The strength of U.S. stock markets in March suggests that equity investors are back to cherry picking economic news and data, and applying favourable interpretations where possible. When investors were doing this in the late 2022/early 2023 rally, it was described by many as the ‘least loved rally in history’.
This is because investors knew that before the Fed could cut rates and trigger a new economic cycle, an economic downturn would have to be endured, as the Fed’s rate hikes since last March took effect.
We now have the added risk of a financial crisis and macroeconomic instability, as banks curtail their lending in order to shore up balance sheets. Wall Street’s current buoyancy appears misplaced.
Two illustrations of stock market investors cherry picking the news:
1)We have seen a fall in interest rate expectations, as the Fed tries to ease stresses in the financial system. JP Morgan Asset Management tell us that expectations are for no more Fed rate hikes, and for rate cuts by the year-end.
Investor response: buy long duration tech stocks. This is despite a heightened fear of ‘higher for longer’ inflation and interest rates in the medium term, as a consequence of Fed moderation in rate hikes today. This is suggested in the narrowing of the negative spread on the U.S yield curve, between 2yr and 10yr Treasury yields (from 1% on 6th March to 0.58% on Friday).
2) A predicted rise in the cost of credit, as the financial system protects its balance sheet by lending less or charging more (probably both). Investor response: this looks likely to affect the shadow banking sector, and highly leveraged companies. Not mainstream Wall Street, where the largest companies sit on piles of their own cash.
This view ignores that Wall Street is part of a broader financial eco system. When investors in leveraged products need to repay nervous lenders who refuse to roll-over loans, it is often the most liquid, ‘safe’, assets that get sold first to raise funds. And can investors in, say, consumer stocks really shrug off problems, in -for example- the housing market?
The contradictions are in the numbers
March saw the S&P 500 rise 1.6%, while the tech-heavy NASDAQ was up an astonishing 7.2%. And yet Goldman Sachs anticipate U.S. and eurozone GDP both reduced by 0.4% this year as a result of tighter credit conditions. How will this help corporate earnings growth this year? It won’t.
Long-term investor in tech should be very cautious over extrapolating reduced expectations of U.S. interest rates this summer, into a long-term reduction in borrowing cost expectations that would benefit long duration stocks.
Falling inflation, but oil prices set to rise
Friday saw release of the Fed’s PCE inflation index, its preferred measure of price changes. It fell to 5% year-on-year in February (from 5.3%), lower than expected. Core inflation also fell, both on a year-on-year basis, and month-on-month.
The tricky task for the Fed in the months ahead is to keep monetary policy tight enough to ensure further falls in core inflation, while avoiding recession and avoiding a financial crisis that might trigger a recession.
Adding to the already complicated picture for the Fed, and other central banks, is the OPEC+ decision on Sunday, to cut oil production by around 1 million b/d. The news led to a 5% rise in the price of Brent crude, to $81.
Is this a meaningful reversal, that might persist, and so raise headline inflation? If so, will higher energy prices weaken global growth, and so actually be deflationary in the medium term?
Money market funds and the yield curve
Unlike most other bank crisis, which are caused by problems on the asset side of the balance sheet, this one is a problem on the liability side.
Instant access deposits have been withdrawn from banks, as money market funds have raised their deposit rates to reflect rising yields on very short-dated Treasury notes. The positive spread between overnight and four-month yields allows money market funds to pay instant access depositors close to the Fed funds rate, and still make a profit.
But the inversion of the Treasury yield curve from four months to 10 years creates problems for banks, who usually lend out deposits on much longer maturities than money market funds. To offer instant access depositors anything close to the Fed funds rate would be an expensive -potentially suicidal- proposition.
For banks, the logical response is to increase their lending rates if they can find suitable borrowers. Ahead of an economic downturn, the temptation is instead to respond to a shrinking deposit base by reduce lending. Ironically, a reduction of long-term lending by banks may accentuate the very downturn that banks are fearful of.
Investors should remain in broad-based multi-asset portfolios that will be protected from the worst of any deterioration of investor appetite that may happen over the coming months.
The tide of liquidity, that Warren Buffet so memorably described, is still going out. We have yet to see who else has been swimming without trunks, and what the ramifications will be on Wall Street and global stock markets.
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