By: Stash Graham
Asset prices were remarkably resilient when facing the worst reported corporate earnings quality in 30 years and a teetering banking system. In the largest discrepancy since 1990, $1.00 of reported profits were matched by only $0.88 of cash inflow. This is not an indicator of bad management behavior but said earnings might not accurately display the entire financial state. Regardless of accounting treatment, the three major domestic indices generated headline gains as the S&P 500 rose +2.8%. The tech-heavy NASDAQ Composite increased by more than +6%. Precious metal, gold, was the big winner appreciating +8.5%.
While the first few days of March brought us headlines of a hawkish Federal Reserve Chairman visiting Capitol Hill, the rest of the month showed a Federal Reserve working with the U.S. Department of Treasury to try and stave off a banking system collapse. While the underlying issues plaguing the banking system are still not settled, the level of deposit outflow from banks has steadied. As mentioned to me by a publicly traded bank CEO, ‘as long as someone can make a couple of mouse clicks from their couch, they will be able to move money out of banks easily.’ Several issues are hurting banks right now. The one persistent issue starting a year ago has been the deposit outflows from banks seeking higher rates of return in other safe vehicles like government money market accounts. Over the last few months, we have seen a historical rise in the amount of cash moved into money market accounts like our Fidelity Government Cash Reserve Money Market Fund, yielding a 7-day rate of 4.52%. Intuitively this move makes sense. Why keep money in a bank account paying 0.1% when you can make 45 times that rate by sitting in a money market account? You would be leaving a lot of money on the table. As inflation continues to be a pressing household issue, people are becoming more aware of these easy dollars to be made and make the necessary changes with the clicks of the computer mouse.
The fall in bank deposits led to tighter financial conditions for which banks needed to figure out how to balance their assets and liabilities. Unfortunately for most banks, the assets they hold have very material unrealized capital losses. When the deposit run occurred at Silicon Valley bank, they were forced to realize these losses when they sold those assets, thus wiping out the equity in the bank. The regulators and authorities then sprung into action to create a wide range of steps needed to stabilize confidence in the banking system. These actions range from deposit guarantees to newly created collateralized credit programs for banks. While these actions stymied a severe surge in deposit departures, serious issues should arise. The main problem in the coming months will be a lack of access to affordable debt that the economy and financial markets have operated in the last 12 years. Per the Federal Reserve regional bank surveys, loan officers have increased lending standards for at least the previous few quarters before the banking system shock. The recent developments of the last couple of weeks will only exacerbate loan officers’ needs to tighten lending standards further and make credit harder to obtain. The higher lending standards in coming months will not necessarily be at the loan officer’s discretion but at the will of a bank’s balance sheet. This development is significant to emphasize, as credit is the blood of our domestic economy.
All of this is occurring when demand for loans has also been falling. Borrowers do not want to pay excessively high-interest rates as it makes purchases and investments uneconomical. To make matters even more complicated, our model of leading economic indicators (LEIs) continues to move lower. Yet considering all of these adverse developments, financial assets were positive, and people continued to put new capital into markets. The overall laissez faire attitude stems from the fact that coincident economic indicators continue to show slight positive momentum. An abnormally strong labor market roots this marginally positive month-over-month growth. Unfortunately, we are starting to witness cracks in the labor market. We have mentioned the longer negative trend in the decline of temporary workers hired and the number of hours worked during a week. Both are leading indicators. Now they are joined by a more immediate leading indicator, WARN notices. Large companies file WARN notices to inform the state they operate in about upcoming significant layoffs. Each state has a different standard, but the consensus is that companies need to file a WARN notice at least 60 days before a mass firing without incurring penalties. In the last two months, we have noticed a significant uptick in WARN notices. As such, we estimate a material rise in initial jobless claims, continuing jobless claims, and the lagging, Unemployment Rate over the next 90 days. The decline in the strongest coincident economic indicator of the last year, employment, could start the next move lower in the stock market.