After the somewhat stunning banking events of the past week, it’s time to turn the focus to the Federal Reserve, Chairman Jerome Powell, and the interest rate decision later this week. If there isn’t a pause now, or immediately after what we’d consider an unnecessary 25-basis-point rate hike (should it occur), Powell will be making the biggest mistake of his career. Upon reflection, his is a legacy littered with a series of big errors over the past six years:
- Overtightening in December 2018, causing a dramatic plunge in the stock market in an otherwise healthy economy.
- Helping break the repo market in September 2019, making interbank rates surge.
- Introducing a pro-inflationary framework in 2020 that targeted “average” inflation rates.
- Suggesting the Fed shouldn’t preemptively lean against “transitory” inflation (there’s that word again).
- Continuing quantitative easing policies for way too long after inflation had already become a clear problem, allowing the Fed’s balance sheet to not peak until April 2022 (about a year too late).
Unfortunately, he might not be done yet.
We think the only bigger mistake Powell could make after this series of calamitous blunders would be to move forward with his original 50-basis-point interest rate increase plan and not pause enough after the downfalls of Silicon Valley Bank (SVB) and Signature Bank. These recent financial failures will do more to tighten economic conditions and credit markets than anything the Fed could do with its limited, dull weapon called short-term interest rate control.
Without going into detail on the bank collapses (we did that last week), we do want to point out how the SVB crash was a classic bank run. It had $42 billion in deposits withdrawn in a matter of hours, amounting to almost a quarter of its total deposit base. The SVB deposit base was big and grew fast:
Obviously the SVB leaders did not handle interest rate risk well. This mismanagement led them to seek a capital raise after a big loss on the bonds that they had to sell to meet redemptions. That caused a panic that spiraled out of control within a few days.
The bank’s rapid growth in the last five years basically blindsided management into forgetting how to run the bank more conservatively. We can see that in its continued lending against illiquid collateral and non-public equity stakes in venture capital seed companies. Someday, this situation will make an excellent case study at business schools on how not to run a bank.
The failed banks aren’t solely at fault though. The driving force behind their respective ruins was the quick, unprecedented short-term interest rate hikes by the Fed. When the SVB crisis came to light, Treasury notes fell. That should be an alarming signal to Chair Powell to pause rates.
In essence, the bond market is demanding that the Fed not only pause rate increases but cut them later this year. For example, as of this writing, the two-year Treasury declined from more than 5% to less than 4% in short order:
While the Treasury did the right thing by guaranteeing depositors and letting the banks fail, the next step to instill confidence in the system should be pausing rate hikes. Historically, the Fed tightens until something breaks – well, now something is broken.
Being behind the curve on inflation was a mistake by the Fed. The seeds laid in 2020 led to these recent failures. The Fed should know that inflation is a lagging indicator. Now the central bank has a reason to justify a pause. The focus should be on the bigger issues present now, rather than problems from the past.
Choppiness Reigns, but Quality Leads the Way
Equity markets are reflecting the chaos too. MAPsignals’ trusty Big Money Index, a 25-day moving average of “big money” investor activity, has continued its significant downtrend that began after it hit overbought territory in mid-February:
This is no surprise to our readers though. About a month ago we said to expect choppy volatility in the short term, and here it is:
So, where do we sit today?
In the near term, we still see more choppiness ahead. However, we keep believing there will be a market uptrend in the latter half of 2023. See, the market has once again been heavily discounted, pricing in a mild recession in the next few months and the impacts of aggressive interest rate policy that (hopefully) will end soon, if it’s not done already. If the post-bank-failure market rises continue, which seems likely if the Fed pumps the brakes, it will signal continuing support for our long-term thesis for this year.
We expect to see high-quality individual companies, not macro indexes, continue to exhibit significant alpha as markets chop along. Put another way, we think the best of the best firms will emerge as the winners throughout the rest of 2023.
Interestingly, since October, technology and discretionary stocks have continued to lead upward movements in markets. That’s despite continual bashing from the media. In these three charts, it’s clear how the industrial, discretionary, and technology sectors have been pockets of strength in the last few months:
More specifically, it's the quality companies within those sectors – the growing firms with solid fundamentals – plowing ahead. We’ve pounded the table on fundamentals before. Given the charts above, it’s clear that fundamentals matter more than ever.
The silver lining in all this mayhem is two-fold. First, hopefully the Fed sees the destruction it’s caused and stops raising rates. That alone should boost markets. Second, the sectors mentioned above tend to fuel economic growth. Hopefully that occurs as we exit this recent malaise caused by rising rates and failing banks.
Securities sold through CoreCap Investments, LLC. Advisory services offered by CoreCap Advisors, LLC. Cornerstone Financial and CoreCap are separate and unaffiliated entities.