• The Fed increased interest rates by another 25 basis points, raising the targeted range of 4.75% to 5%, the highest level in 15 years.
• Failure of Silicon Valley Bank and Signature Bank resulted in a market reevaluation of regional bank risk. Investors seeking to reduce or eliminate the risks of banking industry exposure quickly led to a “flash crash” in the financial sector.
• Regional bank ETFs lost nearly 27% because of investor concerns about the banking industry.
• Markets are assuming one more Fed rate hike, but clarity is absent given high inflation rates and new banking concerns.
• Technology sector stocks have outperformed the broader market, up nearly 17% year-to-date. The semiconductor component of the technology sector is up 25%.
Putting Inflation, The Fed, Jobs and the Consumer Into Perspective
The March 22nd Fed policy decision to raise interest rates by another 25 basis points (one-quarter percent) reflected an abrupt shift from market expectations earlier this month. Two weeks before this decision, Fed Chair Powell spoke to the Senate Banking Committee and made a case for a more aggressive hike of potentially 50 basis points (one-half percent) later in March.
Only days and two bank failures later, the tone changed, as did investor confidence—at least temporarily—in the banking system. Though the underlying situation that resulted in the failure of the two banks, Silicon Valley Bank and Signature Bank, was exacerbated by the past 12 months of monetary tightening (higher interest rates), the more fundamental issue dated back to the pandemic-era deposit buildup in the banking system.
Recalling the rapid liquidity infusion by the Federal Reserve in early 2020 during the COVID pandemic/recession, “money” created by the Fed and Treasury was deposited into the banking system. Ultimately, the banks subsequently invested the enormous inflows of liquidity deposits into longer-term government bonds as part of the banks’ reserves.
As investors and the markets suddenly realized this month, even though those Treasury investments didn’t have credit risk, the typically longer-dated securities did have duration (maturity) risk. And unfortunately for regional banks Silicon Valley and Signature Banks, both had extremely concentrated customer bases with more than 90% of their deposits uninsured. The two banks also had unique risk, leading to a rapid withdrawal of customer deposits, forcing the banks to liquidate those longer-dated Treasury investments. The net impact was realized losses because of poor risk management and forced realized losses of their longer-dated Treasury investments funding customer withdrawals. As withdrawals escalated, so did losses and the banks’ illiquidity.
On March 10, the FDIC took control of Silicon Valley Bank, and two days later Signature Bank suffered the same fate. These two banks made the record books—a dubious honor—as the second and third largest bank failures in the U.S., the largest being Washington Mutual in 2008.
And the troubling headlines continued as another regional bank, First Republic, required a cash infusion of $30 billion from a number of national U.S banks to keep its doors open. Today, that issue is still unresolved as customers continue to pull funds from the California-based bank. Overseas, UBS took over Credit Suisse in an attempt to stabilize the Swiss bank as investors began pulling out approximately $10 billion per day.
As banking troubles made headline news, the banking industry became an investors’ nightmare. The smaller regional bank ETF (KRE) fell approximately 26.8% from March 8 to March 23, while the larger national bank ETF (KBWB) fell 28.8% from March 6 to March 23. Ultimately, the impact of these troubled banks’ issues throughout the past two weeks likely led to the Fed’s decision to raise its benchmark rate by 25 basis points rather than the 50 basis points that most market watchers had been expecting several days earlier.
Today the Federal Reserve, Treasury and the Biden Administration have made repeated assurances about the soundness of the banking system. In the past several days, the Fed introduced a channel for banks to borrow the par value of their government securities for as much as one year, regardless of their mark-to-market prices. This action is an effort to sidestep those unintended realized loss issues that escalated with customer withdrawals from both Silicon Valley and Signature Banks.
