That the Fed took the decision to enact a further 25 basis point rate hike, after the banking turmoil triggered by SVB, is instructive as to how far inflation remains over what would be considered a ‘comfortable level’ of approximately 2 per cent.
The Fed’s preferred ‘super core rate’ (PCE services less energy and housing) remains stubbornly high at +4 per cent.
To intensify chairman Jerome Powell’s heartburn, falling borrowing costs combined with sharply rising interest income [on the back of a massive ‘excess savings’ pool, threaten a mini reacceleration of the economy that is set to feed through to the inflation data over the coming months.
Cumulative excess savings have not yet been depleted, which also lends credence to the prevailing market narrative prior to the SVB news, that forward earnings from corporate America would not be as adversely affected as earlier feared.
That is certainly the outcome suggested by the outsized performance of technology and e-commerce stocks during the first quarter.
Arguably, that message has been reinforced by credit markets, where spreads have been remarkably well-behaved overall.
However, an altogether different signal has emerged from other asset markets including gold and bonds, where the SVB debacle provoked price reactions that; a) indicate the Fed is closer to the end than the beginning of its tightening cycle (or should be) and; b) that a recession in 2023 is all but guaranteed.
Chief among the harbingers of doom is the relationship between the Fed Funds Rate (FFR) and the two-year Treasury yield curve (2Y) which inverted by 100+ basis points - the deepest inversion ever during a Fed hiking cycle.
It is an unusual occurrence and reflects bond investors’ expectations for a decline in longer-term interest rates, typically due to a recession.
FFR-2Y inversions are typically associated with systemic events and/or recessions and can provide important signals regarding future Fed policy.
The list of dates where an inversion of this magnitude has occurred historically does not make for great reading. Perhaps most importantly, these inversions typically occur before major market tumbles.
Underlying tension in markets year to date has been the result of two opposing forces: inflation data and earnings/economic forces. This has yet to be fully resolved, creating rangebound market conditions.
Difficulty in reading the tea leaves is reflected by the stasis that has gripped forecasters on Wall Street who have failed to reassess their predictions for where markets may finish this year.
Whether the US economy enters recession territory in 2023 is likely to determine the future path of asset prices.
Two of the signals are look at are:
1) Developments in the Commercial and Industrial (C&I) loans market, credit facilities for small businesses and around $3trn business for banks in the US.
Between 2000 and 2019, these businesses were responsible for approximately 65 per cent of new employment in the US.
When banks begin refusing loans or diverting capital away from C&I loans, stresses begin to appear in the economy and lags between tightening lending and real economic outcomes are short.
This has started to happen, with data from Bank of America showing loan growth for US small caps is not firmly in recessionary territory.
2) The trajectory of corporate earnings. Looking back over history, three-six months after a major bear market low, aggregate earnings for the S&P500 large cap index have tended to stabilise, before accelerating.
If October 2022 was ‘the low’ for the cycle, we can expect earnings announcements in the coming four-six weeks. Events during March are likely to weigh on estimates and indeed financial sector estimates are, unsurprisingly, being marked down sharply.
Earnings are now contracting across small cap stocks, midcaps, and the S&P 500 on an aggregate basis.
For the S&P, consensus estimates are for a -8 per cent contraction in the growth rate in the first quarter for earnings, followed by a -6 per cent contraction in the second quarter.
The calendar year 2023 estimate is at -2 per cent and coming down. Our sense is that there is downside risk to this number.
Should the earnings contraction turn out to be modest, this may be well received by the market, assuming the Fed pivots by creating a more favourable liquidity backdrop as a result.
In closing, our data driven investment framework indicates that we should continue to tread carefully. At this juncture, the risk to reward for risk assets is not overly compelling, a position reflected in our asset allocation across our core range of strategies.
Geopolitical risks still loom large, and the lagged effects of the monetary tightening cycle and the global housing bust will start to bite hard.
We have a hard time believing the recent SVB episode to be a ‘storm in a teacup’.
In addition, the US debt ceiling limit has been breached and will need to be negotiated in the coming months. This is an underappreciated risk, and adds to the prevailing sense of uncertainty.
Our flexible investment framework at TEAM, underpinned by a diverse asset allocation universe and the ability to tactically allocate with conviction will remain critical, as risks and opportunities present themselves in the months ahead.