Bank panics and the footrace between lower inflation and EPS
Bank panics are nothing new. Not that the current episode qualifies at this point. In our view, it's more of a “scare” since only four banks have failed so far. Two of them crypto related, and the other two being Silicon Valley Bank and Credit Suisse, both victims of very poor risk management practices. As for the second part of our title, we are referring to the conflicting impacts of higher stock valuation multiples when inflation comes down and declining earnings trends when economic momentum slows. Both are happening right now. In fact, the Institute for Supply Management’s gauge of manufacturing activity decreased to 46.3 in March, missing consensus expectations from economists. Still, we believe the tailwind from lower inflation will trump the headwind from lower earnings per share (“EPS”) trends resulting in a positive year for equities.
Stress in the Financials sector sector should never be taken lightly. However, before panicking, it is important to look at fixed income indicators that have proven their worth in the past. At this point, there does not seem to be significant fear in the fixed income market. Forward Rate Agreement/Overnight Index Swap (“FRA-OIS”) spreads (which basically shows the difference between a rate that builds in the credit risk of major banks vs. the risk-free rate) along with credit default swap spreads (think of those as an insurance contract that pays off if the issuer defaults), and bond spreads have come down significantly. A move lower indicates that the perception of risk has come down. Also encouraging is that the U.S. Federal Reserve's (the “Fed”) data shows a marginal decline, as of March 29, in demand for the liquidity facilities available to banks. As noted by BMO’s U.S. Financials Analyst, James Fotheringham, this implies that deposit outflows may have slowed enough to dampen bank funding needs relative to prior weeks.
This can certainly change quickly depending on any future bank problems, but it helps explain the relative resilience of equities, along with the fact that the 10-year yield has moved down substantially, which boosts the fair value for stocks. It is also worth noting that real estate markets – despite some price weakness – are proving resilient, bank capital ratios are generally very strong, and regulators are far more proactive than they were in the past (i.e., Swiss authorities adding US$24 billion of additional capital and up to +US$100 billion of additional liquidity for UBS, and the Federal Deposit Insurance Corporation (“FDIC”) guaranteeing uninsured deposits at Silicon Valley Bank and Signature Bank). As always happens in situations like these, the strong will get stronger and gain market share in deposits, wealth management and banking business. Clear medium-term winners include J.P. Morgan, Bank of America, UBS, and some Canadian Banks.
On the negative side, bank lending will get tighter as risk management departments will be more empowered to turn down marginal business which means that the odds of a mild recession have increased.
Some pundits have pointed to the Bank Panic of 1907, as a good parallel with the current situation. Interestingly, in that case it was the assertive intervention of J.P. Morgan (the legendary banker) and other wealthy bankers which restored confidence in the system. That incident led to the creation of the Federal Reserve System, and later, the Baimportant in this particular episode is the inflation dynamic. Equities have historically performed very well in periods where inflation is high but falling back toward 2%, and that is the case today with clear evidence that price pressure is cooling. Going back to 1960, the S&P 500 Index averaged annualized total returns of 14% in that environment (versus 7.5% for all years), while the S&P/TSX Composite Index averaged total returns of just over 9% (versus 6.5% for all years). Both markets also outperformed 10-year Treasuries and cash. This makes intuitive sense since the value of future corporate cash flows is worth more in today’s dollars when inflation and interest rates are low. Again, the timing with respect to a possible recession matters in this context too, but from a big picture perspective, the inflation backdrop now looks bullish if trends hold.nk Panic of 1933, led to the creation of the FDIC to guarantee deposits. In both instances, the market rallied aggressively once the risk was ring-fenced and uncertainty abated.
Inflation still the key variable for financial markets
Maybe more important in this particular episode is the inflation dynamic. Equities have historically performed very well in periods where inflation is high but falling back toward 2%, and that is the case today with clear evidence that price pressure is cooling. Going back to 1960, the S&P 500 Index averaged annualized total returns of 14% in that environment (versus 7.5% for all years), while the S&P/TSX Composite Index averaged total returns of just over 9% (versus 6.5% for all years). Both markets also outperformed 10-year Treasuries and cash. This makes intuitive sense since the value of future corporate cash flows is worth more in today’s dollars when inflation and interest rates are low. Again, the timing with respect to a possible recession matters in this context too, but from a big picture perspective, the inflation backdrop now looks bullish if trends hold.
There is uncertainty in the markets regarding the state of the U.S. banking system, but there are three important things for investors to focus on. First, the gauges in our bond sentiment model, which remain very far away from the extreme readings that developed during the credit crisis and early on in the pandemic, are nowhere near the levels that defined the actual systemic risk of those events.
