We see four reasons why the stock market has punched through the turbulence and give our thoughts on the main risks from here.
March 30, 2023
Vice President, Portfolio AnalystPortfolio Advisory Group – U.S.
If you’d been away on vacation and had left your smartphone behind, you probably wouldn’t even know that markets recently endured the most stressful period since the onset of the COVID-19 crisis in 2020.
Just a couple weeks after the banking system scare on both sides of the Atlantic, the S&P 500 has come back to roughly where it was before the SVB Financial and Credit Suisse crises began, and other key markets have rebounded off their lows as well.
Line chart measuring four key equity indexes from March 8 through March 29 of this year: the S&P 500, Hang Seng, STOXX Europe 600, and Canada’s S&P/TSX. Each index declined right after SVB Financial began to collapse, and have subsequently rebounded. The S&P 500 reached a low point of -3.4%, the Hang Seng -5.2%, the STOXX Europe 600 -5.4%, and the S&P/TSX -4.7%. Each of these indexes have recovered off of their lows. The S&P 500 and Hang Seng are now up slightly, by 0.9% and 0.7%, respectively, since March 8. The STOXX Europe 600 and S&P/TSX are down 2.3% and 2.5%, respectively.
Source – RBC Wealth Management, Bloomberg; data from 3/8/23 – 3/29/23
Why have markets shrugged off financial system stress?
The “powers that be” proved they learned some lessons: U.S. and European financial authorities reacted much more rapidly as SVB and Credit Suisse were collapsing than they did during the onset of the global financial crisis when then-U.S. Treasury Secretary Hank Paulson and then-Fed Chair Ben Bernanke essentially sat on their hands by letting Lehman Brothers fail in 2008, which kicked off a terrible chain reaction worldwide.
Have the authorities’ actions been perfect this time? No, we have already discovered things they could have done better. But we have to give them credit for stopping the bleeding. Importantly, their rapid responses signal that if additional knock-on effects happen at other financial institutions, they stand ready to act again. We think this has supported depositor and investor confidence, and equity markets.
Troubled banks, not a large swath of banks, seem to be using the Fed’s emergency programmes: U.S. financial institutions are primarily accessing two Fed vehicles to plug liquidity holes: the discount window and the new Bank Term Funding Program (BTFP). Funds accessed at the discount window spiked in the first two weeks following the SVB crisis to levels that rivaled those during the global financial crisis in 2008–09, and the BTFP has been used as well, but to a much lesser degree than the discount window.
Importantly, RBC Capital Markets believes the bulk of funds accessed in these programmes has been used to manage liquidity at two of the institutions that failed (SVB and Silvergate Bank) and to assist First Republic Bank, which has acknowledged liquidity challenges. We think this is evidence that the current problems within the U.S. banking system are more idiosyncratic than systemic in nature. Our fixed income colleague summed it up well in his commentary on this topic by saying, “A crisis for a few banks is not a banking crisis.”
The Fed seems set to change course: In our view, SVB’s collapse and related deposit flight at other regional banks sent a loud and clear message to the Fed: an uber-hawkish rate hike posture is no longer tenable because interest rates are prohibitively too high for the regional banking system to bear without significant external support from the Fed itself.
As a result, we think the Fed’s 25 basis point rate hike last week will be either the last or second-to-last one of this rate hike cycle – despite the fact that inflation is currently elevated. RBC Capital Markets anticipates inflation will recede further in coming months, not yet to the Fed’s two percent target, but enough to give the Fed at least some breathing room.
Historically, in the months following a pause in the Fed’s rate hike cycle the S&P 500 has typically traded higher, and in the months following the first rate cut the market has often risen at an above-average rate.
Cooler heads prevailed: Most fund managers and individual investors have been through volatile periods before, including the extreme COVID-19 selloff and subsequent rapid recovery, not to mention the deep global financial crisis selloff in 2008–09, which markets overcame by rallying sustainably for years thereafter. Perhaps long-term investors have learned that it’s generally best not to react hastily to market stress and, at the very least, it’s often prudent to have a “wait-and-see” attitude until conditions settle down.
Of course, just because equity markets have stabilised does not necessarily mean the aftershocks are over.
To gauge the banking system stress, market participants will keep a close eye on funds accessed at the Fed’s discount window and within the BTFP. Another week’s worth of these data will be released in the afternoon on March 30 and each week thereafter.
Bank deposit outflows are also being closely monitored. Fed data indicates that outflows of smaller banks surged to a record level for the week ending March 15. But there are nuances. The largest 25 banks recorded significant deposit inflows. Also, there is evidence a lot of funds shifted from traditional bank savings and checking accounts into money market accounts where they generally fetch higher rates of return. Another week’s worth of Fed deposit data is set to be disclosed on March 31 and more data will follow in subsequent weeks.
The shift from traditional bank deposits to money market accounts is important, in our view. It signals that going forward banks could be under increasing pressure to compete with money market rates and/or to entice large depositors to use in-house money market funds rather than shift deposits into money market funds at other financial institutions. Some large U.S. banks, for example, have just recently introduced new, higher-yielding in-house money market programmes. Ultimately, we think it will be expensive for banks to pay competitive rates on deposits. This may have a number of consequences, including constraining banks’ willingness or ability to lend, and constricting profitability, especially for smaller banks.
Market participants will likely remain on edge until smaller banks’ deposit outflows subside meaningfully, and until the use of the Fed’s emergency liquidity programmes diminish notably. We think this will happen over time.
Moreover, we believe recession risks are more elevated now due to ongoing interest rate-related challenges for banks and the overall economy. We think bank lending standards, which had already begun to tighten before SVB collapsed, will tighten further. Normally this development is a key precursor to a recession.
But even if the economy does indeed succumb to a recession – which we think will happen – this just might be the most telegraphed recession in modern history. Recession risks have been discussed by analysts and economists over and over, including by us, for months. We think a recession already has been at least partially factored into stock prices. This is a key reason why the S&P 500 is down 16.0 percent from its all-time high in early 2022 and had been down even more last autumn.
In the near term, the equity market will likely focus on the degree to which credit tightening will impact economic trends and recession risks, along with the Q1 earnings season that will begin in earnest in mid-April.
We continue to recommend Market Weight exposure to U.S. equities, an allocation that attempts to balance the heightened economic and volatility risks against what we think is already priced into the market.
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