{"id":2672,"date":"2023-03-16T19:00:00","date_gmt":"2023-03-17T00:00:00","guid":{"rendered":"https:\/\/www.rbcwealthmanagement.com\/en-ca\/insights\/could-struggling-banks-drag-down-the-economy\/"},"modified":"2024-02-05T09:08:42","modified_gmt":"2024-02-05T14:08:42","slug":"could-struggling-banks-drag-down-the-economy","status":"publish","type":"post","link":"https:\/\/www.rbcwealthmanagement.com\/en-ca\/insights\/could-struggling-banks-drag-down-the-economy","title":{"rendered":"Could struggling banks drag down the economy?"},"content":{"rendered":"\n

When an extreme event impacts the financial system or a major economy\u2014like the collapse of SVB Financial<\/a>, which has jolted the U.S. regional banking system and weighed on equity markets worldwide\u2014it usually takes markets more than just a few days to work through it. Knock-on effects and volatility can occur over weeks or months. <\/p>\n\n\n\n

An example of an early knock-on effect during this period is the turmoil at Swiss financial institution Credit Suisse, a major global bank and investment firm. <\/p>\n\n\n\n

Some of the internal problems at Credit Suisse have been known by market participants for a long time, as evidenced by the fact that its equity shares have been under pressure since early 2021, and especially in the past year. After stress in the U.S. regional banking system surfaced and shook many bank stocks and bonds in the U.S. and Europe, the situation at Credit Suisse deteriorated more, triggering a further selloff in bank stocks and equity markets worldwide. Questions about Credit Suisse\u2019s viability became so acute that on Wednesday Switzerland\u2019s central bank pledged to provide liquidity if needed, and subsequently granted the firm a roughly US$54 billion line of credit. <\/p>\n\n\n\n

Until this period of stress on the U.S. and global financial systems passes, we can\u2019t rule out more knock-on effects\u2014perhaps in other European or U.S. financial institutions, or among global hedge funds. <\/p>\n\n\n\n

While central banks, financial regulators, and government agencies have shown they are ready to respond quickly to additional problems, there could be more equity market volatility or downside if other pressures surface. <\/p>\n\n\n\n

This didn\u2019t happen overnight<\/h2>\n\n\n\n

What are the causes of the current financial system stress?<\/p>\n\n\n\n

In our view, bad decisions by management teams and corporate boards of troubled firms are one obvious cause. The role of lax and\/or inappropriate financial industry regulatory standards and missteps by regulators, along with related misguided decisions by lawmakers, should not be understated either. <\/p>\n\n\n\n

While management decisions and regulatory shortcomings are important factors, we can\u2019t give the Federal Reserve\u2019s monetary policymakers a pass. <\/p>\n\n\n\n

During the COVID-19 crisis, the Fed flooded the U.S. financial system (and thereby the global financial system) with liquidity by cutting its already-low overnight interest rate from 1.75 percent to 0.25 percent and more than doubling the assets on its balance sheet through quantitative easing. This happened at the same time the U.S. federal government was handing out trillions of dollars to support the economy. <\/p>\n\n\n\n

Then, when the pandemic had passed and inflation was starting to heat up, the Fed shifted policy in the opposite direction, embarking on an unprecedented campaign of interest rate hikes. In just the past year, the Fed has raised its benchmark rate from 0.25 percent to 4.75 percent, the highest level since 2007. It has also trimmed the assets on its balance sheet by about seven percent through quantitative tightening. <\/p>\n\n\n\n

According to RBC Capital Markets, LLC\u2019s Chief U.S. Economist Tom Porcelli, the tightening cycle wouldn\u2019t have needed to be so aggressive had the Fed started raising rates earlier, when inflation warning signs first emerged, and then backed off when inflation data began to improve recently. <\/p>\n\n\n\n

Following the Fed\u2019s aggressive moves and the associated extreme volatility in the Treasury market, outsized unrealized losses now sit in financial institutions\u2019 bond portfolios. This has been challenging for some less-liquid regional banks to navigate, although the situation has improved since the Fed, U.S. Treasury, and FDIC implemented their emergency measures last Sunday. <\/p>\n\n\n\n

In our view, the fallout from all of this could force the Fed to pause its rate hike cycle and quantitative tightening sooner rather than later, despite the fact there are not yet clear signs of when inflation will decline to the central bank\u2019s two percent target. The Fed\u2019s upcoming policy announcement and Chair Jerome Powell\u2019s press conference on March 22 could be the most anticipated in years. <\/p>\n\n\n\n

