Equity markets have regained their poise after March’s mini banking crisis; UK equities have gained c4% through the first four months of the year while US equities are now c15% higher than the lows reached in October of last year. In our view, however, investors are travelling much too hopefully – not least in ignoring the growing impact of the highly aggressive and ongoing interest rate increases imposed by central banks over the last year to tackle sticky inflation. In this context, the tightening of credit availability, a consequence of serial second-tier bank failures in the US, is likely to prove a further turn of the screw – bearing down on lending, economic activity, and thereby corporate earnings. In this note we review recent developments and present the evidence for continued caution.
US Regional Banks
At a press conference following the meeting of his interest rate setting committee on 3rd May, Fed chair Jerome Powell sought to reassure financial markets that the failure of three US regional banks was a discrete and contained series of events that was now safely in the past.
“There were three large banks, really, from the very beginning that were at the heart of the stress that we saw in early March, the severe period of stress. Those have now all been resolved, and all the depositors have been protected. I think that the resolution and sale of First Republic kind of draws a line under that period.”
Chair Powell’s Press Conference 3 May 2023
As he was speaking, however, Powell must have had a keen sense that his words were rooted more in hope than reality. The share price of another regional bank, PacWest Bancorp, was plunging at that very moment, losing more than 50%. It wasn’t the only one – shares in other second tier lenders were also plummeting.
US regional banks might be considered a dusty corner of financial markets, but they are far from insignificant for the US economy. According to the FT, US banks with less than $250bn in assets (that is all banks beyond the 12 largest) provide 80% of all commercial property loans, 60% of residential real estate loans and half of the commercial and industrial loans in the US. Unsurprisingly, given the storm they find themselves in, their willingness to lend is declining rapidly. The chart below shows two readings from the latest Fed’s Senior Loan Officer Opinion Survey, together with recession bands for the US economy. It shows that banks are rapidly tightening lending standards for commercial and industrial (C&I) loans – and also that demand for such loans is declining. As can be seen, with data going back to 1990, current readings are at or close to those seen in past recessions.
*The surveys ask senior loan officers a series of questions. Shown above are (LHS) Net percentage of Domestic Banks Tightening Standards for Commercial and Industrial Loans to Large and Middle Market Firms and (RHS) Net percentage of Domestic Banks Reporting Stronger Demand for Commercial and Industrial Loans from Large and Middle Market Firms. The scale is from +100% (all respondents replying in the positive) to -100% (all respondents replying in the negative).
Looking ahead, given that US businesses are now labouring under the yoke of interest rates at their highest level since 2007 – and regional banks are continuing to suffer deposit outflows while enduring losses on their bond investments – it appears highly likely that the situation will deteriorate further.
Economic Data and the Recession Narrative
At such times we believe it pays to watch the economic data very, very carefully. The numbers are panning out broadly as one might expect as the dead-weight of higher and still rising interest rates progressively bears down on economic activity. Readings that have historically given early indications, most notably the outlook surveys and housing market data, have long been signalling weakness ahead. Elsewhere, inflation itself has been slow to fall back while in the labour market the picture remains, inexplicably, resilient. However, in our view the direction is set and we attribute the contradictions between leading and lagging indicators to timing. The maxim that monetary policy works with long and variable timelags, although too often quoted, remains apt; we do not believe there is much more than the remotest chance that a marked economic downturn is avoided. While there are few commentators yet prepared to say that the downturn could be very painful, to our mind this is more about not wanting to be accused of talking the economy down, rather than any genuine belief that further weakness will be avoided.
Consideration of just one economic series is sufficient, to our minds, to demonstrate this point. The chart below plots theUS Conference Board Leading Economic Index (LEI) series since the late 1960s. Once again, we include recessions as shaded areas. The LEI is constructed from ten components such as manufacturing new orders and building permits. The direction and magnitude of monthly changes in the underlying components are standardised to give the index itself. As can be seen, the index has proven a reliable indicator of recessions. The current level of the LEI is consistent with US recession. The commentary accompanying the latest data release (20th April) included the statement:
‘The Conference Board forecasts that economic weakness will intensify and spread more widely throughout the US economy over the coming months, leading to a recession starting in mid 2023.’
Since 1970, whenever the LEI has reached the level denoted by the dotted line, a recession has followed.
Equity Markets – earnings and valuations
One of the ten components of the Conference Board’s Leading Economic Index discussed above is the stock market, as measured by the S&P 500 Index. Notably, it was one of just two of the ten that has contributed positively over the past six months. There is a striking irony here; if the stock market wasn’t holding up far better than circumstances justify, the LEI would be deeper in negative territory. To put numbers around our contention that equity markets are doing rather better than warranted, we highlight the current P/E ratio on the S&P 500 Index. It currently stands at 18.6x – almost exactly in line with the 10-year average of 18.5x. With earnings already suffering downgrades as higher interest rates start to bite into economic activity this, in our view, is too generous – especially as investors should be demanding a margin of safety at this point of the cycle, given the very real possibility that earnings could fall a long way should the economy tip into a recession.
Conclusion
Higher interest rates, tightening bank lending conditions and current valuations all suggest that investors should proceed with caution. We have not touched on the impact of the ongoing conflict in Ukraine, political risks around US-China relations or indeed the impending debt ceiling wrangle fast approaching in the US: all add to the argument that a defensive stance is warranted.
Given the above, it will come as no surprise that recommended portfolios are light on equities – with a preference for highquality companies that exhibit strong cash generation, robust balance sheets and earnings resilience – and heavily weighted to high quality bonds. We expect the latter to provide a degree of protection in the event of further equity market weakness and expect to recycle bonds into equities in due course as opportunities present themselves.
