It was quite a first quarter. January was a superb month following heavy tax selling in December. Momentum slipped in February as the economy continued to run stronger than expected and inflation seemed resistant to Fed pressures. At one point, Fed officials began to signal that a 50-basis point increase in March was quite possible, if not likely, but then came successive bank failures led by Silicon Valley Bank and Signature Bank. Credit Suisse followed and had to be absorbed into UBS. Regional bank shares tumbled, especially many in California, but no others failed, at least not yet. By the end of March, confidence started to rebuild and markets finished strong. For the quarter, the NASDAQ rose by over 16%. The S&P 500, top heavy with tech names, rose by more than 7%, but both the Dow Industrials and the equal-weighted version of the S&P 500 barely rose by more than 1%. Regional banks fell by more than 20%. Big banks, health care and energy names overall experienced a down quarter. Q1 was all about tech and similar high-growth favorites.
Bond yields followed mixed paths. 2–5-year maturities saw yields fall as markets perceived that the end of the interest rate hiking cycle was near. 10-year Treasury yields fell as well, but widening credit spreads, reflecting rising credit concerns, kept other long bond prices steady. High-yield bonds actually fell in price.
By quarter’s end, the Fed and markets seemed to be on different planets. The Fed professed that banking concerns were real but could be contained. Most suggested at least one more rate hike was necessary in May. Furthermore, no one within the Fed was even considering rate cuts over the balance of this year. Looking at how markets priced Fed Funds futures, the consensus is mixed whether there will be another hike in May. More importantly, markets believe two cuts will happen before the end of the year. That consensus suggests that the economy will be weaker than the Fed thinks, or more likely, that more credit and banking related problems are likely to surface. The prognosis of rate cuts suggests notable economic weakness ahead. Without rising credit or economic concerns, there is no substantive reason for the Fed to start cutting rates.
Obviously, both the Fed and market consensus can’t be right. If the economy proves weaker than expected with rising credit concerns, stocks could be in for a tough time over the short term. Economic weakness would force earnings expectations lower. Even with less inflation, the short-term impact of a significant earnings shortfall would weigh on equity prices. Ideally, the actions taken by the government to stop the panic and slow the run on bank assets would lessen deposit outflows. Notably, since rates began rising in the spring of 2022, the deposit drain from large banks has been higher than from smaller institutions. Quite simply, the spread between the amount banks pay for deposits (virtually zero) and what could easily be earned in short-term instruments with little or no credit risk became so large that money flowed out of banks into Treasuries and money- market funds. With signs that rates are peaking, that outflow could slow, but it won’t stop until rates drop significantly or banks start paying to retain deposits.
Invariably, the government reacts to a crisis after the fact, and creates new laws, rules and regulations to prevent a reoccurrence. The 2008-2009 financial crisis centered around loan quality and leverage. Banks took too much risk and compounded the problem by assuming too much leverage. Dodd-Frank was passed to prevent that from happening again.
The problem this time, however, was very different. In the cases of Silicon Valley Bank and Signature Bank, the problems were a mismatch of asset and liability duration, and a geographic or business mix concentration. It had little to do with either credit quality or leverage. Signature was too tied to crypto markets and Silicon Valley was too tied to the tech venture community.
A big problem was trying to define the duration of these banks’ largest liability, demand deposits. As noted, higher rates accelerated deposit outflows. When it became clear that holdings of Treasury securities left a big hole of unrealized depreciation, depositors panicked, setting off runs that couldn’t be stopped. Normally, bank deposits are sticky. They can move around seasonally, but generally don’t require much action. Post-Covid, most banks had too many deposits relative to the size of loan portfolios.
All that changed with QT, quantitative tightening. The Fed shrank the money supply with higher rates and a steady balance sheet reduction of $90 billion per month. Excess deposits gradually disappeared. Bank security portfolios declined in value, commensurate with rising rates. Excesses evolved into stress. At first, as we saw last month, the most flawed banks failed. What we don’t know is how far this filters down, creating new concerns. Low quality car loans are witnessing a sharp increase in defaults. Office building occupancy rates haven’t recovered. A surge in new apartments will stress that sector later this year. Venture capital funded firms may not have access to new capital when needed.
The Fed, more often that not, is reactive, not proactive. It was late in raising rates to stem inflation and there is real justifiable concern that it will continue to hike rates past the point necessary. They will also ramp up regulation to solve a problem that likely will be solved once the rate hiking cycle ends. The March increase was done amid the turmoil surrounding the recent failed banks, as it appeared the flight of deposits based on fear of future bank failures was ending quickly. While that may be true, a supposition that no new problems will surface is a good faith guess more than a comfortable prediction.
The real concern now is that higher rates, while helping to subdue inflation, will also accelerate the flight out of all banks. Banks, of course, have an option; they can pay depositors to stem the flight of capital. But higher costs, and new backwards-looking regulations are sure to decrease loan demand and increase bank costs. In effect, tighter rules will have similar impact to the ongoing rate increases. Indeed, a slower economy is just the recipe for lower inflation.
The strong performance of stocks last week suggests that markets (1) feel the rate hiking cycle is ending, (2) that few, if any, future bank failures are likely, and (3) even should there be a recession, it should be mild and largely over within the next several months. By year end, inflation may be back below 3%. Lower rates, less inflation, and an ongoing real cost to money continues to favor growth stocks. But with the NASDAQ up 16% year-to-date, and many high-profile, high-tech names up 20% or more, the leadership in this market must widen to sustain itself. Q1 was all about high-tech names that lagged last year. Where else might future leadership come from?
One idea is healthcare, a sector not notably dependent on economic growth. Another is those interest-sensitive businesses that will improve as rates fall. Early cycle companies in the housing and retail sectors should benefit. Another is to look at where the government is spending its money. In the Biden administration, it’s all about climate change. That could mean anything from electric vehicles, to alternatives, to fossil fuels. Yet, the movement away from traditional fuel sources has slowed the development of traditional energy resources, to a point where any pick up in demand is likely to send oil prices higher once again.
I have been saying for some months that the first half of 2023 would likely be bumpier for investors than the second half. I haven’t changed that view. The first quarter was surprisingly good, especially for the tech sector, but the overall market could best be characterized as sideways choppy. We will find out in Q2 the consequences of tighter banking policies and slower loan demand. The need to focus on near-term liquidity is likely to slow capital spending. So far, the market sees this as a problem well understood and discounted. We will see in the weeks ahead whether that is a sound prognosis or not.
Today, Eddie Murphy is 62. Alec Baldwin turns 65. Jane Goodall turns 89.
James M. Meyer, CFA 610-260-2220