The Next Phase

The Next Phase

Against the background of a complicated economic landscape, a banking crisis emerged with the failure of Silicon Valley Bank (SVB) and Signature Bank and intense pressure on a number of regional banks.  The blame rests with the management of the banks, the dysfunctional regulatory process, and the Fed itself, as it raised rates too fast and too much.  The lagged effect of monetary policy has placed other regional banks in precarious positions and has exposed the failure of the regulatory process.  Fortunately, the tacit guarantee that the Treasury Department offered to depositors above $250,000, the Fed’s emergency lending facility, and the help of 30 banks to some regional banks to prevent massive deposit outflows, prevented a major crisis. Many issues remain and the banking landscape will never be the same.  In the rate environment that exists, with high short-term rates, the business model of many regional banks just doesn’t work, and they remain on an unprofitable path.

Be prepared!  Major banking reform is likely to emerge over the next two years.  As a consequence, higher capital requirements, increased regulation, higher FDIC fees, and lower loan growth are the likely outcomes. Reforms are also a prospect for the non-banking financial sector.

The changing regulatory banking environment is likely to bring with it declining profit margins, declining profitability, and an end to stock buybacks.  From an investment perspective, the industry faces heavy headwinds over the next two years and constraints on growth.  For some time, we have maintained an underweighting in the financial sector and given the current changing landscape, plan to maintain that posture.  Over the coming months, volatility is likely to capture this sector and individual opportunities (M&A) should emerge.  However, the burdens are likely to remain for some time.

One important byproduct of the banking crisis should be the changing attitudes at the Fed, and ultimately, monetary policy.  Financial stability appears to be moving up the priority scale at the Fed and the Monetary Authorities’ own failures suggest a pause in raising the federal funds rate may be in order at the May FOMC meeting.  Moreover, the economic data that has emerged supports a pause.  The Core PCE price deflator, the Fed’s favorite price variable indicator, continues to record a declining trend.  Year-over-year, it showed a 4.3% rate of increase in February, lower than the prior month, and 0.3% month over month, an annualized rate of less than 4%.  This trend is occurring at the same time that money supply continues to contract, a precursor of lower inflation and weakening economic growth.  The consumer’s credit burden has increased, and the consumer now faces an availability question.  At the same time, personal income and spending have not kept up with inflation (i.e. they are declining in real terms).  This decline suggests an anemic level of consumer spending in Q2.  Such a backdrop gives the Fed the flexibility to pause on rates, particularly since the pullback in credit availability is equivalent to an increase in rates and further tightening (no one knows how much).

One disconcerting factor is the constant reference by some Federal Reserve board members and bank presidents to the 1970s.  Given the intellectual capital at the Fed, they should easily recognize the massive differences in the economies of the 1970s and today.  In fact, the data has not kept up with the changes and could explain in part the difficulties in understanding underlying factors.

As we have discussed in prior commentaries, a cornerstone of financial market valuation is interest rates, particularly the 10-year Treasury rate.  In the changing monetary and credit environment, the 10-year Treasury has receded to the 3.5% area, following a move to near 4.5%.  Despite the upward pressure on short-term rates, Fed funds near 5%, the 10-year rate still managed to move to the 3.5% area.

As we indicated in earlier reports, that level is constructive for the equity market, particularly the growth sectors.  The performance of the equity market in Q1 appears supportive of this view and highlights the resiliency of equities.  Wide disparity in sector performance took place, but it was generally a good quarter for stocks.

The domestic crisis has overshadowed the geopolitical pressures that have been building, such as the growing Xi/Putin alliance and the enduring Ukrainian conflict.  What is becoming more apparent is the growing deficiency of the military complex to meet the accelerated demands for “guns and materials” that have been depleted.  The aerospace and defense sector should come into even greater focus in coming months and is experiencing heavy tailwinds.  In our judgment, the long-term secular growth in this sector warrants expanded participation (refer to previous Insight Report on space and defense).

The second quarter will have its share of surprises and contribute to market volatility.  Sluggish growth, a pressured consumer, a rolling recession (housing, semiconductors, durables, and now autos and commercial construction) will pepper the landscape.  However, a stable rate structure is likely and financial stability should take center stage, thus providing an upward bias to the equity market.

The recession scenario appears to have been discounted many times and negative investor sentiment (a contrary indicator) suggests that the market is looking beyond the near term and attempting to assess the fallout, the nature of the recovery, and the corporate managements that have successfully navigated the downturn.  The Q1 earnings reports and future guidance should confirm the emerging trends.