Not out of the woods

The U.S. equity market has held up reasonably well recently – all things considered.

It has digested serious regional banking system problems, further erosion in corporate earnings estimates, more Fed rate hikes, and mixed-to-deteriorating economic data.

The S&P 500 is toward the top end of its wide, year-long trading range. It’s up 7.8 percent year to date as of Wednesday’s close.

The market has responded positively to the decline in inflation from the highest level in 40 years and to better-than-feared corporate earnings data. Market participants’ perception that the Fed has likely reached the end of its aggressive rate hike campaign has helped hold up share prices. Technology stocks have done a lot of the heavy lifting.

There are, however, three lingering risks we think investors should keep in mind, as they could generate volatility in the coming months during the time of year when market performace tends to soften. Historically, the S&P 500 and other major markets have typically underperformed from May through October.

Regional banking system stress persists

News that JPMorgan Chase acquired a substantial majority of First Republic Bank’s assets did not bring relief for U.S. bank equities. As of midday trading on Thursday, the S&P 500 Regional Banks Index has declined almost six percent since the deal was announced on May 1.

We think First Republic’s problems, combined with the Federal Deposit Insurance Corporation’s lack of action to temporarily guarantee larger uninsured deposits, led some hedge funds to search for what they perceive to be the next regional bank victim(s). Short selling has added pressure on select bank stocks with deposit outflow vulnerabilities, in our view. As these stocks took another downward turn recently, this weighed further on bank equities overall.

Uncertainties and concerns about the potential for higher deposit insurance and regulatory costs have brought additional headwinds to bank stocks.

And the fact that all of this is unfolding amid the normal process of banks tightening lending standards due to weak economic trends hasn’t helped matters. Bank stocks may not be factoring in the possibilities of a full-blown credit crunch, commercial real estate problems, or a recession just yet.

If additional banks succumb to deposit outflow and funding pressures, we think federal financial authorities have the tools to deal with the problems. But in the interim, any further negative news about specific regional banks would likely continue to weigh on bank stocks as a whole and could pressure the S&P 500 and other major indexes.

The debt ceiling debate could get messy

Equity market reaction to previous debt ceiling debates has varied.

A study by RBC Capital Markets shows that when there was not much drama in financial markets generally and when the debt ceiling political risks were relatively muted, S&P 500 declines associated with debt ceiling deadlines were modest, in the two percent to seven percent range.

However, the market had more difficulty coping with debt ceiling risks when angst in financial markets was already high for economic and various other reasons, and when political drama associated with raising the debt ceiling was also high. According to RBC Capital Markets, S&P 500 declines ranged from 10 percent to 19 percent during such periods.

2011 was the most acute episode when the S&P 500 dropped 19 percent. The political clash in Washington over the debt ceiling resulted in a near crisis. While a debt default was ultimately averted, the political resolution came late and the missteps resulted in the downgrade of the U.S. credit rating. During this period, fear regarding the European sovereign debt crisis was also high.

This go-around, we can’t rule out an outsized negative equity market reaction if the debt ceiling clash comes down to the wire. There are high partisan tensions in Washington and major disagreements about how to raise the debt limit. This comes at a time when the market is also grappling with banking system stress and recession risks. (For additional thoughts, see the article, “The rocky road for debt ceiling negotiations.”)

A recession looks more likely

Our U.S. leading economic indicators continue to point toward a domestic recession starting in the second half of the year, possibly in the summer. Three of our seven indicators have been pointing in this direction for months, and two started flashing yellow caution signals recently.

RBC Economics just revised its U.S. Real GDP growth estimates lower, and now forecasts three successive negative quarters instead of two. It anticipates GDP growth will fall 0.8 percent in Q2, 2.5 percent in Q3, and 0.5 percent in Q4.

If (or when) economic data deteriorate further, the market’s path could be bumpy again. For market participants to contemplate a recession – like they have for many months – is one thing, but to actually see economic weakness revealed in the data is quite another.

There are two silver linings

Due to these lingering headwinds, we think the risk-reward outlook for the market is more challenging over the near term, and the S&P 500 is vulnerable to additional volatility and downside.

But it’s important to keep two things in mind: (1) The S&P 500 typically bottoms well before economic conditions improve, and often when headlines and investor sentiment are still rather negative, and (2) A shift in Fed policy could support the market over time.

Historical data show there has often been downside risk to the S&P 500 right before the Fed paused its rate hike cycle, but gains typically occurred in the months afterward, as shown in the top table. We think last week’s Fed rate hike, which lifted the fed funds rate to 5.25 percent, will be the last increase of its aggressive hiking campaign.

Historical U.S. market performance when Fed policy shifts

Before and after the final rate hike in a Fed tightening cycle: Downside risk right before the Fed pauses, but typically gains afterward

Before and after first rate cut in a Fed loosening cycle: Stocks typically rise, including at an above-average rate 6 months later

Source – RBC Capital Markets U.S. Equity Strategy, Bloomberg; periods of positive performance shaded in green, periods with negative performance shaded in red

In the periods before and after the Fed’s first rate cut, stocks typically rose, including at an above-average rate three and six months later, as the lower table illustrates. We think it’s possible the Fed will start to cut rates later this year, especially if a recession occurs.

These factors support our view that investors with long investment time horizons should maintain long-term strategic asset allocations.