In more than 100 years of Kentucky Derby racing, no duel was more chaotic than 1933’s “Fighting Finish.” As Broker’s Tip and Head Play battled down the homestretch, jockeys Don Meade and Herb Fisher grabbed, punched, and whipped each other. In the melee, horses and jockeys locked together at the finish. With no photo-finish technology, the racing stewards met and declared Broker’s Tip the victor, which led to continued fighting between jockeys.
The competition garnering investor attention this Spring is the jostling for position between stubbornly persistent inflation and a tight labor market. Which will fade first—inflation or the economy? We expect a fighting finish.
Inflation
Inflation has eased across a number of metrics. This chart shows the Consumer Price Index (“CPI”) on a year-over-year basis. The current reading of 5% remains well above the 2% target set by the Federal Reserve, though significant progress has been made since June when the reading was around 9%.
The three inflation categories often referenced by Fed Chair Jerome Powell—goods, shelter, and services ex-shelter—are notably improving.
Prices for goods have been rapidly returning to normal as supply chains have healed. In fact, the Fed’s Global Supply Chain Pressure Index just recently returned to zero, indicating that supply chain stress has fully dissipated.
Prices for shelter (housing) have been persistently high, though current “real-time” market data show softer pricing that will eventually flow through to index calculations. With mortgage rates significantly elevated, housing inflation in coming quarters is likely to improve, giving the Fed some support if it chooses to pause rate hikes.
While shelter or housing inflation is softening, largely owing to higher mortgage rates, services inflation has remained more persistent. We agree with the Fed that a tight labor market is one culprit. Pandemic-era savings and pent-up demand is another influence, as consumers embrace in-person activities. Nevertheless, spending on services is moderating, and we expect spending to normalize in coming months.
Despite improvements, inflation remains well above the Fed’s 2.0% target and remains an important problem for the Fed and investors.
The Economy & Bank Stress
Economic growth continues apace, though momentum has slowed and a likely lending slowdown following recent bank stress presents a new headwind.
What Happened with Banks
The banking system is the foundation of the global economy. In recent weeks the stability of the system was tested as analysts—and depositors—began to scrutinize the impact of rising interest rates on bonds held on bank balance sheets. That scrutiny led to an intense focus on loan-to-deposit ratios, levels of uninsured deposits, and unrealized losses on hold-to-maturity investments among other metrics of financial stability.
Some banks reacted to increasing interest rates by transferring substantial holdings to a “held to maturity” category, valuing securities at par but preventing their sale for cash demands. Concurrently, some depositors grew concerned about cash deposits exceeding the $250,000 FDIC-insured level, transferring uninsured funds to other banks or investments like Treasuries. As these deposits exited certain banks, some securities backing them were frozen in the “held to maturity” category, sparking fears of imbalance, scrutiny of the U.S. banking system, and several bank closures.
Three key things to watch for in the banking sector:
- Depositor psychology around deposit safety
- Increased bank regulation that impacts bank profitability
- Economic drag from a reduction in bank lending
Deposit Safety
The regulatory response to the depositor run at Silicon Valley Bank (“SVB”) was swift and forceful, stemming the risk of contagion. Banks like SVB whose bond investments were under water were encouraged to use the existing Federal Reserve Discount Window and a new facility, , the Bank Term Funding Program. These facilities provide banks with a mechanism for receiving par value for bonds held to maturity, thus improving their balance sheets.
In addition, for certain banks, The Federal Deposit Insurance Corporation (“FDIC”) provided protection to depositors above and beyond the standard $250,000 limit. By reiterating federal support of bank deposits—while stopping short of a full guarantee of insurance above $250,000—regulators quelled much of the fear that could cause additional bank runs.
A Likely Increase in Regulation
Most bank crises lead to new regulation, and we assume this time will be no different. Fed Vice Chair Michael Barr is leading a full review of the recent events and will publish his findings on May 1. While the White House has proposed some ideas for bank regulation and supervision, Treasury Secretary Yellen and officials at the Federal Reserve have said they will await Mr. Barr’s review before offering suggestions. While it is too soon to know what to expect from increased bank supervision, regulation, and the potential impact on bank earnings, we assume it will not positively affect the economy.
