Stocks rallied sharply on Friday, led by a sharp recovery in regional banks. This will be a big political week as President Biden meets with Kevin McCarthy and then with Congressional leadership teams. Thursday will mark the end of Title 42. Without any administration response, beyond sending troops to our southern border, immigration will once again be a headline stealing focus.
Let me start with the regional banks. The drop last week, after First Republic failed and Fed Chair Jerome Powell seemed to understate the reaction, combined with fears on Wall Street concerning possible subsequent failures, pulled the entire market lower. It appeared, however, that Wall Street fears were far worse than what was actually occurring within the banks themselves. When a story surfaced that PacWest was examining strategic alternatives, its share price was cut by more than 50%. However, the headline was nothing more than a repeat of what PacWest’s management had said previously. While we won’t know for some days the pace of withdrawals from PacWest or any other regional bank, it appeared that the panic on Wall Street wasn’t being replicated on Main Street. The mass selling was aggravated by a spike in short selling. A particular target was the largest regional bank ETF. When shares of an ETF are sold (whether a short sale or otherwise), the manager of the ETF must proportionately sell shares of all the stocks that make up the index. Thus, while few expect short-term liquidity issues beyond a few banks concentrated in the Silicon Valley area, shares of all regional banks sank as well.
To be clear, these banks all face problems ahead. Via higher deposit insurance premiums, they will have to pay for the FDIC losses related to forced takeovers. Silicon Valley and First Republic alone will cost the FDIC almost $35 billion that will have to be recovered over several years. In addition, we all know Washington’s response to a crisis. More rules and regulations, which will certainly be backward looking and expensive. Banks have already responded on their own, raising fees and lending rates. Some are paying more to retain deposits. Thus, some of the selling post the failures of the past two months has been justified. But by last Thursday, clearly investors were in panic mode and leaving rational behavior aside. What is critical now for the regionals are two things. First, Friday’s rally has to be sustained. One day bear market spikes upward can simply be short-covering. To be meaningful and prove to be a true selling climax, the spikes have to morph into a sustained recovery.
A selling climax isn’t a buy signal beyond a short-term recovery to rational price levels. It will be a long time before regional bank shares return to pre-March levels, but the worst might be over. I mentioned that two things needed to signal at least a short-term “all clear”. The second is that time must pass without another significant bank failure. If PacWest or any other regional banks fail due to a run of deposit outflows, the clock will restart and another bank will come into focus. Time may be the best healer.
Clearly, however, the serial failure of banks over the past two months has ignited concern on Wall Street. But it hasn’t moved stocks out of their one-year trading range. Economic data suggests the economy hasn’t approached recession territory yet. Bond yields in recent weeks have been relatively stable, with most of the focus being on the very short end of the curve, a consequence of concern over a possible credit default as our nation approaches its debt ceiling. That brings me to the political topic that crosses over into the financial and economic world, the approaching debt ceiling.
Treasury Secretary Janet Yellen has said that crisis could come as early as June 1. While mid-July is more likely, plans have to be made for an earlier ceiling. To date, Republicans and Democrats have been playing party line tunes that simply don’t overlap. Biden and the Democrats want a clean raise to the debt ceiling. Republicans won’t accept that without spending cuts. To date, both sides have been shouting without listening to the other. This week’s White House meetings are a first step toward trying to find common ground. Don’t expect any solutions this week, but what we all want to hear is that (a) both sides agree time is running short, and (b) some path forward becomes visible. Our fiscal year ends in September. If, for instance, the debt ceiling could be raised slightly to sustain normal business until September, then both sides could save some face. Biden could get his “clean” debt ceiling increase while Republicans could accomplish some net spending restraint to start fiscal 2024. That is only one possibility. There are many. All have their political advantages and disadvantages depending on which side of the aisle one sits. A further reality is that both parties have stubborn extremities. There are Democrats unwilling to accept any spending restraints and some Republicans who won’t support any increase in the debt ceiling even as they acknowledge no path away from deficit spending. Any increase in the debt ceiling has to be approved by both chambers of Congress, which means 60 votes in the Senate, which in turn means any solution must be bi-partisan. Bi-partisan is a word rarely spoken in Washington these days. Hence, ongoing fears that this time the ceiling will be traversed for the first time.
Debt ceiling crises aren’t a new occurrence. The last time that Congress went to the proverbial 11th hour was in 2011. After that, S&P lowered the U.S. Credit rating to AA+. While it is unlikely that the White House’s choice to respond to hitting the ceiling will be to actually default on principal or interest payments on our debt, so far it hasn’t spelled out how it might act if the ceiling is reached. That decision will come closer to the end point. Needless to say, however, preparations are being made. Some spending will have to be deferred. Most often mentioned are military pay and Social Security payments. They aren’t the only options. All options are bad ones, certain to instigate a flood of calls to every member of Congress. Thus, a true crisis is unlikely to be long lasting. However, consequences could be meaningful which is why markets usually have a hissy fit at some point if Congress can’t find a solution before the deadline. Given the lack of bi-partisanship today, odds certainly favor no solution being reached until the last moment, if then.
But early May is still too early to worry. That may change if the tone after this week’s White House meetings remains belligerent. That seems somewhat unlikely as both sides want to sound like they are making an effort to find a solution. Whatever the message post-meeting might be, it is likely to be market moving.
Today, however, the focus will be on the banks. If recovery continues, stocks could have another solid session.
Today former Steelers coach Bill Cowher is 66. Former NYC Mayor Bill de Blasio turns 62.
James M. Meyer, CFA 610-260-2220