Highlights from the May 4, 2023, webinar featuring Brian Sommers, CFA, HBKS Principal and Chief Investment Officer.
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Early in the year, it seemed we would be able to avoid a recession and achieve a soft landing.
Consumer spending has been on a steady uptick since Q3 2020, especially on services like restaurants and travel, as opposed to earlier in the pandemic when people were spending on goods, like home improvements, cars, and other big ticket items.
The year started with strong economic data, even rebounding from some weakness late in 2022.
Wage growth was still improving.
Job creation and wage growth were strong despite Fed’s effort to slow the economy in order to bring down inflation.
That changed beginning on March 10 with the closing of Silicon Valley Bank (SVB) due to a run on its deposits.
Issues were unique to SVB as the bank of choice for many technology startups, which were flooded with cash and their deposit wound up in SVB.
SVB deposits grew from $60 billion to over $200 billion in just two years.
SVB invested in longer term U.S. Treasuries and mortgage backed securities, which was their mistake; should have kept them in shorter term securities.
As the same time, the Fed was increasing interest rates at a faster pace than ever historically.
Value of longer-term investments fell.
Funding for technology companies became harder to access and more expensive, so they needed to withdraw cash.
Banks had to sell bonds at a loss to cover withdrawals.
SVB accrued about $1.8 billion in losses in its loan portfolio and couldn’t cover the withdrawals.
SVB was taken over by First Citizens Bank.
Then Signature Bank failed for similar reason and was sold to Flagstar Bank.
On May 1, regulators seized the assets of First Republic Bank and sold them to JP Morgan Chase.
Consideration is being given to raising the FDIC insurance limit from $250,00 to as high as $1 million.
While bank failures might slow economic growth, there is not likely to be a run on other banks. The differences between the failed banks and most other banks;
Many banks are “too big to fail,” so the Fed would step in.
Larger banks have much higher capital controls, so are safer.
Most banks have a more diverse clientele, and the majority of their assets are covered by FDIC insurance.
Majority of banks either have a majority of clients fully covered by FDIC insurance or a smaller percentage of capital in unrealized losses.
There may be additional stress the on banking industry, but regulators are likely to step in to relieve the level of stress.
Capital requirements for small banks could be made as stringent as for the larger banks.
Lending standards will be tighter and fewer loans will be made.
What does it mean for the economy?
Banks will tighten their lending standards and will maintain greater liquidity to cover potential for withdrawals.
Tightened lending standards is resulting in less loan demand and a worsening outlook for business activity.
Consumer loans have already declined.
Banks are tightening their credit standards.
Loans are also more expensive as rates are higher.
Bankers expect non-performing loans to rise and to see waning consumer confidence. That will slow business growth even further.
But it hasn’t stopped the Fed from continuing to raise rates.
Fed Chairman Powell didn’t say at the May 3 rate hike announcement that it would be the last hike, but suggested that.
He did say the Fed won’t cut rates anytime soon.
The recent rate hikes and leading economic indicators suggest an impending recession.
The Conference Board forecasts economic weakness will continue and spread throughout the economy and lead to a recession in mid 2023.
Manufacturing activity has been on a steady decline, down 46.3 percent since an activity peak in 2021.
Service sector has been strong but has begun to fall off.
Concerns about higher interest rates and hard-to-obtain loans have affected consumer confidence.
People expect their incomes to remain relatively stable, but pay growth is weakening and job postings are sharply lower, especially in the retail sector, which indicates weakness in the jobs market going forward.
Inflation is falling as growth slows and will fall more, perhaps rapidly as economic growth slows.
Prices are declining: rents, automobiles, transportation.
For the first time in 11 years home prices are staring to fall.
The combination of higher rates and tougher lending standards are likely to push inflation lower and faster than previously expected.
In the past 70 years, CPI has fallen with this magnitude and as quickly only three times and they were at the start of recessions.
Also there has never been a time in the past when the Fed has raised rates this close to the debt ceiling deadline.
The recession is likely to be mild and short due to strength in some of the sectors in the economy.
Many consumers and businesses are still flush with cash.
When the Fed does stop raising rates, spending will resume. As we move through the end of the year, the economy should rebound.
The stock market
Expect a lower market in the near term.
When attention is turned from Fed rate hikes to other economic issues, that should lead to a sell-off.
Could provide for buying opportunities in Q4.
A recent market hike was due to perception that rates might be lowered.
Investors attention will turn to corporate profits.
Outlook is not good.
Growth has been resilient but recently on a steady downturn.
Projections and companies themselves have been lowering their earnings estimates: With over half of the S&P companies reporting for Q1 2023, earnings are down about 3.7 percent from the previous quarter.
Profit margins are falling.
Inventories are high, so companies will have to discount prices to move that inventory.
Three things that portend lower stock prices before they begin a more durable recovery:
If you take Amazon out of picture, earnings growth is even worse than headline number, down 5.1 percent. Earnings for S&P 500 companies, not including Amazon, for the full year are projected to be flat.
Since beginning of the year performance in the S&P is driven by 20 stocks. Growth in market cap for remaining stocks is flat.
Stock market valuations are above long-term averages.
High valuations, weak profit outlook with higher interest rates and lower loan volumes combine to indicate a downturn in the stock market. Likely precipitated by a recession.
Stocks typically don’t begin a sustained recovery until the recession has begun and valuations have retreated below their historical averages.
Markets not likely to bottom out until the Fed stops raising rates and until we are well into the recession.
There will be downward pressure on markets until recession is identified, then we will begin a more durable market recovery.
Companies with strong balance sheets could drive a recovery in spending, leading to stronger growth and higher prices by end of 2023 or the beginning of 2024.
A great deal of volatility until we get there.
Historically stocks rise 20 percent after Fed pauses; bonds rise 11.5 percent.
What should a long-term investor do?
Stick to your long-term plan, including your strategic allocation of stocks and bonds.
2022 was one of the worst years for a traditional 60 percent stock, 40 percent bond portfolio. Expect improved performance for that portfolio ahead.
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