Frayed, but Resilient
Over the past 3 weeks the economy and the banking system have become more frayed, yet markets have remained resilient. So, this week, we attempt to make sense out of what doesn’t make any sense.
Our recession call remains in place as many economic indicators point toward a recession. Here are a few:
- Leading Indicators: The Leading Economic Indicator (LEI) Index, nudged slightly higher in February, but remains well into recession territory.
- Personal Consumption Expenditures: After a brief surge in January as social security beneficiaries got their 2023 inflation adjustment, February marked a return to weakness. While we are still spending more, the increase has more to so with inflation than real increases in demand. Anecdotally, Citi credit card activity took a dive as the banking crisis emerged.
- Industrial Production Index: The year over year percent change in the index turned slightly negative in February (-0.2%) versus +0.5% in January. Although small as a percent of the economy, the manufacturing sector is clearly slowing down.
The alternate economic view remains based almost exclusively on strong employment trends, which are not yet wavering, despite increased news of layoffs. It is hard to dispute that recessions are hard to come by when employment Is strong, so for any recession forecast to be correct, it requires some weakening in the employment data. The banking crisis could be the event that triggers it.
Banks Runs are the Side Show
Most of the attention has been focused on bank runs that closed SVB and Signature Bank and continue to threaten several others, including First Republic, but this is not a systemic risk, unless the Treasury Dept. and the Fed allow it to become that. Those banks most at risk are those with a high level of uninsured deposits. It appeared that we were close to moving past this episode, but some irresponsible comments (in our opinion) from Treasury Secretary Yellen succeeded in rekindling fears and the bank run problem is lingering longer than it should have. But bank runs are not the main show, it is the effects they produce that matter:
- Consumer Sentiment – There is nothing like a good bank scare to close consumers wallets and cut back on spending.
- Banker Sentiment – There is nothing like a good bank scare to make capital scarce as lenders stiffen their standards for lending, making it harder for the economy to remain on a growth track.
The consumer issue is straightforward, when you are concerned about your money in the bank, you tend to spend less freely. The only remaining question is how long that feeling lasts and the Yellen missteps are not helping.
In our view, what matters more is how this bank run saga will impact lending practices. It only makes sense for banks to respond to the bank runs by tightening lending standards and therefore lending less than they otherwise might have. That alone is more than enough to put a serious crimp into economic activity.
But, wait, there’s more. With office buildings sitting empty as work from home has become the norm for many, commercial loans, which reset periodically, are struck with a double whammy. The buildings are empty with little near term hope for new tenants to sign up, and owners are being forced to refinance at much higher interest rates. Without some reasonable prospect for recovery, that math simply does not work. Property owners are loath to give up properties, unless the situation looks truly hopeless, but that trend is already starting. (Refer to our comments last week.)
This places even more pressure on banks, particularly the small and mid-size banks that tend to be the biggest lenders into this market. With this as a back drop, it is getting increasingly difficult to see how the banking sector muddles through this period without some significant pain. All that means is lending standards are likely to get even tighter and that is a major headwind for the economy.
“Still, I Look for a Reason to Believe” (with apologies to Rod Stewart)
But the stock market appears unwilling to see this reality. It continues to look for a reason to believe that this economy will deftly find its way around these obstacles and continue to grow. If investors had completely given up on the bull market, we suspect the S&P 500 would be a lot lower. To us, it appears to be a perfect setup for a fall. In our view the market is overly focused on a decline in interest rates and under-focused on the prospects for a recession. There are plenty of ways for our view to be incorrect, but the preponderance of evidence suggests that a contrarian view is warranted and harder times lie ahead.
“You stole my heart, but I love you anyway” (with apologies to Rod Stewart, again)
The stock market is a discounting mechanism, but that doesn’t imply that it always discounts correctly! The constant market flip-flopping we have experienced recently is evidence of that. Markets tend to make major shifts when one side or the other (optimistic or pessimistic) is dragged completely into a trade. It wasn’t long ago that everyone owned tech stocks and valuations were largely ignored. Once nearly everyone has succumbed to the trend, it reversed. Bear markets end when everybody is bearish and bull markets end when everybody is bullish. Right now, we are somewhere in between, but since the start of QE and the start of the bull market in 2008 (when everybody was bearish), we have enjoyed almost unbridled optimism. Though there are currently cracks in the market, we are still only 16% off from a speculative, bubble driven, all time high. The bear cycle is not over; there are still far too many optimists out there. The stock market has stolen their heart, but they love it anyway. This bear ends when there is no more love.
What We’re Reading
Fed balance sheet is telling us it’s not getting any worse (3 min. video)
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