A Pause to Refresh?
By Crest Capital Advisors on May 5, 2023
Dow: (1.24%) to 33,674.38
S&P 500: (0.80%) to 4,136.25
Nasdaq: 0.07% to 12,235.41
Russell 2000: (0.51%) to 1,759.88
10-Year Yield: 3.43%
Outperformers: Technology 0.60%, Healthcare 0.09%
Underperformers: Energy (5.81%), Financials (2.65%), Communication Services (2.29%)
US stocks were mostly lower this week as the S&P gave back last week’s gains. However, the absolute change of the S&P index was less than 1% for a fifth-straight week, while the tech-heavy Nasdaq edged out a slight gain on the back of a powerful rally on Friday.
Stocks finished off the week’s lows with some push and pull from a number of factors. The bullish narrative continues to center around the perceived achievement of the elusive Fed pause, better than expected earnings results, consumer resiliency, and labor markets still posting job gains despite the rate hike cycle. However, growth fears remain a key overhang, reflected in the latest bout of bank stress and weak energy/commodity performance. Bond market signaling continues to reflect recession risk with long rates heavily inverted vs. short.
As alluded to with our title this week, the May FOMC meeting ended with a 25 bp rate hike to 5.0-5.25% with one significant change…the policy statement eliminated the forward guidance language implying additional rate hikes…instead focusing on data dependence. Of course in typical Fed fashion, they can’t seem to bring themselves to speak plainly enough to markets to finally say the word “Pause”. Instead, they leave it open to interpretation. Fortunately, market participants broadly have decided the interpretation is indeed that we have finally reached the end of the rate hikes.
Regional banks were again the big corporate story after First Republic was handed over to JP Morgan on Monday morning. Unfortunately, this seemed to set off another series of bear raids in the shares of various regional banks, despite assurances from officials that the system is sound and resilient (more on this below).
On a positive note, according to Bank of America, as of Friday morning, 402 S&P 500 names have now printed earnings results for Q1. 71% of them beat on earnings, 78% beat on sales, and 58% beat on BOTH metrics! The S&P 500 is now tracking a +4.1% earnings per share beat versus consensus expectations. Much better than feared!
“Sound and Resilient”?
So much for wilting in a banking crisis. The Federal Reserve hiked short rates again this week by another 0.25% on Wednesday. Policymakers did (finally) suggest however they may be almost done turning the screw, after 500bp of rate hikes in 14 months helped cause three of the four largest US bank failures ever—with another at PacWest Bancorp seemingly in the works. As investors flee US regional banks en masse, it is clear that the sector’s prospects will probably worsen before they improve. The fear is the same may be true for the broader US economy.
And yet, Jerome Powell had the nerve to tell us that the banking system is “sound and resilient” during his press conference this week. Literally the same day, within hours even, PacWest Bancorp became the latest bank forced to explore “strategic options” (this has been a code phrase for FDIC seizure and asset sale in recent months) and saw its stock price plummet to all-time lows.
We have a suggested re-wording of Powell’s commentary. How about unsafe and teetering? Literally the opposites of sound and resilient!
But let’s unpack why these banks are encountering such difficulty. The myriad of factors are many, but It starts with the Fed’s relentless rate hiking cycle that has driven the yield curve inversion to historical extremes. Sure, there has been some mis-management (SVB for example) and poor communication plans (SVB and First Republic). These factors certainly accelerated the deposit flight. But the root source of the problems is the inability of many of these banks to adjust to the extreme changes in short-term interest rates, going from literally 0% to 5% in a span of 14-months. This is a rate of acceleration from a low base that has NEVER been tried before.
Powell’s dismissal of the problems faced by smaller banks in particular reeks of a tone-deafness that is really unbecoming of one of the most powerful financial figures in the country. These small banks need relief, or they will struggle to exist, and instead we’ll have a landscape with just a few systemically important banks (SIBs) remaining.
Powell also said that the Fed can tighten borrowing costs in its effort to bring down inflation while also providing support to troubled banks. But the very act of raising rates is only exacerbating the crisis, driving even more bank deposit capital into money market funds and T-bills. Depositors everywhere have awakened to the high yields available in these instruments and they are draining the banking system of much needed liquidity.