Lending Outlook & Economic Drag
A segment of banks will now be “capital constrained” and reduce their lending volumes, likely slowing the economy. To estimate the size of the potential economic drag, we reviewed prior banking crises, including the Global Financial Crisis and the Savings & Loan Crisis in the 1980s and 1990s. Present conditions are less challenging than either, although the bank failures of the 1980s have some similarities to today’s crisis.
To date, the FDIC has “bailed out” just two banks: Signature Bank of New York and Silicon Valley Bank of California. These two banks (each in the top 50 largest in the country) represent approximately 1% of U.S. bank assets. In contrast, in the period from 1980–1994, seven states had at least 20% of their banks fail, representing a full 9% of all U.S. bank assets.
A detailed FDIC survey also provided state-by-state data on economic activity during periods of bank stress. Problems with farming were closely associated with the 1980 recession, while oil industry problems were linked to the 1982 recession. The 1991 recession was primarily associated with real estate loans in the Northeast and California.
While today’s bank crisis has largely been resolved, it is worth considering what might happen if lending conditions deteriorate and cause a recession. The 1991 recession provides a useful comparison as it emerged at the tail end of the crisis and was partly a result of the lending malaise and economic lethargy that ensued.
While the 2023 bank crisis is only 10% the level of the 1980s’ bank stress, we modeled a conservative 30% level, allowing for further deterioration. Our review of national and state economic data before and during bank crises—adjusted for the severity of the current crisis—indicates that current banking stress could result in an economic drag of 0.5% to 1.0%.
The Atlanta Fed and the New York Fed expect economic growth of +2.47% and +1.23% respectively. Even allowing for a full 1.0% drag on growth from a lending slowdown, the economy would proceed at 0.5%—just above a stall speed, not entering a recession.
Recessions & Investing
If a recession were to emerge, Bloomberg’s BQuant tool provides a useful data set on economic recessions and equity performance.
On average, stocks often decline by a small amount during the first nine months of a recession. The worst instances were in 1973, the tech bubble, 9/11, and the Global Financial Crisis. In our view, those are not good comparisons to the current situation.
One relevant comparison is the 1991 recession where GDP declined across three quarters, with an average decline of –0.5%. During that timeframe, stocks declined by –14.5% in a three-month span, turning positive by 12 months at +5.6% and solidly positive by +15.9% after 18 months.
While economic momentum is slowing, the job market is still on sound footing.
Job Market
The most recent jobs report showed a gain of 236,000, a figure consistent with economic expansion, not recession. However, the pace of gains is slowing. The average gain over the past six months was 315,000, compared with 376,000 for the six months prior.
Similarly, job openings remain high, with 9.9 million jobs being offered per the Job Openings and Labor Turnover Survey (JOLTS). Yet, jobs offered have also slowed, which is a welcome development for Fed officials who fear an overly tight labor market contributes to wage inflation. For context, 12 million jobs were being offered in March of 2022, and have been in a range of 10 to 11 million over the prior six months. Over the past twenty years, job openings have averaged 5.3 million. Thus, today’s strong (though slowing) level of job openings indicates a healthy labor market and should coincide with ongoing strength in consumer spending.
At a recent gathering of the National Association of Business Economists, several labor market experts provided theories on recent job market changes. One theory suggests that the job market has been “reshuffled,” with the pandemic providing a catalyst for changes in job industries, geography, and lifestyle choices.
Another emerging trend has been the retirement of Baby Boomers and the entry into peak earning and spending years for the similarly sized Millennial generation. As the large Baby Boom generation ages, demands for health care will increase with jobs migrating from manufacturing to health care. Over the past twenty years, jobs in health care have grown from 11.8 million to 16.7 million while manufacturing jobs declined from 14.6 million to 13.0 million.