And what about future rate hikes? The central bank is now signaling that it may be nearing the end of its aggressive series of rate hikes. In the FOMC rate statement, language was removed that previously indicated it would keep raising rates at upcoming meetings. The statement now says “some additional policy firming may be appropriate”—a weaker commitment to future hikes. Even though the Fed signaled that the end of rate hikes is likely near, there are no assurances that this is a firm commitment. If CPI stays near 6% between now and May’s Fed meeting and the bank crisis is contained, the Fed may very well signal more rate hikes ahead. The regional banking crisis will likely put downward pressure on bank lending standards (and the economy/inflation), but this situation hasn’t made the task of navigating a soft recession landing any easier.
Tight Labor Markets Despite Headline Layoffs
Follow-up commentary from this week’s Fed meeting that “hiring is running at a robust pace” confirmed what we’ve been discussed in this space since last year. The labor markets continue to expand, countering the conventional wisdom that higher rates lead to declining corporate margins—as they generally do—followed by rising unemployment levels (not yet). Consider that in February 2022 the unemployment rate was 3.6% versus this year’s level, also 3.6%, and in between, the markets have weathered nine rate hikes.
The latest unemployment report documents 311,000 new jobs added to the economy. Granted, the prior six-month average posted a gain of 343,000 jobs, but to date, the job markets have defied the impact of rate hikes. Labor force participation rates were little changed at 62.5 percent, and the average hourly wage growth for the month was up only 0.2%. But over the past 12 months, wages were up 4.6% while initial jobless claims ticked down a bit to 191,000.
Not to downplay the rate hike impact on select parts of the economy, there were layoffs from several of large national companies such as Microsoft, Google, Salesforce, Direct TV and Zoom. These job losses did contribute to the slight uptick in February’s unemployment rate from January’s 3.4%. According to the Bureau of Labor Statistics (BLS), losses were primarily in the information, motion picture, transportation and warehousing industries.
Job growth was evident though in the leisure and hospitality industries, up 105,000 jobs in February (versus the prior six-month average of 91,000 jobs). Also adding jobs in February were retailers (up 50,000), government (up 46,000), professional and business services (up 45,000 versus the prior six-month average of 35,000). Obviously, select industries and market sectors are trimming staff, but at the same time, a rather robust consumer is driving hiring demands in service-related companies.
The Consumer Barometer
Beyond the recent headline bank troubles, the broader consumer-driven economy has shown surprising strength this year, even after the most recent 25 basis point rate hike. So far, employers have added more than 800,000 jobs during the first two months of the year (versus approximately 1.14 million over the same period in 2022), while overall spending at retailers and restaurants during the first two months of 2023 eclipsed sales over the comparable two-month period in 2022. Over the three-month period of December 2022-February 2023, sales were up 6.4% versus the comparable three-month period in 2022. Retail sales fared just as well, with January’s year-over-year sales posting a positive 6.4% growth and February posting comparable sales growth of 5.4%.
Declining inventory has also supported both sales and housing prices. According to National Association of Realtors data, total housing inventory at February’s close was 980,000 units, the same as January but up 15.3% from last year. Based on the current sales pace, today’s inventory represents approximately 2.6 months of supply, up from 1.7 months last year. Good news for both the inventory problem and affordability is the number of construction permits and starts posted earlier in March. The most recent data points to month-over-month growth in single-family permits and starts of +8% and +1%, respectively. For multifamily units (apartments), permits and starts growth was +21% and 25%, respectively.
Manufacturing and Economic Uncertainty
As it was in February, data underlying the manufacturing and services sectors continue to paint different pictures. It is particularly interesting that at these rate-risk crossroads, the small business association National Federation of Independent Business (NFIB) posted a small increase in its Optimism Index for the second consecutive month. According to the survey results, business owners are expecting stronger retail sales against the backdrop of declining inventory levels.
Reviewing manufacturing data for February, sustainable growth was most noticeable in the services-related industries, registering an expansionary index reading of 55. According to the Institute for Supply Management (ISM) Services Index, these business service categories are in their second month of expansion, with improvements evident in new orders, employment and delivery performances of suppliers (highest level since June 2009). The brighter outlook wasn’t limited to domestic related businesses; it was global as well and included hotels, restaurants, financial businesses, professional and technical services, retail, residential and utilities—the mainstay of consumer health. According to one research firm, Renaissance Macroeconomics, 85.7% of those service industries monitored globally were in expansion territory.
