Where expectations for the Federal Reserve’s monetary policy goes, so goes the stock market? Well at least in March that was the case as it was quite a tumultuous month when it came to the news flow. The failure of Silicon Valley Bank and Signature Bank created the tumult and the bank run fears that it created for the broader banking system. Luckily though, for now, there have not been any runs on other banks and the scare seems to have been calmed. I’ll get more into this later in the letter. What followed was a sharp change in what the bond market has priced in for the Fed. On March 8th, the day before Silicon Valley Bank started to implode, the bond market was pricing in a December 2023 yr. end fed funds rate of about 5.60%. As of this writing, expectations are for a year end fed funds rate of about 4.20%, which when compared with the current fed funds rate of about 4.80% implies two or more rate cuts in the 2nd half of 2023.
This belief that the Fed is not just likely done raising rates but might be soon cutting is what helped the S&P 500 gain 3.5%. Under the hood though the rally was very contained to large cap technology stocks. The S&P 500 Information Technology sector was up almost 11% while the small cap Russell 2000 was lower by 5%, which includes many small regional banks that suffered in the month.
In response to the changed outlook on the Fed, the 2 yr. yield dropped 79 basis points in March, closing the month at 4.03%, the lowest since last August. As the 10 yr. yield was down by 45 basis points to just under 3.50%, the yield curve lost some of its very deep inversion. Most of corporate credit rallied too, high yield and investment grade but leveraged loans where the interest rate component is floating rate, sold off.
Noteworthy too in terms of market performance was the resumption lower of the US dollar versus a variety of currencies. After seeing a sharp rally beginning in June 2021 and all the way through October 2022 in response to Federal Reserve monetary tightening, both with interest rates and its balance sheet, the US dollar has been falling as the Fed has slowed the pace of rate hikes and now might be done with them. As of this writing, the dollar index is near its lowest level in a year and in turn gold is trading above $2,000 an ounce, nearing a record high. It was up 7% in March.
We are also on the cusp of seeing Q1 earnings and that will most likely be the next main driver of markets. The importance of this is because Q4 earnings for the S&P 500 declined 3.2% y/o/y according to Refinitiv and they expect Q1 earnings to drop by 5% in Q1. With Q1 revenue expected to be up by 1.6%, that implies further degradation in profit margins.
The bank runs and eventual bailouts of the uninsured depositors at Silicon Valley Bank and Signature Bank were the first major breakage seen as a consequence of the very aggressive rate hikes from the Federal Reserve. There is no doubt though that mismanagement and regulatory failures were a key part of the downfall for both. Banks broadly are facing a challenge right now where deposit rates they are paying on savings accounts are well below what one can get in a Treasury money market fund. Deposits are thus leaving the banking system and ending up in Treasuries. This also leads to slower loan growth and mostly small and medium sized businesses are the most hurt by that because they are most reliant on this form of credit access.
I want to make clear that this is not 2007-2008 regarding the banking sector. Yes, we will likely see more bank failures as many small and medium sized banks have large exposure to commercial real estate which is under pressure now but I’m more worried about profitability issues rather than viability questions for banks broadly speaking. That said, there will be some banks that will need to raise more equity capital which will lead to dilution for the shareholders of those banks.
To highlight the importance of small and medium sized banks, according to the Federal Reserve they extended 38% of all bank loans. Their market share in commercial and industrial loans is 28%, 37% for residential real estate, 67% for commercial real estate, 27% for credit cards, 15% of auto loans and 48% for other consumer loans.
Inflation, the Economy and Central Bank Responses
The global trend in inflation is moderating further and we’re seeing some central banks that are calling a timeout on rate hikes as a result. The Reserve Bank of Australia just paused its rate increases and this followed what the Bank of Canada did recently as well. The Bank of England slowed its pace of hikes to 25 basis points from 50 basis points and while the European Central Bank recently raised rates by 50 basis points and might again at their next meeting, there is already a big debate on how much further they go from there. I believe the Fed will pause at its next meeting in May and not raise rates again for the foreseeable future.
Lunch is not free though as the Fed, the ECB, the BoE and others are still conducting quantitative tightening and trying to shrink their balance sheets. Also, growing concerns over global economic activity is a key factor in the recent drop in market driven interest rates. I believe a US recession is not a question of if but when and how deep and long it lasts.
China’s economy has been a positive as they finally reopen and get past Covid. The benefit though has mostly been seen in leisure, hospitality and other services. Manufacturing has been more challenged, as is the case globally. We do think as the year progresses, the Chinese economy will continue to improve broadly speaking and that in turn will help the entire Asian region and parts of Europe whose countries do a lot of business with China, particularly Germany.
With respect to the US economy, growth continues to slow. As seen in the Institute of Supply Management’s manufacturing index, it is in contraction for 5 straight months. Housing in terms of the pace of transactions is in a recession. Capital spending has been moderating. It’s been the consumer that continues to hang in there but even that is more bifurcated as higher income consumers are maintaining spending levels more than others who are more negatively impacted by inflation. We also have a close eye on all those companies that have floating rate debt that haven’t hedged that exposure and those that have debt coming due this year and which needs to be refinanced as it will take place at a much higher rate than the maturing loan.
What was most important for investors in March? It was all about rate and Fed expectations. What was not a focus was the repercussions of two major bank failures and the economic consequences of it, which is on top of an already fragile economy. As we enter April and earnings season is upon us, I think the attention will shift back to the economic and earnings fundamentals.
While it’s been a good start to the year for both stocks and bonds after a very tough 2022, I still expect the macro environment to remain challenging and choppy. The old play back that worked so well over the past 10 years no longer is applicable. The world of zero rates and massive QE are over for now and a higher interest rate and stickier inflation backdrop is something we need to acclimate to. In this new world, investors should be realistic of the risks of this shift to a new investing regime.
Whatever comes our way though, it remains vital that investors have adequate short term liquidity over the next 2-3 years. Knowing that period is covered can help separate the balance of one’s portfolio from the ups and downs of the market. Time horizon is very crucial right now and is the best friend of any investor.
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