Another labor market theory is that job availability drives participation rates. As a field becomes popular, job candidates are likely to acquire the skills needed to participate in areas with rising wages and good working conditions. This theory helps explain some labor pattern shifts as workers used the pandemic to reset or switch careers. Clearly, emerging trends will influence labor participation and wage gain differentials across sectors.
Overall, the labor market remains quite strong and by most metrics has exceeded 2019.
The Consumer
The job market has supported strong consumer spending which has, in turn, buoyed the overall economy. We expect that trend to continue, though gains will slow. Data from credit card vendors and mobility trends suggest a slight downshift in consumer spending, though the data is notoriously noisy and the changes are relatively modest. Similarly, credit card delinquencies have crept up just a touch, to 1.11% vs. 0.79% in June of 2022. They are still well below a normal range of 1.5% to 2.5% and a high of nearly 6% during the 2008–2009 financial crisis. We expect the consumer to remain a stabilizing force in the U.S. economy.
Global Economy: Back to the Future?
Looking further ahead, we see interesting similarities between the late 1980s to 1990s and today. Stress in the banking sector has led to a lethargic economic outlook, and the geopolitical situation also has some similarities. China has replaced the rivalry from Russia’s military and Japan’s economic might. Geopolitical stress over the role of China’s military in the world has not yet hit levels of the U.S.-Russian Cold War, though tension is building. In the early 1990s, Japan represented over 18% of global GDP, equal to China’s level today.
Often, global rivalry drives innovation. Investors had plenty to worry about in the late 1980s: bank failures, potential nuclear war, the market crash of 1987, and fear of the U.S. economy being surpassed and constrained by Japan’s economic might. Yet in the years that followed, the economy grew and investors were rewarded. One of the most critical elements of success was American innovation in technology.
Today, the United States retains a lead in cutting-edge technologies and has made some impressive strides in Artificial Intelligence (“AI”) in recent months. A combination of AI and the use of robotics has the potential to equalize the cost of production around the globe, allowing the United States to re-shore manufacturing at an accelerating pace.
Our long-term view is for a 2% economic growth rate, formed by assessing the slow pace of population growth and current productivity gains. In the near term, a drag from bank lending could take growth toward the zero line. Longer term gains driven by technological advances and fueled by global rivalries are quite possible.
Outlook
Markets are increasingly on edge. One example is the MOVE index of bond volatility, currently at a level of 122.69, matched only by the crises of the early 2000s, the Global Financial Crisis, and the early days of COVID.
The edginess is a rational response, as major indicators could break in either direction. With a multitude of challenges and crosscurrents, the short-term outlook is decidedly undecided, rather than either bullish or bearish. Earnings gains are likely to be lackluster, especially if financial services companies struggle. Therefore, we expect flat earnings for 2023.
Progress on inflation is likely to be slow, though we expect interest rates to stabilize around current levels and for bonds to maintain current yields. These economic improvements should slightly boost equity valuations over the course of the year.
Absent any worse news from banks, we expect the wall of worry to be slowly climbed as the year progresses.
So, while inflation is stubbornly persistent and the economy continues to plod along, we expect a fight to the finish but a rather unexciting conclusion. Inflation will continue to fade, and the economy will see a few quarters of slow or slightly negative growth before returning to trend growth of around 2%. Amidst numerous factors affecting inflation, the economy, and geopolitics, we are optimistic over the long term as innovation will continue to drive the U.S. economy’s progress.
This communication contains the personal opinions, as of the date set forth herein, about the securities, investments and/or economic subjects discussed by Mr. Teeter. No part of Mr. Teeter’s compensation was, is or will be related to any specific views contained in these materials. This communication is intended for information purposes only and does not recommend or solicit the purchase or sale of specific securities or investment services. Readers should not infer or assume that any securities, sectors or markets described were or will be profitable or are appropriate to meet the objectives, situation or needs of a particular individual or family, as the implementation of any financial strategy should only be made after consultation with your attorney, tax advisor and investment advisor. All material presented is compiled from sources believed to be reliable, but accuracy or completeness cannot be guaranteed. © Silvercrest Asset Management Group LLC
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