Second, despite the recent volatility and lack of upside progress, our short-term timing model remains fully bullish after giving new buy signals in late March. It’s also the first time we have seen simultaneous buy signals in all of the breadth and momentum gauges in that model since last October. In fact, the last two times we saw them all turn bullish at the same time were at the major trading lows in June and October of 2022. Despite the lack of upside progress in recent trading, the recent low likely represented a significant turning point in equity markets.
And finally, despite the talk of a recession in 2023, most market-based measures of economic activity continue to improve. Some examples include the S&P 500 Steel Sub-Industry which recently made a new all-time high, the PHLX Semiconductor Index recently making a 52-week high, homebuilding stocks recently making new 52-week highs, and copper remains in a long-term uptrend after breaking out of a base pattern late last year.
The bottom line is that for all the uncertainty and doubt in the markets right now, the improvement in our short-term timing model suggests equity markets made a significant trading low in late March. In terms of upside potential, the minimum expectation is for a challenge of the February price peaks. That’s 20,843 for the S&P/TSX Composite Index and 4,195 for the S&P 500 Index. Breakouts there would clear the way for the S&P/TSX Composite Index to rally back to its all-time high of 22,213, and for the S&P 500 Index to challenge its August 2022 peak of 4,325.
Interest rates: Flow of funds
News of bank failures brought back some memories of past crises, but while concerning, it is difficult to find comparisons. Unlike more recent events, overall markets have remained relatively calm with traditional stress/risk indicators behaving well and most not even flashing yellow. Generally, the impact on investment-grade credit spreads is small with limited signs of a flight to quality. Even in the high-yield sector, known to exhibit the first signs of market turmoil, credit spread trading has been well contained within long-term averages.
Bank debt has been under some pressure, including Canada. But, while spreads widened the yields have not moved much thanks to the significant decline in government bond yields.
Like any other periods of market turmoil, investors tend to pile into lower-risk government bonds, pushing interest rates lower. The weeks following the Silicon Valley Bank announcement were no different than previous periods, including a drop in U.S. 2-year yields of more than 100 basis points in a week.
Not surprisingly, the significant decline led to the repricing of potential rate cuts by the Fed and even by the Bank of Canada (“BoC”) before the end of 2023. Similar pricing earlier this year felt premature, but today the increasing stress and tightening financial conditions could force the Fed to reconsider its more hawkish policy stance.
Then again, lower bond yields could be telling a different story this time as indicated by the flow of funds. In previous crises, the flows into money market funds and short-term government securities would be coming out of risky assets. Instead, flows are from depositors looking to move funds off bank balance sheets. Despite the decision by the FDIC to guarantee all deposits at the failed regional banks and the market’s unconfirmed perception that it could extend similar guarantees to others, clients continue to withdraw deposits from the U.S. banking system. With close to US$10 trillion in uninsured deposits, recent trends indicate a renewed sense of investors’ need for diversification. Interestingly, it also indicates that depositors are waking up to a different interest rate environment. After years of low-yielding bank accounts, depositors are noticing the attractive spread differentials that can be earned, with many limited to low-risk investment alternatives yielding in excess of 4%.
For the time being, U.S. and European regulators appear to have restored confidence in the banking system, but deposit withdrawals are a sign of just how fragile the situation remains. Bank lending will likely get tighter due to more rigid risk management and may impact earnings. However, we cannot ignore the fact that losing deposits will force banks to pay up to compete for funding, further impacting margin. More importantly, the loan industry could lose a significant source of funding, a potential net negative for the economy. Considering that regional banks fund up to 80% of commercial real estate, 50% of personal loans, and 40% of commercial industrial loans, reduction in the deposit pool may lead to a pullback and will undoubtedly impact access to credit.
For the Fed, who raised rates again in March by 25 basis points in the midst of turmoil, it continues to see the world in a pre-March 8 failure lens, with a focus on persistent inflation and a strong labour market. If the data remains strong, another rate hike is possible in April. However, tighter lending conditions and signs of slower economic growth should open the door for the Fed to follow the BoC and lean toward a pause. As for the odds of a potential cut this year as implied by the market, they remain low in our opinion, but certainly not impossible. The bar seems to be set relatively high for a 180-degree turn by the Fed, but we think support is gradually growing for lower rates which indicates the end of this tightening cycle is near.
Please contact your BMO Nesbitt Burns Investment Advisor if you have any questions or would like to discuss your investments.
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