As the unwinding of legacy excessive stimulus continues at the hands of the Federal Reserve (Fed), financial markets are struggling to discern the signal from the noise. A year of monetary tightening, which saw short-term interest rates rise to 5%, has begun to take its toll and cracks are forming within the stressed financial system. In a matter of a few days, we witnessed panic-laden bank run(s) resulting in several bank closures and out-right failures. And yet, across the world, persistently high inflation continues to run well north of central banks’ targets. In response, credit conditions are expected to tighten further, drawing a recession closer and leaving corporate earnings and employment to bear the consequence. Despite risky asset valuations remaining elevated, safe haven assets, such as the U.S. Dollar, Treasuries, and gold, are in demand. For policy makers and market participants, the chance of a misstep appears to be everything everywhere all at once.
As this year progressed, there were increasing murmurs among market participants that the Fed's tightening of financial conditions may lead to a breaking point. In a startling event, a U.S. bank collapsed due to rampant withdrawals, posing a threat to the stability of the entire banking system. Silicon Valley Bank (SVB), a vital artery to the innovation economy, was the largest bank to fail since the Great Financial Crisis (GFC). As is typical with a bank run, any bank - regardless of size - is susceptible to the liquidity spiral that often accompanies such events. In an emergency step to help bolster financial stability, the Bank Term Funding Program (BTFP) was created to offer loans to banks in need of liquidity. In an additional effort to restore confidence in the banking system, the Federal Deposit Insurance Corporation (FDIC) intervened by guaranteeing all depositors of select banks most affected by the turmoil in the sector. However, despite these interventions, many regional bank stocks continue to trade at a discount, as their stability remains vulnerable to factors beyond their control. Liquidity is at the heart of a well calibrated financial system - either too much or too little and chaos ensues. This delicate balance has been the focus of central banks for the last year, and it now appears that the hard part has just begun.
Despite efforts to reduce liquidity in the economy, high inflation within the service sector continues to plague the economy due to residual liquidity still present on consumers' balance sheets. The Personal Consumption Expenditure (PCE) index, the Fed’s preferred inflation indicator, remains elevated reflecting strong nominal wage growth. Stripping out the PCE's more variable and lagged components, such as food, energy, and shelter, reveals the newly coined “super-core” inflation measure. This important measure most closely reflects the service sector, the largest contributor to the U.S. economy.
Left unchecked, inflation expectations will become entrenched within the minds of consumers, ultimately requiring even more restrictive policy to reverse the sentiment. To get ahead of this phenomenon, the Fed relies heavily on clear communication to set market expectations and drive behavior. They have vowed to restore price stability by maintaining a restrictive policy for as long as it takes to achieve this goal. Indeed, according to their latest base case projections, no reduction in interest rates is expected for the remainder of this calendar year.
Much of the economic growth we have experienced in recent years has been financed by credit. This is logical in a low interest rate environment where credit is cheap. However, as the lagged effects of higher interest rates penetrate the economy, banks will likely tighten lending standards. This tightening will send a ripple effect through the economy. Because of this, moving forward we expect a decline in revolving credit expenditures (i.e., credit cards) on discretionary goods and services. U.S. Consumer credit card utilization has reached historic levels and combined with interest rates not seen in over a decade, an expanding debt service load could potentially choke off consumer-driven economic activity.
As fallout from the SVB collapse continues, we also anticipate that smaller banks will be among the most aggressive in tightening their lending standards. This is a trend that bears monitoring closely, as small banks play an outsized role in the commercial real estate market, making this sector particularly vulnerable. Higher interest rates are not just impacting the commercial real estate market, even the residential housing market is feeling the effects. In fact, the monthly average home payment with a new 30-year mortgage is now at least 75% more expensive than it was prior to the COVID-19 pandemic. This has led to an affordability crisis, which we expect will result in continued downward pressure on house prices. While certain housing markets are faring better than others, the national median existing home price fell year-over-year for the first time in over a decade. However, on a more positive note, credit tightening can serve as a headwind on inflation, although the full effects of this headwind may not be felt until the second half of this year. As consumers' excess savings are gradually exhausted and spending power decreases, we expect to see a more pronounced impact on inflation.
Beyond consumers and real estate, tighter credit conditions impact businesses as well. With consumers’ spending power dwindling, topline revenue growth forecasts are falling. In defense of profit margins, we expect labor conditions to loosen in the coming months. We expect to see initial jobless claims accelerate in 2Q, as many companies announce layoffs during quarterly earnings announcements and future guidance. There will be a longer lag before the impacts of layoffs are reflected in the actual unemployment rate. According to the current projections from the Fed, unemployment is expected to rise to approximately 4.5% by the end of the year. Given the souring forecast for economic growth, the market is anticipating a reprieve from the Fed in the form of lower interest rates at the end of this year. However, given the stickiness of inflation, we are skeptical that the Fed will come to the rescue in the near term. As we have already seen this cycle, the market’s eventual appreciation of persistently higher interest rates can be painful.
In our estimation, asset valuations remain high. Yields almost anywhere along the curve are lower than they were at the beginning of the year. When evaluating the attractiveness of more risky areas of the bond market, we consider the yield spread or premium with which we are compensated for taking additional risk. However, these metrics are currently nowhere near the expected value for a recessionary environment. Similarly, equity market valuations are stretched beyond our liking. With corporate earnings expectations likely declining in the coming quarters, we prefer to wait for more attractive opportunities.
In the meantime, we are taking advantage of higher interest rates provided by short-term Treasuries. Additionally, we are evaluating gold as a historical holder of value in uncertain times, despite its recent appreciation. We have also rotated equity positioning towards more defensive, cash-flowing companies. We expect volatility to run higher than historical averages for the remainder of the year. As the situation continues to evolve, we will be opportunistic and selective in our approach to ensure that we achieve more upside than downside.
To this point, the Fed has held firm that inflation will be tamed, and price stability will be restored. In our estimation, the market has become overly reliant on accommodative monetary policy and has become rather complacent as a result. The volatility we have experienced over the last year is a direct reflection of this inconvenient truth. Further tightening of lending standards will undoubtedly cause uneasiness with the financial system and broader economy. We are approaching an inflection point where further progress may be difficult to achieve and discomfort is plentiful. Continued discipline will be necessary to see us through to the other side.
Jim Ulseth has been working in the ultra-high net worth advisory space for over a decade.