Last week was an eventful one.
Heading into the week, the FOMC rate decision on Wednesday looked like it would be the week’s biggest market-moving event. It turned out to be a relatively mild affair, however, ultimately overshadowed by the ongoing bank crisis and the mixed messages by officials on how the crisis would be handled.
The week got off to a rocky start last Sunday evening when the Swiss National Bank announced the forced takeover of Credit Suisse (CS) by Union Bank of Switzerland (UBS).
Unlike the initial ebullient reaction two Sundays ago when the FDIC announced all depositors, insured and uninsured, in SVB would be protected, this time around the futures markets sold off significantly from Sunday night into Monday morning (perhaps roiled by the fact some CS bondholders would be wiped out before equity holders).
By 3 a.m. ET Monday morning, however, the selling magically stopped and the S&P 500 futures proceeded to rally almost 4% in a straight line from Monday morning until Wednesday afternoon’s FOMC announcement.
While the market was expecting the Fed to raise rates by 25 basis points, the rationale for that rate hike was not that it would be appropriate from a policy standpoint, but rather if the Fed did not raise rates, it might panic the market (“What does the Fed know that we don’t?”).
Consequently, the Fed did raise rates by 25 basis points, but the Fed’s statement and Chairman Powell’s press conference were about as dovish as could be with inflation still (seemingly) on the high side (“seemingly” because we don’t yet know what effect the bank crisis will have on the near-term inflation numbers).
Powell opened his press conference by stating history has shown bank crises can lead to bad outcomes for the economy. As a result, the Fed’s first priority is to stabilize the banks. He also said depositors should assume their deposits are safe.
Further, he said the bank crisis will have the same effect on the economy as one or two Fed rate hikes, and thus the Fed will likely not have to raise rates as high as it had initially thought.
The equity markets responded favorably to Powell’s comments with the S&P 500 futures reaching as high as 4077 shortly after the start of his press conference (compared to a Monday morning low of 3898).
But then, near the end of Powell’s presser, the market turned on a dime and sold off more than 2.5% to finish at its intraday low.
Pundits attributed the market’s reaction to a comment made by Treasury Secretary Janet Yellen, who was testifying before Congress on the bank crisis at roughly the same time Powell was speaking.
She said the Treasury Department and the FDIC were not working on expanding deposit insurance—a statement in direct conflict with Powell’s assertion that all depositors should assume their deposits are safe.
Yellen retracted her statement on Thursday and the market attempted to rebound but ultimately finished flat.
On Friday, more bank concerns surfaced–this time regarding Deutsche Bank–but nobody, including the most plugged in people on Wall Street, seemed to understand why.
By Friday morning S&P 500 futures were down 3% from their post-FOMC high.
Secretary Yellen, perhaps feeling the heat, convened an emergency meeting to discuss the bank situation. (The NYPost ran an article Friday quoting unnamed White House insiders as saying the President has been unhappy with Yellen’s handling of the crisis.)
Whether Yellen’s emergency meeting was the catalyst or not, the S&P 500 rallied all day Friday and finished the week up 1.5% (following up on last week’s 1.5% gain). The Nasdaq 100 gained 2% for the week, as it reclaimed its early February highs.
So, where do we stand? How severe is the bank crisis? Are we out of the woods?
On the one hand, regional bank stocks remains severely depressed, down 33% from their 2023 high (reached in early February); financial media present a continuous stream of negative news; and certain banking sector analysts have raised the alarm that if the Fed doesn’t cut rates immediately, we will be faced with a banking catastrophe.
Comparisons to 2008 are rife. And depositors are still removing money from small banks in search of either the safety of bigger banks or the higher yields available from money market funds.
On the other hand, the S&P 500 is up 3% since SVB collapsed. The Nasdaq 100 is up 8%.
Long-term Treasury bond yields, whose increase during 2022 contributed to the current crisis, have come down substantially (thus easing the unrealized losses on banks’ balance sheets).
And several prominent frontline veterans of 2008 have said the current bank situation is nowhere near comparable to the conditions of the Great Financial Crisis.
The Bull Case
The bull case for equities relies on sentiment and positioning, favorable seasonality, and the belief that the Fed, Treasury, and White House will act to prevent things from going from bad to worse:
Amidst the fear and confusion of the past two weeks, institutions have stepped up their buying, as speculators and retail investors have sold. Institutions now have their highest net long position since the fall of last year (right before the market bottomed).
What may be more telling, however, is that bank insiders have begun buying their own shares. According to the research firm Sentimentrader, “...the recent action of financial company corporate insiders is quite compelling.”
Market sentiment is depressed and hedge funds have extreme short positions–conditions that leave the market vulnerable to a violent short squeeze.
We are about to enter a seasonally strong period for equities.
The Fed indicated bank stability is a priority. The White House and Treasury also seek bank stability. Thus, in a pinch, those institutions are likely to provide the necessary liquidity to head off a catastrophe.
The Bear Case
The bear case for equities is wide ranging. It rests on continued uncertainty in the banking sector, the likely contraction of credit that will result, the ongoing meltdown in commercial real estate, and declining forward earnings.
It’s possible the market will continue to put pressure on officials to back up their soothing words with concrete actions (such as forcing some resolution with respect to a guarantee for all deposits)–the only way to apply such pressure is for the market to continue selling off.
As small banks supply a majority of the credit to the economy and they are currently on their back foot, reeling from deposit flight, it’s a certainty they will reduce the amount of money they lend. What effect this will have on the economy remains to be seen.
Commercial real estate loans are losing value on account of low occupancy rates, as the widespread adoption of work-from-home policies continues. Small banks have big exposure to these loans and this may prolong the pain in the banking sector.
While the daily and weekly gyrations of the market have been unsettling, our view remains unchanged: Equities are likely to see higher values first, given the state of investor positioning (with retail investors bearish and institutions bullish).
The 2-year Treasury yield made some of the biggest moves in its entire history the past couple weeks and equity markets remained largely unscathed. In prior instances of such large 2-year yield moves, equities melted down (e.g., October 1987, 9/11, March 2020). We believe the current state of investor positioning is a big reason for the market’s resilience.
The market is higher since the SVB collapse despite the banking index being near its lows. Any positive catalyst for the banks–and the fact bank insiders are buying their own shares suggests one may be on tap–might set off a ferocious short squeeze and lift the market even more.
Thus, we favor continued upside. Nothing is a certainty, however. Consequently, we will be watching the dollar—as the dollar goes, so go risk assets. Right now positioning is still bearish on the dollar, but smart money has begun buying it again (though not nearly enough to flip the positioning bullish).
If that trend were to continue, it would suggest either things are really bad for the economy or the bank crisis went away on its own and the Fed is once again focused on higher rates for longer. Neither would likely be good for equities. Let’s see how it plays out.
There were no changes to Allio’s portfolio this week. We continue to position strategically for an inflationary secular bear market–with our portfolio tilted toward energy, commodities, and gold.
And from a tactical perspective, we continue to favor the Nasdaq 100 (QQQ) as a means to capture any intermediate-term upside in equities.