2Q23 Market Outlook

Fed Policy Mistakes Mounting

John P. Swift, CFA, CPA Chief Investment Officer
312-259-9595 or [email protected]

Summary:

• The Fed was quick to drop rates near zero when the pandemic struck. However, it made a mistake to see inflation as transitory and kept rates low for too long.
• As a result, the Fed needed to raise rates at an aggressive pace and in unprecedented increments to keep inflation within its target.
• Due to the low-rate environment after the Great Financial Crisis, the financial markets and the economy were not ready for such aggressive hiking of rates. You only need to look at the market response to rising rates in late 2018 and early 2019 as evidence.
• That has resulted in unintended consequences like regional banking stress and increased likelihood of a recession.

Fed Mistakes Mounting

The Federal Reserve made its first policy mistake when it denied the existence of inflation, it then acted too late to tame inflation before it started, and now central bankers have put themselves in a position where its few remaining choices all lead to the potential risk of financial and economic accidents. Finally, the latest Fed mistake is not reinforcing its bank supervision to assess the impact of a very concentrated interest rate hiking cycle which was sure to create cracks among the weaker and poorly managed regional banks that were not part of the Fed’s Systematically Important Financial Institutions list.

Today we are more worried about economic contagion than financial or banking contagion. Nevertheless, the banking woes we’ve experienced lately will lead to a reduction in credit to the economy over the next year. Credit contraction will make economic growth more elusive. Moreover, it may result in a credit crunch that impacts highly levered sectors of the economy and small to mid-sized firms that do not have ready access to capital markets and rely heavily on traditional bank financing. Credit will be most affected in community and regional banks that have lost deposits due to capital flight to larger banking centers.

What We Have Here is a Failure to Communicate

In the past month, the two-year Treasury Note has gone from yielding 5.1% to 3.6% and is now back to 3.9%.

That is a massive swing in just one month for a bond maturity supposedly anchored by the Fed. We’ve gone from an economic forecast of a hard landing to a soft landing to a no landing and now back to a hard landing. The bond and equity markets tell divergent stories, which stands to reason when you have a Fed that doesn’t know how to stick to its script. Market participants are forced to determine the economy’s future direction with the resulting volatility and lack of agreement that you would expect under such circumstances.

Deglobalization and its Supply Chain Effects

As nations rewire their supply chains, part of the future aggregate supply constraints will be caused by on-shoring, near-shoring, or friend-shoring. Rewiring global supply chains is a tremendously complex task, and some nations such as Vietnam and Mexico that will benefit the most from this reordering either have infrastructure and labor supply limitations or energy availability and environmental issues to contend with before they can become a larger partner in global supply chains. Additionally, companies would like to diversify their supply chains to add redundancy in case bottlenecks arise in parts of the system. This redundancy adds complexity and cost to the system.

This multi-year effort will add to inflationary pressures as your friend next door may be someone other than the low-cost producer.

The Weakening Economy in the U.S.

We increasingly see weakness in some critical leading indicators. The ISM new orders less inventories fell below zero while the ISM manufacturing PMI composite index fell below 50, indicating a contraction in purchasing of industrial goods. Falling new orders and rising inventories is a leading indicator suggesting a manufacturing downturn later in 2023.

At the same time, young, unprofitable companies are still struggling and could struggle even more as liquidity and credit contraction in the market tightens. These are the same companies that continue to have significant and increasing negative free cash flows. They have also suffered severe multiple contractions in their valuations. Some companies with unsustainable business models could reduce spending or even go out of business, resulting in a worsening economic scenario.

Adding to the difficult conditions, lending standards have increased in both the U.S. and Europe. Some experts refer to the sudden decline in U.S. banking system loans in the week ending March 29 as “the largest decline ever.” Most of the weakness was driven by commercial real estate lending and commercial and industrial lending. Based on the tight credit standards we see today, the U.S. and Europe are seeing credit standards rise to levels seen in the 2001 and 2008 recessions.

Finally, monetary policy tightening globally as part of efforts to combat inflation adds to the risk of a recession in the U.S. in 2023. Apart from China, the money supply is contracting everywhere else. With the restrictive money supply in the U.S. down to levels not seen in the past two decades, this drastic decline in money supply in the U.S. is adding to risks for businesses in the U.S. in 2023.

Banking Sector Problems

One unintended consequence of the Fed’s monetary policy was the turmoil in the U.S. regional banking sector.

First, the Fed flooded the market with liquidity during the Covid pandemic, resulting in substantial deposit inflows to banks. As banks took on more deposits, they also created more problems. Investing large portions of these new deposits in low-yielding, long-term governmental credit issues has resulted in massive unrealized losses on these securities when interest rates rose quickly. This has resulted in lower capital ratios.

Unrealized losses on bank balance sheets have never really been a problem. This is because if these losses are unrealized, they are not deemed a threat to the U.S. financial system.

These unrealized losses on securities are usually a problem if there are large deposit outflows, deemed a low probability event. But, as we all know now when panic enters the financial and banking system, a low-probability event could happen, and the banks least prepared for the deposit outflows are the ones that will suffer the most.

However, when a bank run happens to one bank, the entire financial system is at stake. As a result, we saw one of the most significant drawdowns in U.S. commercial bank deposits since 1970.

While the Fed can help improve liquidity for the banks, there continues to be a large part of the bank balance sheets that have unrealized losses. Furthermore, the trend of deposits leaving banks for higher money market fund yields also threatens U.S. banks.

One of the biggest winners of the banking saga is Money Market Funds. These funds have seen significant inflows. Balances at Money Market Funds reached a new high of $5.2 trillion, with $348 billion of inflows since the failure of the Silicon Bank.

At the same time, there is still a large gap between deposit rates and money market fund rates. If the gap persists, this will bring a more significant risk to deposit outflows from banks.

While many system indicators and financial metrics indicate that the situation is stabilizing, all it takes is one bank to announce bad news, and the entire financial system could be subject to a crisis of confidence.

Conclusion

The Fed aggressively increased rates in 2022, rising from 0.125% in early 2022 to 4.75%-5.0% at the end of March 2023. This rapid rate increase is unprecedented and could have unintended consequences, including the regional banking issues we saw in March 2023.

The Fed is in a difficult position. As a result of its actions taken in the Covid-19 pandemic that resulted in easy monetary policy have also contributed to the elevated inflation levels we see today. The Fed wants to bring inflation down to its target of 2%, meaning they need to keep rates high for longer to see inflation normalize. But, on the other hand, it needs to do a delicate balancing act as the regional banking turmoil, higher lending standards, and weakening economic data are pointing to a recession. If we do enter a recession, it should be shallow and not long lasting, but it would certainly be deemed as an unforced error from a Fed that has made significant policy missteps along the way.