2023-03-13 12:46:19 ET
Summary
- The collapse of SVB Financial Group was not a "Lehman moment."
- The fiasco's effect of damaging market confidence may be enough to keep the Fed from hiking rates at the next FOMC.
- Stocks have more upside as macro conditions remain resilient.
There's never a dull moment on Wall Street and that's why we love it. The latest is the stunning weekend developments in the collapse of SVB Financial Group ( SIVB ), with regulators ensuring all depositors will be made whole . Signature Bank ( SBNY ) was also proactively shut down.
The big takeaway here is that all banks have this apparent implicit guarantee. "Your money is safe in a U.S. bank." So any images of a bank run with people lining up to pull cash, or investors betting that another bank is set to fail are simply unjustified in our opinion. Compared to that extreme fear, we expect stocks and risk assets to rebound from here.
As it relates to SVB and SBNY, the equity and bondholders get wiped out, but the guarantee is that customers including corporate depositors will have immediate access to their funds. This allows companies to make payroll and fund other bills, averting a domino effect of apocalyptic repercussions.
The move by the Treasury Department and Fed to set up a Bank Term Funding Program ((BTFP)), providing additional market liquidity through an Exchange Stabilization Fund, is intended to shut the door on contagion fears by restoring confidence in the system.
At the same time, some mixed signals have created a separate set of challenges, with the market otherwise skeptical of the "all clear sign." The concern of some is that the BFTP may not be big enough, with some questioning the underlying stability of the entire financial system.
The New Fed Pivot
Bonds and short-term notes have surged based on both a flight to safety and the new expectation that the Fed is set to hold off on further rate hikes. According to the CME " FedWatch Tool " which quantifies the market-implied expectation for the direction of Fed policy, rate futures now suggest the Fed may hike just 25bps or at all in the upcoming March 22nd FOMC. That's also a view shared by the economics team at Goldman Sachs Group ( GS ) penciling in a "no change" in the Fed Funds rate. This is a major reversal compared to the consensus for a 50 basis point increase just last week.
The explanation here is that a "pause" may balance a lingering perception of financial system stress. By this measure, if voting members were on the fence between a 50bps hike or a 25bps hike at the upcoming Fed meeting, a new sense of caution may be just enough for a wait-and-see approach, at least through this meeting.
More nefarious is another interpretation by some that the financial system is indeed broken with economic conditions deteriorating rapidly, which will force the Fed to abandon its inflation fight and eventually cut. We see this view as ungrounded considering economic conditions remain resilient.
So the question becomes how big of a problem is inflation relative to financial conditions and economic activity; which of these three dynamics represents a bigger risk?
Bears Need to Reconcile A Contradiction
So here is where we start getting into an apparent contradiction that may be exposing holes in the bearish case for stocks extrapolating the current volatility as the start of a bigger move lower. We post:
- How is the economy "collapsing" while inflation "re-accelerates" higher at the same time?
If economic conditions are as poor as the bears and doom-and-gloomers want to believe, then naturally inflation should not be a problem, based on a looming deflationary demand drag.
Here the Fed could just sit back and watch the CPI trend sharply lower over the next several months- assuming that a long-awaited recession with surging unemployment finally materializes. Significantly higher rates may be unnecessary.
On the other hand, if the economy is indeed "stronger than expected," as was the battle cry just last week, that momentum should work to keep the wheels of corporate earnings moving, with companies well-positioned to outperform a low bar of EPS expectations.
This is a net positive compared to lingering inflationary pressures. Also consider that with long bond yields, the economy has limited one of its biggest headwinds from the past year. Approaching the end of Q1, there's a good case to be made that S&P 500 companies had a strong quarter.
So what we have here is a current stock market weakness based on an overriding air of pessimism that the economy is falling apart and is concerned that inflation is still running out of control. If neither of those two is correct, stocks and risk assets should have room to reprice higher.
Soft Landing Still in Play
The way we see it playing out is that the "soft landing" scenario is still on track, meaning inflation will trend lower while the economy avoids a deep recession. This can work regardless of the Fed's decision on March 22nd or even what the February CPI print comes out to.
The combination of the rate hikes already in place alongside the possibility that the SVB event added a layer of pessimism to the economy should be enough to tap the breaks on inflationary pressures.
In terms of the upcoming CPI, the current consensus is for a headline rate of 6%, down from 6.4% in January. While still well off from the mythical target rate of 2%, a path to approach 4% by the end of the year would help reset the narrative that inflation is "out of control." There is nothing to suggest this downward trend that has been in place since June last year is going to suddenly reverse higher. We can start thinking about the March CPI which should likely continue the decline.
We were previously anticipating one or two more 25bps hikes, but the move by the Fed to simply pause now as a first step in a "pivot" is good news for stocks and financial conditions.
What's Next
In our last note this weekend we suggested the SVB fiasco would blow over and ultimately set up a rebound in risk assets. In our opinion, a "real" stock market crash still needs to see a deterioration in the real economy in terms of the labor market or consumer spending. We haven't seen that. The February jobs report supports the view that the U.S. economy remains solid.
Our base case is that the market begins to recognize that the collapse of SVB was based on company-specific or "idiosyncratic" factors, not some cataclysmic credit event. The case with SBNY is simply that the bank was a casualty of the situation as the next closest proxy to SVB by investors. With a bank run driven by a self-fulling prophecy, the confidence here is that the Fed's new stabilization program specifically addresses the concerns regarding systemic risk.
The chart that tells the whole story comes down to credit spreads which remain at historically low levels. As desperate as bears are for stocks to re-test the lows of 2022, we believe that move would require a blowout in credit spreads implying companies are facing a higher risk of default based on sharply weaker operating and financial conditions. We don't see that here.
What about Stocks?
Anyone expecting the current situation to be a kickstart of a new financial crisis must contend with new financial market tailwinds being lower rates and a backdrop of still resilient economic conditions. The setup would be for a "bear trap" with doom-and-gloomers betting on a big move lower in stocks and ending up on the wrong side of the trade as the dust settles.
This wouldn't be the first time that conditions have evolved more favorably. Keep in mind that the same group has been calling for surging unemployment, sharply lower corporate earnings, crashing economic activity, and higher rates as a pretext for stocks to move lower going back to levels in the S&P 500 last May and June. They may end up wrong again.
With the SBV field selloff marking a low in the SPX at $3,839, that level now works as an important area of support the market will need to hold from here on out. The 2022 market low technically under $3,500 is still a far way out and is far from certain we will rest that level in this cycle.
To the upside, a climb above $4,000 would place the February market high of around $4,200 back in sight as the next target. We also believe valuations are attractive reinforced by the new equity risk premium from the lower bond yields.
If anything, the abundance of headlines with many complexities and moving parts are what can continue adding to volatility. The sense is that there is a lot of conflicting information out there. The risk here is that we do end up getting those sharply weaker economic activity indicators that some have been predicting since this time last year. Monitoring points include retail sales and labor market data while noting the balancing act of those trends implies inflationary pressures.
In terms of the CPI, it would take a very improbable resurgence higher of monthly inflation to really begin undermining the disinflationary outlook from here. Some sort of supply-side shock including through higher commodity and energy prices would be the most concerning.
In conclusion, our view that inflation is dead, and the Fed is done, can lift the market higher. There are plenty of reasons to remain bullish on stocks.
For further details see:
The Big Contradiction That Sets Up A Bear Trap In Stocks