Perspective on Last Week

By Published On: March 19, 2023Categories: Market Commentary5.6 min read

Last week was an historic one in many ways. Events are transpiring rapidly. We write this note to offer a real-time perspective.

First, a quick review of the headlines last week and over the weekend:

  • Two banks failed, and regulators stepped in to save depositors and reduce the risk of runs on smaller banks.
  • The Swiss National Bank announced an initial rescue package for Credit Suisse bank during a crisis of confidence, only to follow it with a government brokered deal for UBS to buy the bank on Sunday at distressed levels.
  • Inflation data and employment reports for February confirm that the US economy remained resilient despite higher rates[1]… and underscored a policy dilemma for the Fed: raise rates to fight inflation or pause to settle the financial system?
  • Yields in fixed income dropped dramatically in response, highlighting fear that things may get worse, increasing the risk of recession.

Here’s our read on the stability of the financial system, the status of the fight against inflation, and the outlook for the economy. We recognize there are many moving parts, making assessments difficult.

Stability of the US Financial System: Stressed but Functioning

As we discussed last week, regulators moved quickly to provide liquidity to banks and built backstops to reassure uninsured depositors they could access their money. Regulators didn’t wait to see if the crisis was just limited to a handful of banks in a unique situation[2]; they took a more comprehensive approach to curtail the risk of contagion.

Despite the backstops and newly available funding, the banking system showed clear signs of distress anyway. Consider that 1) banks tapped the Fed’s discount window[3] for an historic $150 billion during the week[4] and 2) that twelve large US banks agreed to provide temporary liquidity to struggling First Republic Bank. Observers questioned the purpose and motivation of the latter, if the regulatory solutions were indeed sufficient on their own.

The next few weeks will confirm if the liquidity measures now in place help secure stability in the banking system. The immediate risk to the smaller banks is a run on deposits. The question becomes do ALL deposits need to be insured to keep small financial institutions viable? We note regulatory backstops imply liquidity support of up to $2 trillion, which is a significant level.

Inflation Outlook: Still Must Be Tamed

We believe current readings show inflation is still embedded in key parts of our economy. Labor remains tight, services prices are still rising, and real wage growth is still below growth in services prices.

From a policy perspective, experts were debating last week whether the Fed can treat the liquidity issues of the financial system as separate and distinct from the challenge of inflation. The European Central Bank’s decision mid-week to raise rates 50 bps despite the challenges facing Credit Suisse show the ECB’s answer: that it was confident the Swiss National Bank had already addressed the liquidity issue of Credit Suisse, enabling the ECB to focus on inflation.

In similar fashion, we would not be surprised to see the Fed raise rates again by 25 bps later this week. It allows it to continue to fight inflation while signaling to the market its confidence in the liquidity measures just announced. If banks continue to access the discount window in the coming weeks, we think the Fed may temper its commitment to “higher for longer.”

Absent a larger banking crisis, and given the economy’s ability to absorb higher rates so far, we expect the Fed to continue to send the signal that fighting inflation is a top priority.

Recession Outlook: Probable

We’ve written extensively on our outlook (most recently here), and it has not changed. To summarize, we believe the bond markets and the leading economic indicators, combined with the rapid increase in rates over a short period, implies that recession is probable within 12 months.

The stress to the banking system only increases the likelihood, in our view. Small banks account for a significant amount of lending activity in the US—according to Federal Reserve data, about 38% of outstanding loans currently. Banks were already tightening lending standards late last year, as concern over higher interest rates and slower economic activity rose.

Continued stress in the banking system—whether to retain deposits or reduce risk—could pressure this group to further reduce risk. Last week’s activity at the Fed’s discount window illustrates the pressure on smaller banks.

We’ll add that if banks lend less after last week’s news, it should help slow the economy and put downward pressure on inflation anyway.

Recap: Our Recommendations

As our clients know, we started making defensive adjustments to investment strategies over 18 months ago—not because we could literally anticipate events, but because certain risks were becoming imbalanced.

To highlight our research decisions during this period:

  • When rates and inflation were low but starting to rise, we added defensive allocations to our equity exposure, including hedged ETFs, structured income notes, ETFs using covered call strategies, and equities with factors that historically bring less volatility.
  • In fixed income, we put a focus on quality, sold our high yield positions, and—as rates got higher—swapped some alternative investments into better yielding government bonds and mortgaged-backed agency bonds.
  • We’ve also included TIPS for inflation protection, where appropriate.
  • If markets reprice risk and return, we could look to become more aggressive.

During this period, we have also been counseling business owners, families and nonprofits about the rising risk of recession, and how to adjust as necessary.

We don’t recommend a change to investment strategy for our clients at this point, if your circumstances have not changed.

Any questions or concerns, please let one of us on your team know.

[1] Core inflation was 5.5% for the month. Labor reports were mixed, but payrolls beat expectations, showing hiring is still strong.

[2] It had become a broad practice for banks to take deposits and invest them in longer-term assets or loan projects, subjecting them to interest rate risk. Unlike the handful of banks in the crosshairs last week, most banks appeared to be well within regulatory liquidity requirements and to have ample liquidity to cover liabilities. Nonetheless, regulators provided broad support for the industry.

[3] The Fed’s discount window allows banks to tap the federal reserve as a “lender of last resort”. It provides short-term funding at discounted levels when other sources are not available. Last week, the Fed waived the “discount factor” for borrowing, enabling banks to get discounted securities at par value. More favorable conditions could explain why smaller banks acted quickly.

[4] According to the Federal Reserve, banks borrowed over $150 billion last week, vs. a peak of about $50 billion during the pandemic and typically $5 billion in a typical week.

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