Markets continue to be whipsawed by a conflicting backdrop of Federal Reserve policy and rising concerns about the durability of the banking sector. Though the S&P 500 eked out a slight gain for the week, anxiety is high and intraday movements have been significant. Market participants are struggling for conviction as they weigh the potential end of rate hikes against the probability of recession. Fed Funds rate increases, totaling 475 basis points over the last 12 months, have lowered the trajectory of inflation. However, we may just now be seeing a glimpse of the toll it’s had on the economy. At a minimum, stress on the financial system will likely result in tighter lending standards and less money in consumers’ pockets. We expect these developments to usher in late-cycle conditions, pushing the U.S. closer to recession.
In the wake of Silicon Valley Bank’s collapse, Fed, Treasury, and FDIC officials have coordinated a policy response aimed at preventing further runs on regional and community banks. Vulnerable banks have been using the newly created Bank Term Funding Program — an emergency lending program that gives eligible banks a liquidity backstop — and easier access to the Fed's Discount Window to shore up their capital base. Still, deposits are being pulled from the system and credit tightening is looking inevitable. To date, spending has held up because consumers are working and have had access to credit. This could change if banks begin to pull back their credit lines. For stocks, this is important because earnings estimates still do not reflect a typical recessionary environment. A downward adjustment to estimates represents a key risk for the market.
At the same time, with inflation slowing down and natural tightening in credit, the Federal Reserve appears to be nearing the end of its rate hiking cycle. Treasury bond yields have fallen across the curve, taking pressure off stocks with values heavily based on future earnings potential. Growth stocks hit hardest in 2022 have held up best over recent weeks. However, history cautions against being overly bullish when the Fed Funds rate is ultimately cut. The average performance of the S&P 500 from the first rate cut to the market low is -23.5%.
With this in mind, we continue to prioritize balance sheet quality and management execution. We want to hold companies with ample liquidity and the ability to follow through on their growth initiatives regardless of the broader economy’s position. In short, we are looking for good soil in stormy weather.
Preston May, CBE®
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S&P 500: Standard & Poor’s (S&P) 500 Index. The S&P 500 Index is an unmanaged, capitalization-weighted index designed to measure the performance of the broad U.S. economy through changes in the aggregate market value of 500 stocks representing all major industries.