It was a wild day yesterday with several strong moves relative to earnings, a wild ride for First Republic Bank, the regional bank most people see as the stress point within the banking system, and a sharp rally in bonds. The major averages were all lower. After the close, solid earnings from Microsoft# reduced some of the fear. Futures point to a more muted market this morning.
Let’s start with First Republic. On Monday, its stock rose in anticipation of an earnings outlook that would clearly set the path for survival and ultimate recovery, but its report after the close of business Monday showed that deposits in the first quarter fell dramatically even as they began to stabilize by quarter’s end. When rumors started to emerge that First Republic was looking at the possibility of selling a large package of underwater assets at above market prices in exchange for equity warrants, investors fled. Volume yesterday exceeded the total number of shares outstanding. I am in no position to opine whether First Republic can survive or not. What I can say is that no major bank is likely to be a savior and the crisis comes a week before the FOMC meeting that will consider another Fed Funds rate hike. Before this week, the overwhelming consensus was one more hike was in order. First quarter GDP, coming later this week, will show continued growth. Inflation remains sticky. Leisure travel is still robust.
There are contradictory signs as well. Trucking activity has weakened considerably over the past six weeks. That was demonstrated to the market via United Parcel’s# weak earnings report yesterday. Existing home sales continue to slide and of course, there are obvious stress points within the banking system. Contagion might be dismissed by some but clearly can’t be ruled out. Should First Republic not survive, focus will move to the bank deemed next most likely to fail. Then there is the bond market. In early March, the yield on 10-year Treasuries rose above 4%. Now it is 3.4%. 2-year Treasury yields exceeded 5%. They are now 3.9%. Clearly, that is inconsistent when the Fed speaks that rates need to march higher and stay there for a long time. Markets strongly suggest that both the economy and inflation are weakening. Granted, backward looking data shows ongoing strength. Nothing better exemplifies that than the 3.5% unemployment rate.
Employment data series are notoriously lagging indicators. Companies don’t lay off workers before sales slump; they respond afterwards. All the tech layoffs we have been reading about are in response to an enduring deceleration of revenue growth, but there is one labor indicator that isn’t lagging. It’s continuing unemployment claims. These represent the numbers of Americans collecting unemployment checks who can’t find a job. In September, that number was under 1.3 million. Today, it is well over 1.8 million and rising. For the past 50+ years, every time claims have hooked up in similar fashion, a recession was imminent.
The bond market agrees. The stock market doesn’t. Earnings estimates reflect a slowing economy but not a recession. Most of the weakness this earnings season to date has come from one-off situations, but there are stress points appearing. I mentioned UPS earlier. Energy stocks, the leaders last year, are giving ground amid weak prices and soft demand. China’s reopening alone isn’t going to compensate. OPEC+ has responded by lowering production. While consumers are still spending, the mix is starting to shift more toward essentials and less to discretionary items. Electronics are a notably weak category.
It remains a mixed picture on the pricing front as well. Home prices have stabilized in many markets. There are fewer buyers and fewer sellers. but the balance has led to price stability. Consumer staples leaders like Procter & Gamble# and Pepsico report both higher sales volumes and little resistance to price increases. Inflation doesn’t die quickly.
All of this leaves everyone in a quandary. Federal Reserve officials must weigh enduring inflationary pressures against stress in the banking system and accelerating pockets of economic weakness. Earnings season once again shows companies beating forecasts while tempering future outlooks. The standoff is likely to be reflected in the stock market until there is further resolution. Can First Republic survive? When will the Fed rate hiking cycle end? Is there going to be a recession in the back half of this year? Until there is better clarity, stocks are likely to remain within the same trading range they have been in for most of this past year. The leadership to date has come from the big tech companies. It is unlikely they can repeat Q1 performance without a reacceleration of revenue growth. Staples stocks, like the aforementioned Pepsi and P&G have already rallied as investors reshape portfolios for tougher times ahead. Healthcare has been a mixed bag. The drug companies have done well but many others are still feeling the downside of deceleration of Covid related activity like testing. Economically sensitive parts of the market, like rails, and manufacturing are unlikely to lead until there are signs of an economic trough. No one wants to touch the banks in the middle of a storm.
Over a decade of easy money gave investors a free ride as asset prices swelled amid a sea of free money. The Fed has reversed course and the possibility that it can remain tight for too long isn’t trivial. All historic indicators now say recession is around the corner. I believe, from 30,000 feet above, investors accept that, but when it hits home directly, as it did for UPS yesterday, there could be additional pain. However, let me put that in context. Despite a drop of about 10% yesterday in conjunction with earnings, UPS’s stock is still up about a percentage point year-to-date. In other words, the false optimism was smacked by harsh reality yesterday resulting in a stalemate. Perhaps that is a great example of what lies ahead. When too much optimism creeps in, there is a correction. When markets get too pessimistic, bargain hunting returns. It’s been a standoff for a year, one likely to continue for several more months.
Today, Melania Trump is 53. Carol Burnett reaches 90.
James M. Meyer, CFA 610-260-2220