Review the latest portfolio strategy commentary from Mike Gibbs, managing director of Equity Portfolio and Technical Strategy.
Financial markets have been shaken over the past week on banking sector concerns. At the heart of this volatility lies the question: Can these issues be contained or is it indicative of widespread contagion to come?
To be sure, the news ratchets up risk in the short-term, and there may be other players that come under pressure. But for now, we believe the problems discovered by Silicon Valley Bank, Signature Bank, and Credit Suisse are more narrow in nature. For example, Silicon Valley Bank was funded by venture capital (rather than consumer deposits like most other banks), Signature Bank was highly levered to the bitcoin industry (which has plummeted), and Credit Suisse pressure should not come as a surprise for capital tied to it (its stock has been in decline for years). Additionally, these entities are experiencing liquidity issues on “money-good” bonds, not widespread defaults. Liquidity is much easier solved than credit worthiness. Moreover, central banks have been quick to respond/add support, which should reduce concerns of widespread contagion.
Unprecedented policy always runs the risk of unintended consequences. The economic normalization process from a global economic shutdown was not going to be easy or smooth, and the recent pressures are a byproduct of very swift central bank tightening over the past year. In fact, today marks the 1-year anniversary of the Federal Reserve (Fed) beginning its rate hikes – and we know that Fed tightening works with a lag on the economy. Record tightening over the past year, which really ramped up in mid-2022, will expose weak hands. And its purpose of driving down inflation (by reducing demand/growth through higher interest rates) is now coming into focus by investors.
In the aftermath of this news, bank lending is likely to tighten even further. This increases the already high likelihood of an economic recession to come. But a silver lining for equities may be that the market is doing the tightening for the Fed right now – shifting up the timeline for an end to the Fed’s tightening cycle. There has been a dramatic shift in Fed rate hike expectations – moving from 100 basis points (bps) of tightening left this year to 100 bps worth of cuts by year end in just one week! And a market that has been highly sensitive to Fed policy may find support from easier policy down the road.
Our anticipated S&P 500 range of 3700-4300 shifts lower to 3500-4100, as the potential for volatility increases in the coming weeks and months. However, we remind investors that this bear market has already experienced a 25% decline spanning over 14 months (recessionary bear markets have averaged 33% declines over 13 months historically). Additionally, equities have regained prior highs out of recessions on average 23 months following a bottom – a bottom that typically comes when the news is the worst. Importantly 5- and 10-year inflation expectations have declined to the 2-2.5% range recently (recessions are deflationary), which has been consistent with the highest P/E multiples historically – a positive for long-term potential equity values. Therefore, despite the likelihood of increased volatility and potentially more downside, we remind investors to not lose focus on their long-term goals. We firmly believe that equities will once again print new highs at some point when the dust settles, as they have following every recession through time.
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