Specifically, here is a chart of money market holdings which hit a record of $5.31 Trillion in the week ending May 3rd. Do you think another 25 basis hike (adding to the yield available to money market funds) will attract more or less capital to this category? Not only was this a record, but the data-series is up $47 billion in one week, and $100 billion in two weeks…the bank run is ongoing.
And while this is happening, the bond market is screaming the Fed is offside. Take a look at the chart below showing the 2-year Treasury (one of the main barometers in the bond market) yield having plunged well below the Fed Funds rate. The 2-year treasury is implying sharply lower rates will be necessary to resurrect growth.
And the following chart puts the 2-year to Fed Funds inversion in historical context. We are now at levels not seen since the Financial Crisis!
Three Pinocchio’s
The March FOMC statement and Chair Jerome Powell’s amplifications in the post-meeting press conference made it clear that the present rate hiking cycle is over. But this morning’s Employment Situation report has the potential to put pressure on that as the report was abundant with the signs Powell typically cites to argue the labor market is excessively tight. There were 253,000 net payroll gains – a big beat versus the consensus for 185,000. The unemployment rate fell to 3.4% – we haven’t seen lower since October 1953! And there was a 0.48% month-over-month jump in average hourly earnings – the biggest in 25 months. That last part, especially, is going to challenge Powell to live up to what amounts to a whopping lie he told in the presser:
“I do not think that wages are the principal driver of inflation. …you know, I’ve never said that, you know, that it — that wages are really the principal driver because I don’t think that’s really right.”
-Jerome Powell
Where would we even begin on this “Pinnochio”?
Well, we can challenge Powell by looking at just about any public statement he’s made in the last two years. For instance, how about this, from his November speech specifically on this subject, called “Inflation and the Labor Market”:
“…core services other than housing… the largest of our three categories, constituting more than half of the core PCE index. Thus, this may be the most important category for understanding the future evolution of core inflation. Because wages make up the largest cost in delivering these services, the labor market holds the key to understanding inflation in this category.”
-Jerome Powell
And there is also this one…
“In the labor market, demand for workers far exceeds the supply of available workers, and nominal wages have been growing at a pace well above what would be consistent with 2 percent inflation over time. Thus, another condition we are looking for is the restoration of balance between supply and demand in the labor market.”
-Jerome Powell
The irony is that Powell’s lie gets at the truth. Wage growth and other indications of labor market tightness have nothing to do with inflation. This is borne out by the fact that while the unemployment rate announced this morning is the lowest in almost 70 years, the subset of consumer prices Powell focuses on as “most important” topped out a year-and-a-half ago and has been steadily drifting lower. In Wednesday’s presser, Powell was clear that falling inflation is the necessary predicate to rate cuts – and we have deep conviction he’s going to get that, no matter what the unemployment rate or wage growth does.
So, in short, while some pundits see it differently, we don’t interpret this morning’s jobs report as disrupting the market’s embedded expectations for the end of this hiking cycle, and the onset of cuts in the second half of this year. And we would suggest the markets ability to rally substantially on Friday, after digetsting this payrolls report, is further indication the majority of market participants believe we have reached a pause as well.
Also, consider net of revisions, employment in April is only 104k higher than the previously-estimated base. The trend is slowing quite relentlessly (black line) and we suggest the Fed should not be overly focused on backward looking data.
No Good Options
With the resurgence of the regional banking crisis this past week, investors are left to ponder “what’s it going to take to calm the markets once and for all and maintain broader banking sector stability?!”
Well, presented below are seven potential options policy makers could take to address the deepening banking crisis. Topping the list for a possible Congressional response would be guaranteeing bank deposits of all sizes. And yet, even that doesn’t do anything to address the huge disparity available to investors in money market funds and T-bills, versus leaving funds in low returning bank deposits.
And further compounding matters, the prospect of getting Congress to agree on any form of legislation right now is quite bleak. Regional banks are therefore at the mercy of half measures and platitudes until the real issue of the inverted yield curve is finally addressed. As a result, we would continue to avoid regional banking exposure.
- Guarantee bank deposits. A huge lift to get Congress to agree on anything…let alone this. Not likely to happen.
