Equity markets show resilience despite turmoil in the banking sector
Through most of this year, until about two weeks ago, economic dynamics were mainly unfolding as expected. Inflation was cooling, albeit slower than many would like to see. Labor conditions remained strong, despite some high-profile layoff announcements in Tech and Financials. Growth remained solid, though with evidence of pressure mounting (mostly as expected). Consumer and business balance sheets were well-stacked to weather a mild downturn (that remains the case, in our view). And notably, the consensus view on major central banker policies was that rates were headed higher in the front half of the year — though that view has shifted considerably over recent days. Today, the events unfolding across the financial space have elevated economic uncertainty and increased risk, in our opinion. And while it is too early to say if the shocks across the banking sector will ultimately have a more pronounced effect on markets and the economy, a defensively biased and high-quality investment approach is certainly coming in handy right about now.
Since the second half of last year, there has been this lurking feeling in some investors’ minds that such aggressive Federal Reserve rate hikes could eventually break something in the economy. On Friday, Bespoke Investment Group harkened back to a report they penned in September 2022, titled “Hike It ‘Til You Break It.” But such analysis was usually vague (including our own) and never could really put the finger on precisely what might break due to higher rates. But well-worn investors, who understood a world accustomed to living on near-zero interest rates for well over a decade, couldn’t shake the idea that the quick spike in rates over the last twelve months would likely have some unintended consequences along the way. Unfortunately, we are finally beginning to see some of the unintended consequences of raising rates so fast. Interestingly, the fallout of higher rates is currently coming through in the U.S. banking sector, an area most assumed would be one of the largest beneficiaries of rate hikes.
Here’s what you need to know as developments continue to evolve:
- The failures of Silicon Valley Bank and Signature Bank prompted regulators to guarantee “all” deposits at both banks and set up a short-term lending facility to help other banks with similar issues meet cash needs. Over the weekend, a coalition of midsized U.S. banks asked the FDIC to insure all deposits for the next two years, which it would pay for through an expanded deposit insurance assessment. Note: Such a change would require Congressional approval.
- The crux of the banking issue: Banks received an influx of deposits since the pandemic. Banks bought long-dated government bonds to match against those deposits, which have now fallen in value as interest rates have aggressively climbed higher. At the same time, higher rates have caused depositors to seek other higher-yielding investments with their cash. The run on deposits combined with paper losses on bank balance sheets has created a crisis of confidence across smaller regional banks. Intense selling pressure on these stocks as of late is increasing anxiety that something else may break.
- Following the collapse of Silicon Valley and Signature Banks, traders quickly targeted other regional banks that may have a similar profile (e.g., large uninsured deposits, cash outflows, and matched against long-dated securities). Hence, First Republic has quickly become the center of the fallout. Last week, First Republic’s stock price plunged over 70%, despite a $30 billion cash infusion from a consortium of big banks, including JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo. Regional banks could remain under pressure this week until investors feel confident that deposit and potential systemic risks have decreased.
- Overseas, Credit Suisse also came under intense fire last week. The bank received a $54 billion loan from the Swiss National Bank after its largest investor, Saudi National Bank, said it could not provide additional funding based on current investment caps and regulations. On Sunday, Swiss regulators hurried a deal where UBS bought rival Credit Suisse for $3.2 billion to help shore up confidence in the banking sector. Shortly after the deal, the Federal Reserve announced it would join other central banks to increase U.S. dollar swap line arrangements from weekly to daily to maintain global liquidity.
Markets showed resilience in the face of turmoil last week
Incredibly, broader U.S. averages finished last week mixed, with the S&P 500 Index gaining +1.4% and the NASDAQ Composite moving higher by +4.4%. The Dow Jones Industrials Average ended the week lower by 0.2%, while the Russell 2000 Index dropped 2.6%. Energy (down 7.0%) fell on rising global recession fears, while steeper declines across the banks pressured Financials (down 6.1%). Over the last week, the S&P 500 Bank Index has dropped 11.2% and is lower by 22.4% over the previous month. For comparison, the S&P 500 is down roughly 4.0% over the last thirty days.
Communication Services (+6.9%) and Information Technology (+5.7%) jumped higher on the week in what appeared as a counter-intuitive market reaction. This was partly driven by the 2-year U.S. Treasury yield finishing the week at 3.82%, down aggressively from over 5.0% just over a week ago. Additionally, the 10-year yield ended the week at 3.41% after sitting above 4.0% as recently as the beginning of the month. Simply, lower yields make future corporate profits discounted back to current rates more valuable in the present. And in an environment increasingly worried about growth, the knee-jerk reaction by market participants last week was to gravitate back to companies and sectors with generally stronger secular growth trends. Of course, if further stress on stocks continues, we’ll have to see if that logic continues to hold water with jittery traders.
Ironically, investors seeking protection from last week’s fallout plowed money into government bonds, like U.S. Treasuries — the same types of securities creating the dislocations across the banking sector. Admittedly, that’s not exactly a fair one-for-one comparison. But it helps highlight that banks do not have a credit problem (like in 2008) but a liquidity issue. And while regulators have installed facilities to help protect depositors and help banks manage through their balance sheet issues, investors have taken a “sell first, ask questions later” approach regarding the banks. Outside of stocks, the U.S. Dollar Index dropped 0.7% on the week, and Gold rose +5.7% to $1,981.30 per ounce. West Texas Intermediate (WTI) oil dropped 13% to $66.36, its worst week since April 2020.
“Well-worn investors, who understood a world accustomed to living on near-zero interest rates for well over a decade, couldn’t shake the idea that the quick spike in rates over the last twelve months would likely have some unintended consequences along the way.”
The direction of rate policy may hinge on inflation and financial stability in the near term
On the economic front, the headline Consumer Price Index came in largely as expected for February, with core prices coming in a tick hotter than expected. Shelter prices remained elevated while used-vehicle prices dropped. On the producer side, headline and core inflation softened last month, while consumer Michigan Sentiment one-year ahead inflation expectations fell to their lowest level since April 2021. And following January’s larger-than-expected gain, February retail sales pulled back modestly. Overseas, the European Central Bank (ECB) raised its key target rate by 50 basis points and will stop providing forward guidance. Some believe the indirect message to the market is that financial stability trumps inflation. While we would tend to agree with that overall assessment, investors shouldn’t discount central bankers’ desire and need to curb inflation. Thus, we believe the ECB actually complicated investors’ roadmap for policy. Moving forward, at least over the near term, rate policy could depend on two main factors, inflation, and financial stability. Each could send policy in opposite directions.
That leads to this week’s Federal Reserve rate decision on Wednesday. Expectations for what the Fed’s FOMC will do this week have swung widely this month, with market odds pricing in as high as a 50-basis point hike to standing pat and leaving rate policy unchanged. Currently, most see the Fed raising rates by 25 basis points this week and providing some acknowledgment that current financial conditions should be closely monitored. A new set of economic projects and Fed Chair Powell’s press conference following the policy statement will be critical areas of focus this week. In addition, investors will likely look to parse out direct and indirect messages from the Fed on how the current banking issues could influence policy moving forward. Lastly, along with the market’s close attention to banking developments this week, February existing home sales, February new home sales, and preliminary looks at March manufacturing and services activity will be background items that draw attention.
For our latest commentary and analysis of all these fast-moving developments, please refer to our daily publications, Before the Bell and Morning Research Notes. This is also an excellent time to contact your Ameriprise financial advisor. They can help you assess how recent market events may impact your financial goals and investments and ensure your portfolio remains diversified and consistent with your risk tolerance, time horizon, and asset allocation targets. https://bit.ly/42C6B8o
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