Overview
- Bank failures, tighter monetary policy, and rising fear of a “hard landing” have heightened economic uncertainty
- Despite these challenges, inflation is subsiding, consumer spending is stable, and the labor market remains strong
- In light of the market turbulence, investors are reacting to any news, positive or negative, in search of clarity about the future
Bank Failures, the Fed, and Inflation
Recent events involving Silicon Valley Bank, Signature Bank, and First Republic Bank have altered investors’ outlook on the possibility of an economic recession, shifting it from a no landing scenario to a more cautious expectation of a soft or hard landing. These failures were largely attributed to poor risk management and concentrated deposit bases. However, the financial industry is under stress due to the Federal Reserve’s rapid interest rate hikes aimed at curbing inflation. Following the pandemic stimulus, banks received an influx of deposits and invested these funds into Treasury and Agency securities. As interest rates rose, the value of these securities decreased, leading to unprecedented levels of unrealized losses, and leaving financial institutions, particularly those with additional idiosyncratic risks, vulnerable to a “run on the bank.”
Lending Demand and Deposit Growth
With the Federal Reserve’s persistent efforts to combat inflation by implementing tighter monetary policy, the benchmark rate used by banks to lend to consumers and other financial institutions has risen. This may lead to a decline in lending activities and heightened credit standards. From a deposit perspective, outflows were initially volatile due to the movement of investors towards larger banks and higher-yielding cash securities, like money market mutual funds, but this trend has since stabilized. Given the inflationary landscape, the Federal Reserve will likely implement at least one more 25-basis point rate hike, which would further strain lending and the economy. Consequently, increasing the likelihood of a hard landing scenario.
Banking Industry Q1 2023 – Earnings
Overall, the impact of the banking issues on large institutions was minimal, and regional banks reported better-than-expected earnings due to in-line deposit outflows and increased net interest income (NII) from higher interest rates. However, a few regional banks, such as First Republic Bank, experienced significant drops in deposits, rekindling investor concerns about a worsening environment. Nevertheless, it seems the banking contagion is contained within a small group of banks that did not appropriately manage their interest rate risk, and predominately positive bank earnings have instilled confidence in the market, at least for the time being.
Recession & Recovery
Regional banks play a crucial role in facilitating small business growth, supporting commercial real estate, and driving overall economic development. If banking stress persists and lending continues to decline, the likelihood of a recession and credit crunch will increase. However, it is important to recognize that recessions are part of the normal economic cycle. Typically, a recession is declared after two consecutive quarters of negative GDP growth. As GDP is a lagging indicator, the stock market will likely have already hit its bottom by the time a recession is officially announced. Since 1926, there have been 16 recessions, with an average duration of 13 months. The longest recession was 43 months (The Great Depression), while the shortest was two months (Covid). As markets have become more efficient, the period from peak to trough (and subsequent recovery) has shortened. The following chart illustrates the significance of remaining invested and focusing on long-term objectives.
Market Outlook
Despite indications of an impending recession, the stock market has experienced a rally, inflation has decreased, supply chains have improved, the labor market has remained strong, and bond spreads have maintained their stability. Although certain areas, such as commercial real estate, have displayed some weakness, future prospects depend on the length of the Fed’s pause and the timing of rate cuts. Despite the year-to-date rally, asset class valuations remain attractive in comparison to historical levels. International equity continues to be significantly less expensive than U.S. equity, and the traditional negative correlation between stocks and bonds is resurfacing. In the years ahead, portfolio diversification will continue to play a critical role in achieving long-term investment objectives and mitigating the uncertainties arising from monetary policy.
Disclaimers:
The views expressed herein are those of Asset Consulting Group (ACG). They are subject to change at any time. These views do not necessarily reflect the opinions of any other firm.
This report was prepared by ACG for you at your request. Although the information presented herein has been obtained from and is based upon sources ACG believes to be reliable, no representation or warranty, express or implied, is made as to the accuracy or completeness of that information. Accordingly, ACG does not itself endorse or guarantee, and does not itself assume liability whatsoever for, the accuracy or reliability of any third party data or the financial information contained herein.
Certain information herein constitutes forward-looking statements, which can be identified by the use of terms such as “may”, “will”, “expect”, “anticipate”, “project”, “estimate”, or any variations thereof. As a result of various uncertainties and actual events, including those discussed herein, actual results or performance of a particular investment strategy may differ materially from those reflected or contemplated in such forward-looking statements. As a result, you should not rely on such forward-looking statements in making investment decisions. ACG has no duty to update or amend such forward-looking statements.
The information presented herein is for informational purposes only and is not intended as an offer to sell or the solicitation of an offer to purchase a security.
Please be aware that there are inherent limitations to all financial models, including Monte Carlo Simulations. Monte Carlo Simulations are a tool used to analyze a range of possible outcomes and assist in making educated asset allocation decisions. Monte Carlo Simulations cannot predict the future or eliminate investment risk. The output of the Monte Carlo Simulation is based on ACG’s capital market assumptions that are derived from proprietary models based upon well-recognized financial principles and reasonable estimates about relevant future market conditions. Capital market assumptions based on other models or different estimates may yield different results. ACG expressly disclaims any responsibility for (i) the accuracy of the simulated probability distributions or the assumptions used in deriving the probability distributions, (ii) any errors or omissions in computing or disseminating the probability distributions and (iii) and any reliance on or uses to which the probability distributions are put.
The projections or other information generated by ACG regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. Judgments and approximations are a necessary and integral part of constructing projected returns. Any estimate of what could have been an investment strategy’s performance is likely to differ from what the strategy would actually have yielded had it been in existence during the relevant period. The source and use of data and the arithmetic operations used for calculating projected returns may be incorrect, inappropriate, flawed or otherwise deficient.
Past performance is not indicative of future results. Given the inherent volatility of the securities markets, you should not assume that your investments will experience returns comparable to those shown in the analysis contained in this report. For example, market and economic conditions may change in the future producing materially different results than those shown included in the analysis contained in this report. Any comparison to an index is for comparative purposes only. An investment cannot be made directly into an index. Indices are unmanaged and do not reflect the deduction of advisory fees.
This report is distributed with the understanding that it is not rendering accounting, legal or tax advice. Please consult your legal or tax advisor concerning such matters. No assurance can be given that the investment objectives described herein will be achieved and investment results may vary substantially on a quarterly, annual or other periodic basis. There is no representation or warranty as to the current accuracy of, nor liability for, decisions based on such information.
This report is distributed with the understanding that it is not rendering accounting, legal or tax advice. Please consult your legal or tax advisor concerning such matters. No assurance can be given that the investment objectives described herein will be achieved and investment results may vary substantially on a quarterly, annual or other periodic basis. There is no representation or warranty as to the current accuracy of, nor liability for, decisions based on such information. Gryphon Financial Partners shall not in any way be liable for claims and make no expressed or implied representations or warranties as to their accuracy or completeness or for statements or errors contained in or omissions from them. This was created for informational purposes only. Gryphon Financial Partners, LLC is an Investment Adviser.