- Ban short selling of bank stocks. A half-measure that has been tried before, with limited success. In 2008 this was implemented but did not stave off bank failures.
- Cut the fed funds rate. LOL We wish! The Fed is wholly unwilling to do this.
- Back off the anti-merger campaign. An easy fix. We are scratching our heads at why regulators want to make it so difficult.
- Pass another TARP. Not going to happen.
- Offer banks below-market loans. This is possible, but cries of government bailout likely preclude this from happening.
- Lower the rate on reverse repos. Same as #6.
On the bright side, the broader market is behaving as though the regional bank problems are not their problems. At least not yet. We’ll certainly be monitoring lending conditions (as will the Fed) for any spillover effects. But for now, perhaps we should echo former Fed Chair Bernanke…”the regional banking problems are contained.”
Skynet is Coming
Whether or not artificial intelligence will indeed be the next-big-thing (as the tech community has been vocal about), the rapid adoption and user growth we’ve seen thus far is unprecedented. It took ChatGPT just 2 months to reach 100 million users! For context, it took Facebook and WhatsApp 42 and 49 months respectively to each reach this level. Many are comparing AI to the revolutionary impact of the internet. Others are raising fears of what it could portend not only for employment, but humanity in general.
Economic Funnies
JP Morgan bankers to potential borrowers in the not too distant future…
Crazy Stat(s) of the Week
Here is this week(s) crazy stat!
If Apple’s earnings on Thursday had come in just a tad bit higher, at $1.72/share v. the $1.52/share reported, it would have put overall S&P 500 earnings for this quarter back into positive territory…for the entire index!
Apple and Alphabet expanded their buyback authorizations by a combined $160 billion in Q1, a sum larger than the market caps of all but the top 35 stocks in the S&P 500!
Quote of the Week
“Money-market funds have attracted $588 billion in new funds in the past 10 weeks, compared with $500 billion after Lehman’s collapse. Fed hiking cycles always break something. This time the US regional banking system.”
-Michael Hartnett, BofA Chief Strategist
Calendar of Events to Watch for the Week of May 5th
Earnings season will shift heavily to the mid and small-cap segments as the bulk of S&P 500 reports are largely in the rear-view mirror. Will the collective resilience of US large caps hold true for these names as well? We’ll have to wait to weigh the preponderance of evidence once we have more reports in the books. On the monetary policy front, we expect a full slate of Fed Governor’s to be out on the speaking and media circuit to try to thread the needle between fighting inflation and saving the regional banking system. Good luck with that as markets are already calling their bluff! And finally, on the economic front, the CPI and PPI reports will dominate the headlines on Wednesday and Thursday. It will be critical to see continued cooling in these datasets in order to confirm the Fed will finally be moving to the sidelines.
Monday 5/8 – US Final Wholesale Inventories for March are expected unchanged at 0.1%. Looking overseas, China will report monthly M2 and Loan Growth for the month of April.
Tuesday 5/9 – The NFIB Small Business Index for April will give a glimpse into the current overall mood and outlook for small businesses collectively across the country.
Wednesday 5/10 – The main event of the week will be the April Consumer Price Index (CPI) which is expected to post a 5.1% headline rate v. last month’s 5.0%, translating to a 0.4% month-over-month increase. The Core (Ex-Food/Energy) is expected to grow 0.3% month-over-month and post an annual rate of 5.5%…higher than the headline. While these are the “expected” numbers, markets will need to see something considerably lower than these numbers in order to accept that a Fed “pause” is finally at hand.
Thursday 5/11 – Right on the heels of the CPI, today we get the Producer Price Index (PPI) which is expected to post a headline annual rate of just 2.4% (!!) v. last month’s 2.7%. The Core (Ex-Food/Energy) is expected a bit higher at 3.3%, with a 0.2% month-over-month increase. We have argued many times in the past that Producer Prices lead Consumer Prices. This is good news for future CPI reports no matter what we get on Wednesday.
Friday 5/12 – US Export/Import Prices for April are expected to post month-over-month increases of 0.2% and 0.3% respectively. The University of Michigan’s Consumer Sentiment for May is expected to be roughly unchanged at 63.0 vs. last month’s 63.5.
Source: FactSet