However, the positive news related to the services industries was in stark contrast to the ISM Manufacturing Index reading, a truly economic-sensitive category, including firms operating in industries such as textiles, plastics, chemicals, computers and electronics, machinery and miscellaneous manufacturing. This manufacturing centric index registered its fourth month of contraction below 50. With an index reading of 47.7, this gauge is at its lowest level since 2009. This statistic is one that is, we hope, noticed and discussed by the monetary policy voting members of the FOMC (Federal Open Market Committee).
The Banking Industry “Flash Crash”
March has been a difficult month for the equity markets across styles, strategies, market caps and regions. Most markets, if not in negative territory, are posting low single digit returns. The S&P 500 is no exception. In early February, the broad market index briefly posted an 8.8% return, but as March progressed, performances fell. Through today (March 24), the return is a positive 2.84%. Looking at the underlying strength of the constituent index holdings, quite a few stocks have fallen behind. Today, only 38% of the stocks are above their 200-day moving average. Last month it was closer to 60%. Also last month, 47% of the S&P stocks were trading above the 50-day moving average; today it is 18%.
No understatement: Much has happened to change the dynamics of the markets over the past few weeks, including another 25 basis point rate hike and the failure of two West Coast banks here in the U.S. Given investor concerns that the failure of a few risk-centric banks had on the nation’s financial system, it is little wonder that the Financial Select SPDR ETF (XLF) was down -9.33%. Looking more specifically at the Regional Bank ETF (KRE), the year-to-date returns were in deeply negative territory at -28.09%.
Considering the recent weakness in oil prices with West Texas Intermediate crude falling from a high of $82 in January to a current $69, it is little wonder that the Energy Select ETF (XLE) is also in negative territory, off -9.13% on a year-to-date basis as well. The decline is great for inflation watchers but not so much for investors.
What has been surprising is how the technology sector has held up this year, with the NASDAQ composite up nearly 13% at this point. Most unexpected though is the Philadelphia Semiconductor Index, which year-to-date is up 25%. Whether or not this data is a precursor for the future direction of the broader markets remains to be seen. Keep in mind that this market sector has not only been a good barometer for the overall economy, but the Index performance has also usually been a good leading indicator for the equity markets in general. At this point, the index has great support trading above both its 50- and 200-day moving averages.
The Fed Glide Path
Although the markets have been rattled by the recent banking industry turmoil, it’s worth recalling that the economy has retained its momentum despite nine successive rate hikes. Retail sales remain strong, as does the service industry in general. The housing market is acting as though there “might” be a turnaround, given the renewed increase in building permits and overall housing sales. Jobless claims remain low, and the unemployment rate has defied Fed Fund rates moving back towards the 5% target range.
Inflation rates remain rather stubborn. However, food costs are up an annualized 9.5%. Core inflation, excluding food and energy, dropped a bit last month to 5.5%. Meanwhile, the central bank’s target benchmark rate has now reached its highest level in 16 years. The new level will likely lead to higher costs for many loans, from mortgages and auto purchases to credit cards and corporate borrowing. The Fed has also acknowledged the recent banking crisis, mentioning that it would also likely lead to “tighter credit conditions for households and businesses and weigh on economic activity, hiring and inflation.”
Economic data over the next few months will remain the key to the timing of the next (or any) rate hike. If there is no further relief found in upcoming inflation data, the momentum we’ve seen in the economy to date will likely be lost—not a positive for either the markets or the economy. However, given the strength we see in the labor and service industries, a longer economic glide path exists.
Despite the failure of the two California banks, the overall banking system is fundamentally sound and in much better shape than during the Financial Crisis of 2007-2009. The housing markets are sound, and so is the overall financial state of the consumer, despite rising rates and credit card levels. Fixed income yields remain attractive for savers, and dividend yields remain attractive for investors.
Not Investment Advice or an Offer -This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing. Argent Financial Group is the parent company of Argent Trust, Heritage Trust and AmeriTrust.