Stocks rallied for the second straight session in front of the conclusion of the FOMC meeting today which will help to define the Fed’s future course. Bond yields rose modestly. Fed Funds futures indicate an 87% certainty of a 25-basis point increase in short-term rates, despite the uncertain future of a few mid-sized banks. While the Fed rarely contradicts a market sentiment as strong as I just noted, the decision whether to raise rates or not will be highly debated at today’s meeting.
On Monday I made my case for why I believe a pause would be more prudent. The Fed essentially has two options. It can pause, suggesting concern that current turmoil in the banking system trumps inflation-fighting efforts at the moment. Post-meeting commentary, however, would make it clear that such a pause doesn’t mean the fight against inflation is over; it’s simply a pause. The final end point would be higher rates than today, unless inflation in the interim falls sharply and steadily. The other option, to raise rates a quarter point, would say that the Fed believes it has the tools to quell any further turmoil within the banking system and contain any damage. Should it go this route, the post-meeting commentary would note that financial condition risks are elevated, such that reticence to lend or borrow is likely to slow economic activity and actually help in the fight against inflation.
Either way, the ultimate terminal rate for this cycle is likely to be lower as a result of current concerns. Markets, again according to Fed Funds futures, actually expect 2-3 rate cuts before the end of the year.
That brings me to the dot plot forecasts by FOMC participants for the future course of rates, economic growth, inflation, and employment. These dot plots are collective guesses of the individual meeting participants. Historically, they are extremely inaccurate. No one should rely on them as statements of where rates will end up, but their importance is that, collectively, they are the best way to show the mindsets of the FOMC members. Dot plots similar to those last done in December would suggest (1) current turmoil has and is expected to have minimal impact on future economic activity, and (2) whatever problems currently exist can be contained. A meaningful change, almost certainly in the direction of slower activity and declining inflation, would mean that the Fed is near the end of its tightening.
In the past, the Fed had warned that rates would stay higher for longer, suggesting the likelihood of any rate cuts this year was less than 50-50. Fed Funds futures suggest one more increase after today’s (assuming there is one today), and 2-3 rate cuts before the end of the year. They both can’t be right. Of course, they both can be wrong! Over the past many months, markets have underappreciated the strength of inflationary forces and the labor market. To date, small and medium-sized businesses have continued to add jobs, most notably in the hospitality and leisure arenas. But there are many signs that inflation is ready to decelerate. Housing and rental costs are in decline. The price of oil is down sharply in recent months, a time when prices normally rise seasonally in front of summer driving season. Despite lower prices, the U.S. government is still releasing oil from the Strategic Petroleum Reserve.
Back to the banking crisis. First, it simply isn’t over. Fear has not dissipated. While the Fed could rescue another bank or two and guarantee those deposits, despite statements to the contrary, it can’t continue to do that ad infinitum. Congress is in early discussions to raise the $250,000 FDIC guarantee per depositor to a higher level, perhaps $500,000. Such an increase wouldn’t be free. Banks would have to pay sharply higher deposit insurance premiums. Markets can surmise what is going on daily in terms of deposit outflows at the banks. The FOMC members today have up to date numbers as of last night. Regardless, it is obvious that money is leaving the banks for several reasons. The original reason was in search of higher income. Banks pay next to nothing for deposits. Savings and CD rates are better, but not as good as available elsewhere in money-market funds and the Treasury market. When money-market funds and Treasuries were yielding less than 1% a year ago, the temptation to withdraw was far less than today. The high-profile failures of a few banks now have depositors worried. Thus, there is a flight of money from smaller banks to larger, more secure banks. The data to support the speed of that flight isn’t available yet. A third factor is that businesses, large and small, are focusing on liquidity needs. One only goes broke when they run out of cash.
