear that others will withdraw their deposits and act similarly without an assessment of the specific situation. This is why the banking system has macro-level safeguards, such as deposit insurance and access to central bank funding if lenders cut off a bank out of “contagious” fear.
Q: How could the Fed still raise interest rates under present circumstances?
We suspect that Fed policymakers believe that regulatory action to support confidence in the banking system will allow them to press on with a rate hike at their next meeting. While we think the Fed, Treasury and FDIC have so far limited contagion risk, the impact of rapid rate hikes on bank balance sheets and reduced Fed lending (Quantitative Tightening) is one of the factors underlying a loss of confidence in the banking system.
Credit is fundamental to how the US economy performs. Tightening monetary policy works through the banks. Banks sharply tightened lending standards for Commercial and Industrial Loans even before the SVB news, though high yield credit spreads have remained tight. We think that further Fed tightening and more cautious lending may reduce the availability of bank credit in the economy in 2023.
Q: If the Treasury, FDIC and Fed successfully navigate this crisis, does that alter our pessimistic view for the US economy in 2023?
We expect US authorities to take whatever action is needed to protect depositors and the stability of the banking system, even if there are subsequent bank failures. Assessing the end point for the turmoil is difficult to do in real time. Broadly speaking, we don’t believe the US or European banking systems face great systemic risk. Yet, we did not count on a banking emergency when forecasting a mild recession this year.
In our view, the move from dramatic stimulus to restraint in macroeconomic policy (monetary and fiscal) in the past few years threatens to turn one shock (Covid) into two recessions. The past impact of Fed policy rate increases seems likely to sink key components of the labor market looking ahead.
Financial turmoil might cause this restraint to be larger and, therefore, the peak Fed funds rate would be lower. Markets are now convinced the Fed will take risk management considerations into account and not resume tightening at a pace larger than 25 basis points this coming week. However, the Fed’s stated goals are to make backward-looking inflation lower. This takes time when their own policy tool has the effect of boosting a key component of inflation – shelter costs.
Q: What does it mean for the Swiss central bank to provide 50 billion francs in loans to Credit Suisse?
Credit Suisse’s common equity has fallen for 16 years since peaking in 2007. The slow decline in this particular financial institution has given its counterparties plenty of notice. We think the loans from the Swiss central bank will slow down the difficulties faced by Credit Suisse – deemed a globally important bank – but not curtail them. It can assure investors and clients there will be a lender to the bank if others balk -- and not at pricing that would cripple the bank. However, this is not a capital infusion (equity), so it doesn’t help the bank offset losses if it has them.
News over the weekend suggest several US and European firms are considering investments in parts of Credit Suisse. A possible merger with another Swiss bank is also in the press.
Q: Where will we look for potential opportunities amid market disruption?
It might be too soon now, but we expect market volatility and a fast-evolving business cycle to present us with potential opportunities to add to equities this year. When we do move to add risk – once the Fed has shifted toward easing – our first steps will likely focus on three broad groups of stocks: rate victims, global firms with strong balance sheets, and secular growth themes:
Rate victims: So-called long duration equities were the biggest victims in 2022 as interest rates rose sharply across the world. With the market quickly moving to price a lower Fed funds terminal rate and a much more imminent cutting cycle, these same growth-oriented assets could see their shares bottom before value cyclicals like industrials.
Global firms with strong balance sheets: We have written recently about the potential for non-US shares to outperform the US in the coming cycle. Compelling relative valuation coupled with an over-valued US dollar make for an interesting entry point with a multiyear time horizon. But as we’ve seen with the European banking sector in successive waves of crisis in the past 15 years, not all global shares are created equal. Indeed, European and Asian commodities, technology, and consumer discretionary names will likely see much stronger long-run earnings tailwinds than more regulated and less dynamic sectors like financials and utilities. Even more so than our allocations in the US market, we’ll likely take an active approach when choosing among international investment options.
Secular growth themes: We will also consider thematic trends when selecting from the universe of growth shares. Leading themes of the last cycle, like social media and smartphones, have seen winning firms evolve into more mature businesses, which will mean more moderate sales and profit growth going forward. We therefore look to the next generation of technological advancement, in areas like AI, robotics, and cutting-edge computing, as a likelier source for market-beating growth in the next decade. Other less tech-oriented themes like clean energy infrastructure, advancements in battery technology, and biologics research are also likely to experience strong secular tailwinds. Further near-term market volatility could present us with attractive entry points across many of these themes.
