The Storm Clouds Keep Gathering, but Where is the Storm?

Michael Grant

• US economic momentum entering 2023 remains strong as 2022’s negative supply shocks fade.
• Financial markets have rightly concluded that the Fed’s 25 basis point hike in March signals the end of monetary tightening.
• Equity returns will be muted, characterized by a new set of winners and losers as the era of “free money” is not returning anytime soon.

The past quarter was remarkable for a banking crisis that has added momentum to the consensus fear that a US recession is inevitable in 2023.

In contrast, we believe economic resilience will be the surprise in coming quarters as robust balance sheets across the private sector add staying power to the US consumer. Meanwhile, the trajectory of inflation through H2 2023 remains the primary determinant for whether a hard or soft economic landing should be the base case for 2024.

The aftermath of the Silicon Valley Bank (SVB) collapse has convinced many that the lending impulse of US banks will contract materially. Of course, credit plays an important role in economic cycles. Compared with robust growth of 12% in 2022, any projected slowdown in lending will surely be felt. Yet, the SVB crisis may prove less systemic for the business cycle than widely perceived.

As interest rates normalize to higher levels, banks must pay more to their depositors and, thus, net interest margins are being squeezed. Banks are caught between paying more for deposits or watching their deposits flee to higher return vehicles like money market funds. This liquidity turmoil is negative for the franchise value of banks as they lose a key support of the post-2008 era: cheap and plentiful deposits.

However, what matters more for the business cycle is creditworthiness and the availability of credit. This repricing of funding costs should be viewed as a transfer of income from banks to their customers rather than the incentive for banks to stop lending. This is different from the typical credit cycle where banks restrict lending as the creditworthiness (i.e. the balance sheet) of their borrowers deteriorates.

The banking system is repricing its deposit base to account for new competitive pressures. This is far less dangerous than perceptions of credit risk. These two forces are incomparable.

The solution for today’s pressures on net interest margins is for banks to make more loans at today’s higher level of interest rates. Whatever rates must be paid on today’s deposits, that dollar of deposit must eventually be lent at an attractive rate. If the creditworthiness of their customers is healthy (as we believe), today’s shock is likely to be tempered rather than magnified by current business cycle conditions. 

To put this creditworthiness in perspective, the cash balances held by consumers, either in money market funds or directly in banks have surged over the past three years. Balance sheet liquidity measured relative to incomes is at 60-year highs. The same is true for home equity values. Until the employment markets show signs of cracking, the US consumer has critical staying power.

This distinction between a liquidity crisis and a classic credit cycle is visible in the resiliency of BBB credit spreads, which barely budged in March. High yield spreads reacted more severely to recent events but are still below the levels of stress witnessed last June and October. These spreads are the early signal for whether the US economy manages through today’s crisis or becomes more severely impacted.

Our conclusion is that the economic momentum at the start of 2023 remains strong as last year's negative supply shocks fade from the scene. Equally important, the pandemic has produced an improvement in private balance sheets—both consumer and corporate—that has almost certainly reduced the sensitivity of demand to higher interest rates and thus, to the kind of shocks witnessed in March.

Investors are viewing all of this through the prism of Fed policy. The FOMC hike in March was perceived as “dovish” because Chairman Powell acknowledged that the banking crisis would prove disinflationary. In short, Powell’s “hair on fire” policy hikes of the past year are producing the desired result. Financial markets have rightly concluded that this slow-motion pause represents an inflection in monetary policy nonetheless.

Directionally, the banking crisis will add to the disinflationary forces across the US economy, but the order of magnitude is unknown.

Turning to inflation, March data appear to support the narrative of broadening disinflation. Core CPI ex-shelter is below 4% versus more than 10% in Q2 2022. This will decelerate further given recent events. Reconfiguring the core CPI for today’s data around asking rents rather than the Fed’s lagging survey implies the core CPI is already moving near a 3% pace. Disinflation has not unfolded as fast as Chairman Powell would like, but the direction of travel is clear.

Summary

The second and third largest bank failures in US history have come and gone. The first-ever failure of a “global systematically important bank” was fully resolved without a hiccup. And the Federal Reserve again raised its Fed funds rate. If all of this could be absorbed by equity markets, what is the likely outcome when the Fed formally pauses, corporate profits prove resilient through the April reporting season and bank funding stresses gradually recede?

For now, the outlook for equities is largely unaltered. Equities can grind higher, but returns will be muted, characterized by a new set of winners and losers as the era of “free money” is not returning anytime soon. Yes, the earnings cycle is mature, but economic resilience will be the surprise. This implies no imminent recession and no collapse of US profitability. The world is simply not ending in 2023.