As Go the Banks, So Goes the Economy
Citi Global Wealth Investments: Charlie Reinhard – Head of North America Investment Strategy | Lorraine Schmitt – North America Investment Strategy
What happened last week?
Despite the fed raising rates by 0.25%:
- The S&P 500 gained 1.39%
- The Dow Jones rose 1.18%
- The Nasdaq composite increased 1.66%
Days after officials moved to protect the depositors of failed lenders Silicon Valley Bank and Signature Bank, the largest US banks made $30 billion in deposits with First Republic Bank to help stem the outflow of deposits at regional banks.
In Switzerland, UBS took over Credit Suisse, creating one very large bank.
Over the weekend, First Citizens agreed to buy Silicon Valley Bank, and take on its deposits and loans.
3 Things to Know
The economy was already slowing
The impact of the failure of two US midsized banks and the forced marriage of two Swiss institutions is rapidly unfolding. Last week another midsized US bank saw a further collapse in its market value.
Most, but not all, developed market banks are well-capitalized and have strong access to liquidity. The banking system is fundamentally stronger and better managed than it was in the crisis of 2008–09.
Still, banks face increasing depositor and market scrutiny, intensified by ambiguous comments from regulators and policy makers.
What does this mean for investors?
We still disagree with economists who think non-financial businesses and labor markets will be immune to the spillovers of 2023’s financial turmoil. The US economy was already slowing prior to the present banking crisis. Large sectors of the US economy will be materially impacted by changes in the availability and pricing of credit, in our view. These sectors will see a greater contraction that will have spillover effects. An overall stall in US growth will follow, along with a likely mild recession in 2023.
Central banks — particularly the Fed — are actively trying to restrain the economy. This is clear from the Fed’s recent decision to proceed with a further 25 basis point increase in its key policy rates amid rising bank uncertainties.
But we also think the Fed’s tightening cycle will end shortly — if it hasn’t already. If there’s a rise in unemployment, this reactive Fed has the predisposition to pivot quickly.
Despite poor headline optics, underlying inflation is slowing significantly.
Keep an eye on vulnerable industries
While housing has been restrained by the Fed’s interest rate pressure, solid underlying demand support remains, though at levels far below the 2020 peak. Compare that with demand and supply in major parts of the commercial real estate market, which are weakening now and likely to worsen further.
US office vacancies have risen consistently during the post-Covid recovery. Looking at a broad measure (much wider than office construction and maintenance), non-residential structures investment has been falling for several quarters and its weakness will accelerate with less credit available from banks.
Commercial real estate defaults are likely to balloon from their present low levels. With small and midsized banks suffering from deposit flight in recent weeks, bank managements will feel less able to extend new credit or restructure old loans.
Even if deposits stabilize, the cost of those deposits has risen sufficiently that banks will need to charge more and lend less (at a lower loan to value) over the years to come.
We see negative post-Covid office trends and the unfolding banking crisis multiplying the stresses that commercial real estate owners and investors will face. This is clearly the area where small and midsized banks have pushed for market share, lending most rapidly.
US is positioned for a shallow recession
Owing to a historically mild period of growth in employment since Covid hit in 2020, we would expect the US unemployment rate to rise two percentage points from its recent low over the course of 2023–2024.
As this unfolds, it’s important to note the Fed’s role in containing the self-reinforcing impact of job declines once they begin. The Fed has previously cut its policy rate in each case of a recessionary rise in unemployment, including the early 1980s episodes.
In the 80s, the Fed cut rates during a difficult fight to restrain inflation. We expect the same reaction from this Fed in the year to come.
See our weekly CIO Strategy Bulletin for more details
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