The stock market has been pricing in the possibility of the Fed cutting interest rates – a Fed “pivot “, which, presumably, could drive higher stock valuations. However, the bond market is clearly pricing in a serious economic recession ahead. Signs that unemployment has hit bottom, and is now rising, have begun appearing in recent economic data, which, historically (since 1948) spells trouble for stocks, particularly in the first three months of rising unemployment. Here is the most recent chart for US job openings from the St. Louis Fed:
When businesses cut job openings, layoffs often coincide. Another leading indicator of unemployment, temporary help services, have been declining as well. Last week, we learned that private sector hiring rose by only 145,000 in March down from 261,000 in February. In the financial sector, 51,000 jobs were lost in March. Both numbers do not yet reflect further cutbacks at US banks, whose woes began in earnest at the end of March.
Tax Day and the Debt Ceiling:
April 17 is Tax Day, and shortly thereafter, the Federal government is expecting tax receipts of between 300 and 500 billion dollars. During that week, the equivalent amount will come out of the money supply, and into the coffers of the US Treasury. This will represent a tightening of financial conditions. If the tax receipts come in on the low side, it also represents a tightening of financial conditions.The day that the US government runs out of money should take place somewhere between June and late July. We hope that the US Congress is wise enough to not use the debt ceiling as a political football, otherwise a financial catastrophe will ensue. When the debt ceiling is raised, the Treasury will have to issue a large amount of Treasury bills, which will be bought by the public (as much as $1 trillion) which will come out of the money supply as well. Earnings season for corporations will also begin around April 15th. If financial conditions tighten into soft corporate earnings, weakness in stock prices may ensue.
The Banking Crisis of 2023
In the week following March 9, the Silicon Valley Bank crisis began, and in the weeks that followed, the second and third largest bank defaults in US history occurred.
Within a span of three weeks, SVB, Signature Bank, and Silvergate Capital all ceased to exist. In addition, Credit Suisse, a “top 50” bank, worldwide tottered on the edge of failure before merging with UBS.
Silicon Valley Bank was the 16th largest bank in the US, primarily serving technology companies with venture capital funding. Last year 44% of all VC backed tech and healthcare IPOs were banked by SVB. The bank had large amounts of uninsured deposits, well above the $250,000 FDIC insurance threshold.In fact, only 2.7% of the total deposits at SVB were FDIC insured, and only 6.2% at signature bank. SVB had $175 billion of deposits which were largely invested by the bank in fixed income securities that had lost a great deal of value during the US Federal Reserve’s historically aggressive rise in rates. On concerns that uninsured deposits were at risk, depositors withdrew $42 billion in one day. That figure pales in comparison to the requested $100 billion scheduled to leave the bank the next day. When the cash demands became high enough, the bank needed to sell its assets at substantial losses.Social media panic combined with online banking caused a bank run. That bank run then began impacting Signature bank, a New York institution, which faced similar issues. To make matters worse, Silvergate Capital, a leading bank in the crypto industry failed simultaneously. And lastly, First Republic Bank, in California, experienced withdrawals of $89 billion, leaving that now troubled institution with elevated risks of default and a stock price down some 92% since February.
Two days after the SVB meltdown, California state, and federal banking regulators, took over SVB’s deposits and put the bank into receivership. The Federal Reserve subsequently created the “Bank Term Funding Program” (BTFP) to backstop depositors and stem a larger panic over the banking system.
The current small banking crisis has launched a series of larger questions:
Small banks are responsible for some 67% of all domestic real estate loans and provide 37.5% of all domestic loans. Large banks, under the regulatory microscope since 2008, will also face increased scrutiny by regulators in addition to the expected greater regulation over small banks. Increased regulation means less lending. Small banks as a first step are likely to reduce their balance sheets from $7 trillion to around $5 trillion which is where they stood pre-Covid. They will also need to begin letting their fixed income portfolios mature, be more discerning over new loans, increase lending rates, and turn away new business. The banking crisis will end up being the equivalent of between 1-1.5% of further Fed rate hikes, because it is causing banks to tighten their lending standards. For this reason, financial conditions in the economy have just significantly tightened, raising recession risks.
These fractures in the US and global banking system are the consequences of an aggressive response to inflation by the Federal Reserve. The Fed’s dilemma now becomes a tug-of-war over fighting inflation (with more rate increases) or jeopardizing the banking system further as a result.
