As the cyclicality of expansions and recessions takes on historical patterns (in a broader sense), the individuality of each cycle within these expansions needs to be addressed. Rarely do the unique qualities of the previous recession rear its head in the next one…though patterns can be broadly interpreted as they do have commonalities. In the current economic state, it has very little to do with the synthetic recession that was induced from the pandemic, but the fallout has been exacerbated by that unprecedented stimulus unfurled into the economy and markets. Since that anemic recession did not fulfill what the function of a recession is supposed to do and only exaggerated the situation, we find ourselves in, we must consider that a truer form of a recession has not occurred since the Great Recession ended in the summer of 2009.
We are currently in various forms of panic across different components of our economy. The most top of mind is the failure of several banks and the “shotgun wedding” of Credit Suisse and UBS. The question is multi-faceted when it comes to the contagion risk, support from the system and how much further it could go. First things first, there is, and should be, concern for the market in general on bank runs of any size as it is as much a behavioral issue as it is a fundamental issue. While most investors will recall the global bank run of 2008–2009, past periods of such massive withdrawals of cash have similar patterns. The biggest difference today is the use of mobile devices and technology to implement flows which can leave a bank in dire trouble in very short order. Once this starts, it becomes a self-fulfilling prophecy as more outflows increase banks risks and then more flows result.
We don’t see an environment that is akin to the 2008–2009 period, however, it is more in that the larger banks have bolstered equity ratios and balanced risk out of necessity and regulatory guidelines. The regional banks that have increased deposits over the years, and as we are seeing, did not manage the duration of their portfolios well have now become the primary focus of investors, consumer deposits being moved and as such, regulators. This trend often does not end abruptly and can have periods of calm until other banks have issues.
So, while we don’t see a banking crisis similar to the one 15 years ago, it is prudent to think that there will be more fall out. As such, we need to go back to the playbook of what the secular cycle and economic cycle are telling us now and what may be the most prudent way to play it.
One way to view the difference is a spread analysis on bonds between regional and the bigger banks as Citigroup published. One major point is the Big Six banks have traded at wider spreads to regional banks the majority of the time over the last decade, while currently it is much wider for regional banks. The middle chart reveals the relative spread at historic levels.
With the updated balance sheet of the Federal Reserve last week, we — for all intents and purposes — saw the short-term cancelation of quantitative tightening.
Due to the use of the Bank Term Funding Program, nearly two-thirds of the recent tapering was wiped out with the increase of nearly $400 billion in the balance sheet. As has been pointed out, this two-week move offset nearly six months of unwinding.
An old axiom stands out: “When the central banks aren’t worried, the markets are worried. When the central banks are worried, the markets are worried just a bit less.” The lesson: the markets are always concerned and when the markets aren’t concerned, you should be.
One of the more telling charts is the one showing the rise in money market funds, the Fed’s terminal rate projections and the spread between money market returns and bank deposits. The gap between what investors get in money market funds and what they hold at banks is as large a gap as we have seen and only increases the vulnerability for more flows to shift in the near term.
Source: Fidelity Investments | Past performance is not indicative of future results.
The Federal Reserve, Bank of England, the Swiss National Bank and others raising rates after the increase in bank failures relays the importance of the inflation battle that they have yet to get under control. History has said that they ultimately do this at the cost of an economic recession so the focus on inflation should still be paramount. It should also point out the bond markets are stating the inevitability of a recession with the recent rally in lieu of the terminal rate still holding much higher than their expectations.
The state of the yield curves and historic inversions across the curve have caused massive shifts into Treasuries and money market funds. We now see money market funds standing at its all-time highest level at over $5.1 trillion.
The current state of the economy has more in common with past slowdowns, though we have not seen them in a while. There is a playbook for this in a broad sense and it seems it is more prescient now than ever…even if it is a bit sobering. We have always considered the overall state of the economy and markets in the form of a helix where the core is fundamental economic data points with interest rates and market conditions orbiting around it. Once one of these begin to strip away from the positive feedback loop that exists between them, we must now view the negative feedback loop potential and whether one or two of these are in a corrective phase or a more serious contraction.
The playbook for these periods when inflation is running at an elevated rate and interest rates have risen to meet it, then it is a matter of time when economic stagnation and asset and debt prices need to recalibrate. The question is, to what degree? The answer is that it is different each time and often is a counteraction to some corresponding degree of the run up in prices.
We call it the Four Ps: Peak inflation leads to peak rates, corresponds to economic recessions and then we witness the Pause from the central banks. The pause leads to a Pivot in action and the cutting of interest rates. It’s currently where most investors attribute too much to the markets pricing in the future events in an efficient manner. History has shown that the last two phases require the last P: Patience.
One of most favored sources of research is Strategas who detailed the final sequence of the Four Ps in the following two charts.
What we particularly like about the chart above is the delineating the periods of elevated inflationary periods and the lower disinflationary periods as separated by the two red boxes (our additions with the numbers to each period). If we took their average days it takes from the last rate hike to the first rate cut, we see it took 161 days on average over the last eight cycles, or a little over five months. However, if we were to take the two periods separately, we see a distinct difference. In the last three decades it would have been 190 days versus the 58 days in the elevated inflationary period. What this signifies is a historical patten of the Federal Reserve to overshoot on its rate hikes to the point where they must act far more quickly due to deteriorating economic conditions that ultimately constricts demand in goods and causes prices to decline. It also speaks to just how critical inflation is and the damage it wreaks on an economy for the most vulnerable of its citizens.
When we called for our portfolio regime change in late 2021, it was based on an economic framework that is more “vuja de” than déjà vu. It means we had forgotten about how ravaging inflation could be and would end up making the same mistakes as we had in the past…one of the core aspects of human behavior is it is repeatable and predictable in large swings and less so in short time frames. As a refresher, we cited that the coming decades would more than likely be more like the 1960–1991 timeframe than what has currently happened. Expansions last half the time with recessions staying about the same. As such this changes the need for how you manage assets tactically and strategically knowing expansions last less than five years relative to the nine years, we have become accustomed to.
The next chart Strategas came up with is how much vulnerability does the market have from the first rate cut and how long is the average of the move. What they show is that the fourth P, patience, is just as vital as getting the beginning sequence correct. Looking at those the last eight periods of an initial Fed cut and when the S&P 500 hits a bottom, we see quite a range. The average obviously will sober the most bullish of us up, however taking it in with a bit of nuance can ease a bit of this. If you take those periods in the 1960–1991 period see the decline is less than the average over all of them. Interpreting this could be that inflation impacted earnings sooner than when in the longer expansions and the market was more forward looking and thusly pricing in pressure. You could make that argument now as evidenced of the markets returns last year. With the excess liquidity built up in the system, risk off behavior of fund managers with elevated levels of cash and households with more cash than during the last true recession all should provide a bit more solace that the correction may be less so than at times in the past.
So, while the current banking crisis may feel like a redo of 2007–2009, there are exceptions that need to be made. We are on more steady ground than in the past as evidenced by the “re-redistribution” of deposits that fled struggling regional banks to the G-SIB (Globally Systematic Important Banks) and then back into the troubled banks. This was done for multiple reasons, certain prodding, an already excess number of deposits themselves and a bit of self-preservation to hopefully halt future rapid withdrawals.
In conclusion, we have seen this before, but it feels new which is why this is more “vuja de” and not déjà vu. Ultimately, patience is required as we work through process, much like the five stages of grief. You must go through each stage to ultimately get to the end. Easier said than done as the markets seem to be experiencing all five stages of grief daily.