Economic activity could take a hit<\/h2>\n\n\n\n

We think the financial system stress and its knock-on effects mean a U.S. recession is now more likely, and the timing of the economic contraction could be pulled forward. <\/p>\n\n\n\n

We have been warning of elevated recession risks for a number of months, given that three of the seven leading economic indicators in our U.S. Recession Scorecard have been flashing red, and two others are moving in that direction. <\/p>\n\n\n\n

With just two exceptions, every U.S. recession for more than a hundred years has been triggered by the arrival of tight monetary conditions in the form of prohibitively high interest rates (which the regional bank stress is signaling has already occurred) and aggressive tightening of lending standards by banks (which could be imminent, given the mounting pressures within the system). <\/p>\n\n\n\n

Now that investor sentiment has been dented, we anticipate the households that are most flush with cash could become more cautious about spending. This, combined with tighter lending standards that affect both households and businesses, should weigh on economic activity. <\/p>\n\n\n\n

The market looks down the road<\/h2>\n\n\n\n

But even if a recession begins sometime this year, we believe the market has already gone a long way toward pricing it in ahead of time\u2014as it usually does. The S&P 500 is down 19 percent from its all-time high in early 2022. In the past 13 recessions, the market declined 31.8 percent from peak to trough, on average. <\/p>\n\n\n\n

Long-term investors should also note that the equity market tends to bottom before recessions end. This occurred in 12 of the last 13 recessions since the late 1930s. Of those 12 periods, the S&P 500 Index reached its low point 4.8 months before the economic clouds lifted, on average. <\/p>\n\n\n\n

U.S. equity market behaviour during recessions<\/h3>\n\n\n\n
\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n
Recession dates<\/th>\n Recession length (months) <\/th>\n Did the S&P 500 bottom before the recession ended? <\/th>\n No. of months from market bottom to end of recession <\/th>\n<\/tr>\n<\/thead>\n
May 1937 \u2013 June 1938<\/td>\n14<\/td>\nYes<\/td>\n3.0<\/td>\n<\/tr>\n
Nov. 1948 \u2013 Oct. 1949<\/td>\n12<\/td>\nYes<\/td>\n5.1<\/td>\n<\/tr>\n
July 1953 \u2013 May 1954<\/td>\n11<\/td>\nYes<\/td>\n9.1<\/td>\n<\/tr>\n
Aug. 1957 \u2013 April 1958<\/td>\n9<\/td>\nYes<\/td>\n5.0<\/td>\n<\/tr>\n
April 1960 \u2013 Feb. 1961<\/td>\n11<\/td>\nYes<\/td>\n4.0<\/td>\n<\/tr>\n
Dec. 1969 \u2013 Nov. 1970<\/td>\n12<\/td>\nYes<\/td>\n6.1<\/td>\n<\/tr>\n
Nov. 1973 \u2013 March 1975<\/td>\n17<\/td>\nYes<\/td>\n6.1<\/td>\n<\/tr>\n
Jan. 1980 \u2013 July 1980<\/td>\n7<\/td>\nYes<\/td>\n4.1<\/td>\n<\/tr>\n
July 1981 \u2013 Nov. 1982<\/td>\n17<\/td>\nYes<\/td>\n4.1<\/td>\n<\/tr>\n
July 1990 \u2013 March 1991<\/td>\n9<\/td>\nYes<\/td>\n6.1<\/td>\n<\/tr>\n
March 2001 \u2013 Nov. 2001<\/td>\n9<\/td>\nNo<\/td>\nNA*<\/td>\n<\/tr>\n
Dec. 2007 \u2013 June 2009<\/td>\n19<\/td>\nYes<\/td>\n4.1<\/td>\n<\/tr>\n
Feb. 2020 \u2013 April 2020<\/td>\n3<\/td>\nYes<\/td>\n1.0<\/td>\n<\/tr>\n
Average<\/td>\n11.5<\/td>\n\u2014<\/td>\n4.8<\/td>\n<\/tr>\n<\/tbody>\n<\/table><\/div>\n\n\n\n

Notes: The 1945 recession is excluded as there was no clear stock market pullback around it.
*The market didn\u2019t bottom until 10 months after the recession ended; this data is not included in the average calculated for this column. <\/p>\n\n\n\n