In a recent study by the National Bureau of Economic Research*, the US banking system’s market value is around $2 trillion lower than the book value of these assets suggest. A full 10% of all US banks have larger unrecognized losses than those at SVB. The study finds that if half of uninsured depositors were to withdraw their deposits, 190 banks are at a potential risk of “impairment” (a polite way of saying “failure”.) The study concludes that recent events have “very significantly increased the fragility of the US banking system to uninsured depositor runs.”
The backstop put in place by the Fed (the BTFP”), as well as by the FDIC to protect uninsured depositors at SVP and Signature bank, arouse fairness and moral hazard questions, concerning which banks and which depositors receive assistance, and which don’t. If the problem gets worse, it is unlikely that there is enough capacity or congressional support for all stressed small banks to receive assistance.
As a result of the banking crisis, some bank deposits and money market fund deposits may leave the money supply altogether; accordingly, overall money supply should decline further in the month of March. Money supply impacts stock valuations with a lag.
Oil and Inflation:
On April 3, OPEC and its allies, including Russia, made a surprise announcement to cut oil production by 3.66 million barrels per day, or 3.7% of global demand. This caused an immediate 8% spike in the price of crude and Brent.
The decline in oil prices in the second half of 2022 led to false impressions that energy inflation was subsiding. However, with these recent production cuts, oil could be on its way to as high as $100 per barrel, according to some analysts.
Every $10 per barrel increase in the price of oil roughly increases inflation by 0.2% and sets back economic growth by 0.1%
Credit Crunch on Horizon?
The National Federation of Independent Business (NFIB) puts out monthly trends on business optimism, and published a decline in optimism of 0.8% in March, the 15th consecutive month below its long-term average. Importantly, 9% of small business owners reported that their last loan was harder to get than previously. Consumer perceptions of credit availability also plummeted in March. 58.2% of Americans report that credit is harder to come by than a year ago. Below is a chart from the Federal Reserve Bank of Dallas on total bank loan volumes. Note that this is before the recent banking crisis even began:
Bond Market is Predicting an Economic Downturn:
The following two charts represent the spread between the 3 month Treasury yield and the 2 year Treasury yield and the 3 month-10 year Treasury yield respectively. Normally, a long-term bond should grant a higher rate of return than a shorter one. In both cases below, the spread is the opposite, i.e., negative. In fact, their relationships have never been more negative in the past 50 years. They are telling us that the Fed is going to decrease interest rates in the future, after one more rate hike. When these two spreads go negative, invariably it means that the unemployment rate is about to rise into a recessionary phase of the economy. Rising unemployment is a headwind for stocks, especially within the first three months of a rise in unemployment.
Shrinking Money Supply:
“M2” refers to what is commonly known as the “money supply”. As mentioned earlier, “M2” impacts both the stock market and corporate earnings. Some believe that the rise in money supply has been driving stocks since 2008, because printed money has increased the amount of money finding its way into risk assets.As can be seen in the chart below, money supply is now on the decline, from the Fed’s efforts to cool inflation:
It is more interesting to look at a historical chart (since 1868) of the annual growth rate of M2 expressed year-on year, we get the following:
As can be observed from the chart, when year over year growth goes negative, bad things can happen.
Inflation:
This week, the consumer price index for March (headline inflation) was released at 5%, down 0.1% from the prior month. However, “Core” CPI, which excludes volatile food and energy prices, ticked up to 5.6%, 0.1% higher than in February. The latter supports the idea that the Fed will raise interest rates again in May by 25 basis points, and that inflation remains “sticky” and persistent. Most Wall Street analysts foresee this as the last interest rate hike before the Fed “pivots” lower.Historically, pivots in the Fed Funds rate, or the short term interest rate set by the Fed, is bearish for stocks:
Market Breadth:
Very few stocks have driven indices higher this year. Today’s narrow market leadership can be best observed in the chart below. Only 25% of S&P 500 members are outperforming the index:
This usually marks a period of weakness in the stock market ahead, particularly as the economy is entering a recession and S&P 500 P/E ratios remain elevated at 22.15.
The Dow was flat in the first quarter of 2023, and the S&P 500 was up 7%.
Grant Rogers
*Monetary Tightening and U.S. Bank Fragility In 2023: Mark-To-Market Losses And Uninsured Depositor Runs?: Jiang, Matvos, Piskorski, Seru. Working Paper 31048 National Bureau of Economic Research, March 2023
