September 5, 2023  |  2 MIN READ

Weekly Market Update

Jobs, Back-to-School, Banks

What happened last week?

  • The S&P 500 gained 2.50%
  • The Dow Jones advanced 4.19%
  • The Nasdaq rose by 3.25%

The US added 187,000 jobs in August, but jobs reported for June and July were revised lower by a combined 110,000. The unemployment rate jumped from 3.5% to 3.8% but it was because more people entered the work force.

Other data showed fewer job openings than before and fewer workers quitting.

In all, it points to a labor market that’s cooling which could help keep the Fed at bay.

3 Things to Know

US Banks Tighten; High-Yield Credit Markets Gain

We have long noted that the US yield curve is the single best performing long-term leading indicator of recession.

Curve inversions have preceded each of the nine US recessions since 1960 with long and variable lags but only one false warning.

Bear in mind, buyers of long-term bonds who sent the US yield curve to inversion in the first half of 2019 couldn’t have known that a world-changing pandemic would crush the economy in 2020.

We would emphasize that an inverted curve is a wager by bond investors that the Federal Reserve will cut policy rates in the future. As we’ve seen in periods such as 1995 and 2019, it is possible for the Fed to ease monetary policy in conditions short of a “standard” recession.

Restrictive monetary policy leaves the economy more susceptible to shocks. We expect the Fed’s desire to both lower inflation and protect the economic expansion favors a risk management approach that will lead to some easing steps in the coming year, even without a broad-based collapse in the economy.

In contrast to the corporate bond market, bank lending standards are consistent with immediate recession.

Banks have tightened standards at rising yields for almost every category of lending for five quarters now.

This tightening of financial conditions contrasts markedly with the narrow credit spreads. And unlike past periods, many related measures of economic activity continue to show growth rather than contraction.

Since end 2019 — prior to the COVID shock, small US banks have grown their commercial real estate (“CRE”) loan book by 40%.

This compares to a 3.6% increase in CRE loans by large banks.

Total private debt — including the CRE loans — grew a far more modest 19.4% during the 3 ½ years. The bank lending data is weekly, while the broader measures are quarterly, creating some distortions in direct comparisons.

Of course, “the office” continues to suffer and will present credit strains for “off-prime” properties in the years to come. The capacity to work from home and save valuable commuting time and cost is a technology shock akin to e-commerce for retailing and “e-home-letting” for hospitality.

Citi Prefers IG Bank Preferreds

The Fed’s sharp tightening - and consequent lure of T-bills yielding 5.5% - has pushed up the cost of deposits for banks. Yet a very large share of bank deposits remain far below bond yields.

This means that bank net interest margins have actually risen in recent quarters. However, regulators are keen to make mid-sized US banks less dependent on short-term funding and instead issue more expensive long-term debt.

Along with uncertainty as to how future Basel capital requirements will be applied to US banks, we believe these regulatory uncertainties have been a meaningful reason why bank shares have underperformed. This is no short-term problem.

High and rising regulatory costs and growth restraints on the financial sector are the largest reason it has underperformed the S&P 500 since the Global Financial Crisis.

At current pricing, we see relatively little reason to take high credit risks in corporate bonds for fairly little spread. But it is also possible that the banking sector’s deep underperformance this year is about more than just economic risks.

As stated earlier, Citi prefers investments higher up in capital structure for financials. Investment Grade bank preferreds yield near 7.5% and have gained 4.5% on a year-to-date total return basis, outperforming common.

Citi Global Wealth Investments
Charlie Reinhard - Head of North America Investment Strategy
Lorraine Schmitt - North America Investment Strategy

See our weekly CIO Strategy Bulletin for more details