Recent jobs and inflation reports were stronger than expected, meaning inflation remains elevated. Futures markets were pricing in an 80% chance of another 50bp increase in Fed Funds on March 22nd, up from a zero probability a few weeks ago. It is highly unusual for the Fed to change course after slowing their cadence (from 75bps to 25bps) and revert back to 50bp hikes. I remain hopeful that the Fed realizes that their policy works with a lag and that they will let the dust settle before going back to more aggressive actions. Bulls hope that today’s jobs report shows fewer new jobs than expected, with wage growth contained, which would ease some of the pressure on the Fed to tighten policy more aggressively.
Stocks opened yesterday’s trading session with some positive momentum following a jump in unemployment claims. Again, normally this is bad news for stocks as more people file for unemployment checks, but in today’s world, the Fed wants to see more people unemployed so that pricing power declines and inflation slides back to 2% and they can get rates back to normal. That relief rally was short-lived and major averages are testing last week’s lows, dragged down by a few bank warnings on the quality of assets on their balance sheets (more on banks below). The 3,900 level on the S&P 500 is critical support and only 18 points from the close yesterday. Breaking through that could bring forth more aggressive selling and a re-test of last year’s October lows.
March is “Conference Season”, where companies gather at numerous sponsored events to tell investors their story and mingle with clients. Weather plays a role as it is a great time to head South where these events are well attended. This also becomes “Confession Season.” Any warts to long-term outlooks are displayed, and vice versa. With so much uncertainty in the world today, these updates are critical.
Banks were a pretty good area to invest from the bottom in October; that is until the past few weeks and exacerbated over the past few days. The majority of them possess low P/E’s, high dividend yields and much cleaner balance sheets due to all of the regulatory changes. This is not 2008 anymore. Most larger banks are well capitalized and can withstand a recession. However, warts are starting to show. Rising interest rates are typically a good environment for banks. They borrow at the short-end of the yield curve where costs are low, and lend at the long-end for a decent spread. For instance, checking accounts at most banks still pay less than 1% in interest but a mortgage now costs over 7%. That 6% spread is profit, minus costs and any potential defaults. The same for auto and business loans.
Fast forward to today and that cheap cost of funding is shooting higher. Gone are the days when bank deposits were tough to move. Each one of us can take cash from one bank earning 1% and move to a T-Bill making 5%+ in a matter of minutes. Banks are loathe to raise rates on deposits, but cracks are emerging from this business plan. Funding costs are spiking. Consumers are getting smarter. This directly impacts profitability, which many companies discussed during their conferences this week. Banks also must maintain a certain amount of capital on hand, relative to deposits. If deposits flee, banks must raise funds. Once XYZ bank has to sell a portfolio of assets, which are not marked to true market prices, they then realize a loss. Think about all of those low interest Treasury bonds that banks purchased in 2020. They are carried at par or $100.00. Today, some of those bonds are actually trading at $80.00. Selling them creates a level of concern, creating a liquidity event, and clients begin withdrawing any amount of assets over $250k, the FDIC insurance level. More withdrawals force XYZ to sell even more assets at discounts.
KBW, the Bank index containing 24 banking stocks, is down a whopping ~13% this week. SVB Financial Group, a banking and financial services company heavily exposed to Silicon Valley, announced a sizable capital write down for assets on their balance sheet. They are in the thick of technology’s malaise and lack of IPO’s from the Tech sector. Their stock dropped ~60% yesterday to a $6 billion valuation. It is down another 40% this morning as investors pull funds quickly. Quite scary considering they were a $45 billion bank a couple of years ago. Not all banks are in this kind of trouble though. Many are in great position to take market share and maintain their deposit core. Consider this a shoot first, ask questions later event.
Banks are the lifeblood of economic expansion. Most small businesses cannot get started without some sort of financial assistance. Expanding factories or taking on large client orders only works when there are available funding options. The issue now will become two-fold.
Back to the lending example from above. Banks borrow at low rates and lend at higher rates, while including some costs and write-downs from defaults. If the cost of funding goes higher, loan rates have to rise commensurately. If the risk of default goes higher, as it always does during an economic slowdown and Fed rate hike cycles, banks require an even higher spread from their loan rates. There is no world where a bank will borrow at 4% and lend at 4% just to be nice to customers.
As the cost of funding keeps rising due to customer deposits being less sticky, rising savings account interest rates, rising CD yields and overall higher interest rates, banks have to respond. Higher and higher interest rates across the board will not only make the approval process tighter for banks but consumers and businesses will start to balk at expansion. How many of us want to purchase a retirement home? Probably a lot. How many of us want to pay 7% on that mortgage? Probably a lot less!
This vicious cycle will impact GDP, but always has a lagged effect. Typically, that is 6 – 12 months. With balance sheets in great shape going into this period, it is quite possible (likely) that the lagging effect is more like 12 – 18 months. This is why markets respond harshly to the Fed possibly getting more aggressive instead of letting previous policy work its way through the system. In fact, the odds of another 50bp hike have already dropped below 50% following the banking issues above. Every Fed cycle creates some havoc, and the SVB situation (along with several other smaller banks) could force the Fed’s hands.
Federal Reserve Operations:
Lastly on banks. They are getting paid to NOT LEND and nicely so! In short, the FOMC uses several tools to impact the economy. One of them is interest paid on reserve balances. Every night, banks deposit excess reserves (the deposits they are not required to hold in order to back client accounts) at the Fed. Every time the Fed raises Fed Funds, they are making it more attractive for banks to just keep that cash in their vaults instead of making risky loans. Less lending directly slows down an economy. Today, banks can earn ~4.6% on anything held with the Fed. Pairing this with the $2.2+ trillion Reverse Repo operation and banks are earning over $700 million DAILY by not lending. A year ago, this was almost nothing. As the Fed pounds the table on more rate hikes, why would banks lend to riskier clients and create more stress on their balance sheets?
With the beating that bank stocks took this week, a lot of this increase in funding costs and asset write-downs is getting priced in. The quicker inflation moderates and the Fed can normalize the short-end of the yield curve, banks will be quite attractive again. They are trading well below historic valuation norms and following this price correction, those growing dividend yields become more attractive. I repeat, this is not 2008. MOST banks are well capitalized and default levels are still below norms, especially at larger institutions.
Financial companies also carry a decent chunk of assets in mid to long-term investments. Anything purchased 3-5 years ago in a sub 1% interest rate world can now be reinvested at much higher levels and lead to earnings growth when those bonds mature (as opposed to being forced to sell early like SVB). It might be time to take a deeper look at your favorite financial institution stocks but wait for the knife to stop falling before jumping in.
Singers Carrie Underwood and Robin Thicke turn 40 and 46 today. Chuck Norris does not blow out birthday candles for his 83rd, they surrender their flames willingly! Plenty of actors/actresses as well: Sharon Stone, 65; Jon Hamm, 52; Paget Brewster, 54; Emily Osment, 31; Jasmine Guy, 61.
James Vogt, 610-260-2214