The current focus is on First Republic Bank, a California institution that bears some similarity to Silicon Valley Bank. Similar customer base. Similar locations. Recently, 11 national banks agreed to deposit $30 billion to slow the run of outgoing deposits, which are estimated to have been $70 billion. That news quelled fears briefly, but after they increased once again, several of the same banks entered discussions to infuse or help raise equity capital. First Republic’s stock rallied yesterday, and is a bit higher this morning in pre-market trading, but it is still more than 80% below where it traded a month ago. In a crisis, the problems spiral from one bank to another, until contained by overwhelming government action. It is possible that the right solution to save First Republic could offer a respite or even stop the runs altogether.
That presumes that (1) interest rates peak soon and then start to recede, and (2) any damage from an economic downturn or recession will not reignite stressful conditions within the banking industry. We can all have our thoughts relative to these presumptions, but the fact is that no one knows. The seeds for stress still remain. So far, the focus has been on problems related to venture capital backed startups and the declines in value of securities held by banks. Credit concerns haven’t been noteworthy, but perhaps that will change. A particular concern might be commercial real estate, particularly office buildings. We all know that Covid changed work habits. Employees are returning to the office, but clearly some form of remote working is here to stay. Demand for office space is weak. A combination of lower occupancy rates and higher interest costs could be lethal to some projects. There are a record number of new apartments coming to market this year. That is already leading to lower rental rates. Once again, lower occupancy, lower rates and higher debt service costs have the potential to create stress. While the situation today isn’t critical, one can see that credit issues during a recession might create stress at poorly managed banks. Banks rarely fail in good times. We aren’t in a recession yet. Caveat emptor.
So, where does that leave equity investors? Let’s start with a few presumptions.
• Whether the Fed raises rates today or not, we are near the end of the interest rate hiking cycle. Current turmoil and a slowing economy suggest that a top rate close to 6% is far less than it was just a month ago. Markets look ahead. They probably are now looking at a world when short-term rates are in decline.
• Fears of future bank failures are likely to stay elevated, even if First Republic can be saved. Banks, particularly regional and community banks, can expect increased costs and supervision. That will make them more apt to increase liquidity and tighten lending standards.
• Businesses will focus on liquidity first and growth second. Recessionary behavior.
• Credit spreads will widen. That process has already begun. Even if yields on 10-year Treasuries change little from here, yields on lower grade bonds will rise, suggesting the proper P/E for stocks may fall before rising again.
• Earnings expectations in the short-run will fall. However, if a recession is relatively brief, the outlook for 2024 and beyond would brighten.
• Inflation is falling and it could fall at an accelerated pace if labor market conditions ease and shelter cost calculations with the CPI and PCE indices reflect current reality.
Right now, the S&P 500 sits at just about 4000. It has been moving sideways with elevated volatility since last May. But the vast majority of stocks are lower, a combination of higher rates impacting P/Es for growth stocks, and difficult economic conditions for many industries. The range since May has been roughly 3500-4250. Thus, we are closer to the top than the bottom. Markets almost never bottom before a recession begins. The banking crisis increases the odds of recession. I have no idea how markets will react to Fed actions today and Powell’s post-meeting comments, but the reality is that the economy will have to traverse many bumps in the months ahead, some already discounted. I can’t make a case currently for the stock market to rally to or past the recent January highs. Conversely, unless the banking situation erupts into a full-blown crisis, I see no need to revisit the June and October lows. The gains of the past two days probably exhaust this current rally for a while. Many leading tech stocks have had significant rallies year-to-date. They are the propellants of the S&P 500. Promises of generative artificial intelligence are exciting investors, but the profit opportunities are still well into the future. Meanwhile, an economic downturn will impact internet retailing and digital advertising negatively. That leaves me neutral at the moment, perhaps with a slightly negative short-term bias given the strength of the last two sessions. To turn more positive, I need to see the point in the future when economic conditions will allow corporate profits to rise again.
Today, Reese Witherspoon is 47. Andrew Lloyd Webber turns 75. Author James Patterson is 76. Finally, Captain Kirk, better known as William Shatner, is a robust 92.
James M. Meyer, CFA 610-260-2220