Source – RBC Capital Markets U.S. Equity Strategy, Haver Analytics, RBC Wealth Management <\/p>\n\n\n\n

Furthermore, an eventual 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 strong gains typically occurred in the months afterwards. In the periods before and after the Fed\u2019s first rate cut, stocks typically rose, including at an above-average rate six months later. <\/p>\n\n\n\n

Historical U.S. market performance when Fed policy shifts<\/h3>\n\n\n\n

Before and after the final rate hike in a Fed tightening cycle: Downside risk right before the Fed pauses, but typically strong gains afterwards <\/h4>\n\n\n\n
\n\n\n\n\n\n\n\n\n\n
S&P 500 performance
Final Fed rate hike <\/th>\n		 Before final rate hike <\/th>\n After final rate hike <\/th>\n<\/tr>\n
6 months <\/th>\n 3 months <\/th>\n 1 month <\/th>\n 1 month <\/th>\n 3 months <\/th>\n 6 months <\/th>\n<\/tr>\n<\/thead>\n
Median 1970\u20131979<\/td>\n -1.0% <\/td>\n -2.5% <\/td>\n -4.5% <\/td>\n 2.6% <\/td>\n -4.4% <\/td>\n 2.8% <\/td>\n<\/tr>\n
Median 1980\u20131989<\/td>\n 9.0% <\/td>\n 7.3% <\/td>\n -0.5% <\/td>\n 1.2% <\/td>\n 1.4% <\/td>\n 8.0% <\/td>\n<\/tr>\n
Median 1990\u20132018<\/td>\n 2.4% <\/td>\n 2.3% <\/td>\n 1.0% <\/td>\n 0.6% <\/td>\n 7.2% <\/td>\n 13.3% <\/td>\n<\/tr>\n
Median since 1970<\/td>\n 2.9% <\/td>\n 0.5% <\/td>\n -0.7% <\/td>\n 1.0% <\/td>\n 1.7% <\/td>\n 5.9% <\/td>\n<\/tr>\n<\/tbody>\n<\/table><\/div>\n\n\n\n

Before and after first rate cut in a Fed loosening cycle: Stocks typically rise, including at an above-average rate six months later <\/h4>\n\n\n\n
\n\n\n\n\n\n\n\n\n\n
S&P 500 performance
First Fed rate cut <\/th>\n		 Before first rate cut <\/th>\n After first rate cut <\/th>\n<\/tr>\n
6 months <\/th>\n 3 months <\/th>\n 1 month <\/th>\n 1 month <\/th>\n 3 months <\/th>\n 6 months <\/th>\n<\/tr>\n<\/thead>\n
Median 1970\u20131979<\/td>\n 0.1% <\/td>\n -0.1% <\/td>\n -0.2% <\/td>\n 1.2% <\/td>\n 9.6% <\/td>\n 8.5% <\/td>\n<\/tr>\n
Median 1980\u20131989<\/td>\n 7.1% <\/td>\n 4.5% <\/td>\n 1.9% <\/td>\n -0.2% <\/td>\n 7.5% <\/td>\n 10.0% <\/td>\n<\/tr>\n
Median 1990\u20132020<\/td>\n 5.9% <\/td>\n 0.5% <\/td>\n 1.7% <\/td>\n 0.1% <\/td>\n 1.7% <\/td>\n 8.8% <\/td>\n<\/tr>\n
Median since 1970<\/td>\n 5.7% <\/td>\n 1.3% <\/td>\n 1.2% <\/td>\n 0.1% <\/td>\n 4.2% <\/td>\n 9.0% <\/td>\n<\/tr>\n<\/tbody>\n<\/table><\/div>\n\n\n\n

Source – RBC Capital Markets U.S. Equity Strategy, Bloomberg; periods of positive performance shaded in green, periods with negative performance shaded in red <\/p>\n\n\n\n

Although the market remains vulnerable to additional volatility and downside, these historical patterns demonstrate that the U.S. market typically bottoms well before economic conditions improve, and often when headlines and investor sentiment are still rather negative. This supports our view that investors with long investment time horizons should maintain long-term strategic asset allocations during this difficult period. <\/p>\n","protected":false},"excerpt":{"rendered":"

The Silicon Valley Bank collapse brought financial system stresses to the surface. 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