THE market continues to grapple with the implications of stress in the US banking system.
There are two questions.
One is the extent to which this is a genuine crisis versus a more manageable, short-term shock.
The other is the degree to which credit growth will slow as an exodus of deposits constrains the ability of banks to lend.
At this point the market is swinging to the more benign view that credit tightening will shave somewhere in the vicinity of 0.5% off GDP growth.
This implies a lower peak in rates than expected before the Silicon Valley Bank collapse. But it also means the pace of subsequent cuts may not be as sharp as some have been looking for recently.
The market is pricing in an 80 per cent probability of one last hike in May — and then for rates to fall around 60bp through to year end.
The S&P 500 has rallied about 7% since its March 13 low after the Silicon Valley Bank collapse.
It has been trading in a range of 3600 to 4300 for almost a year.
The recent rally in the face of a financial shock has been driven by the prospect of US rates peaking, inflation softening and the economy remaining resilient, all combined with bearish positioning.
The market valuation discount rate effect from the prospect for lower rates has outweighed the negative impact from the financial sector.
This was bolstered last week by receding fears of a bank-induced credit shock, retail sales holding up better than expected, bank deposit outflows settling down and a better-than-expected start to US bank results.
The S&P 500 returned +0.82% for the week and US ten-year Treasury yields rose 21bps to 3.52%. The S&P/ASX 300 gained 2%.
There are two schools of thought for the economy and markets:
The first scenario keeps the market at current levels with perhaps some upside to valuation rating.
The latter sees the market returning towards lows.
In the near-term, markets could remain benign as we enjoy a phase where inflation continues to ease while the economy holds up.
We also have the benefit of a reasonable liquidity environment. In this environment volatility stays muted and market focuses more on stock specifics.
Our view is that the risk increases as we approach the debt ceiling negotiations in July and August, which could coincide with emerging signs of the economy weakening more meaningfully.
Given this, we continue to balance the portfolio in terms of skew between cyclicals and defensives and focus on stocks with less exogenous risk and greater control over their outcomes.
It’s worth reflecting on the contrasting views on some key questions facing markets:
1) How will the banking crisis affect growth?
Annual deposit growth in the US has very rarely been negative — as it is now. The scale of the decline is by far the largest on record.
Declining deposits constrict a bank’s ability to lend. The market is concerned about how large this impact will be.
This remains to be seen. But there are reasons why this financial shock may not be as bad as people fear.
The minutes from the last Federal Open Market Committee meeting released last week suggest the Fed staff were more fearful of a significant credit shock than the FOMC members.
Interestingly, more recent submissions indicate initial fear is dissipating, emphasising the dynamic nature of this issue. Friday’s US bank results were also supportive for sentiment around banking.
JPM and Citi both beat earnings expectations materially, driven by better-than-expected margins.
JPM’s CEO Jamie Dimon chose to be more constructive on the banking shock, noting it involved far fewer players and required fewer issues to be resolved.
This week we will see the Senior Loan Officers Opinion Survey (SLOOS) on credit conditions, which will be an important signal for the Fed.
2) How fast is inflation falling?
There are clearly more signs that the lead indicators of inflation are easing.
US import prices excluding food and fuel dropped 0.5% month-on-month in March and are running at -1.6% annualised, versus a peak of about 7% in 2022.
The Producer Price Index (PPI) readings are also slowing. The US Core PPI is running at 3.4% annualised in March, down from above 9% in 2022.
Historically, PPI measures have been a decent lead on broader inflation.
This is a constructive trend. But on the other hand, Fed officials continue to highlight the issue of tight labour markets and persistent inflation.
FOMC members Christopher Waller and Raphael Bostic emphasised this on Friday.
Waller noted core inflation had only moved sideways since the end of 2021 and said there was much work to be done.
This was reinforced by the latest Atlanta Fed wage tracker data, which did not support the recent average hourly earnings drop in wage growth.
3) The risk of recession
A high proportion of US economists are now expecting a recession, according to surveys.
It should be noted that the Fed themselves are now forecasting a mild recession.
The signals supporting this view are more ambiguous. Consumer spending is slowing but not more than anticipated by the market.
“Real-time” indicators of credit and debit card spending from Bank of America show spending is now flat year-on-year. The mix breakdown shows retail spend is deteriorating, while services growth may have peaked.
Last week’s revisions to jobless claims data revealed a more material rise in claims, which is more consistent with signals on job losses.
History suggests that once claims pick up they can break materially higher very sharply.
The counter to this is that real-time indicators of layoffs remain at normal levels, including notices to employees.
We are also seeing labour supply beginning to return, which should enable wages to slow without a significant rise in unemployment.
Sentiment improved last week, which was reflected in mining stocks performing well.
This was driven by lower inflation numbers and strong credit data.
This suggests the economy is seeing early signs of picking up post-winter, with improvements in the housing market and consumer spending.
Inflation is being held in check by production growth also ramping up along with consumer demand.
As concerns over the banking shock mellow, the implied Fed funds rate has crept higher.
However, it still suggests 60bps in cuts by the end of the year, which indicates caution over the economic outlook.
This is also reflected in consensus expectations for earnings as we go into US first-quarter 2023 reporting season. The market is expecting 7% annual decline in earnings in Q1 and 6% declines in Q2.
This is conservative and may have the potential to surprise on the upside.
The bigger issue is the expected recovery. The market has 9% annualised earnings growth in Q4 and 14% in Q1 2024. This seems inconsistent with the economic outlook.
Bears suggest that when earnings start to roll over, they can then plunge suddenly as companies throw in the towel and start to cut costs.
But it’s important to note that while this may have been the case in 2008 and 2020, you can also get extended periods of stagnant earnings, such as in 2014-15.
The S&P/ASX 300 has lagged the US in 2023, reflecting less skew to tech and the issues with banks.
Last week we saw some catch-up, mainly driven by resources after positive signals on China and less fear around US growth.
Banks lagged the market but did begin to see some price stability return.
Heading into bank reporting season, the key issue will be competition in mortgages where back-book re-pricing may be accelerating and the cost of deposits increasing.
Crispin Murray is Pendal’s Head of Equities. He has more than 27 years of investment experience and leads one of the largest equities teams in Australia. Crispin’s Pendal Focus Australian Share Fund has beaten the benchmark in 12 years of its 16-year history (after fees), across a range of market conditions.
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