SUMMARY
A silver lining amidst the present uncertainties is that we are likely in the final stretches of the bear market. Asset markets are now more likely to quickly price the economic weakness to come with the Fed recognizing this as well.
- Confidence is the life blood of the banking system and critical to the economy’s performance. Once a financial institution loses the confidence of its customers, it becomes vulnerable. This past week, we saw what a lack of confidence looks like in internet time.
- The US Federal Reserve’s abrupt and rapid reversal of monetary policy set the stage for the recent tumult. Responding to the pandemic shock, fiscal authorities borrowed and spent a record stimulus in 2020 and 2021, and maintained a zero-rate environment after expanding money supply by a record amount in 2020. To tame the inflation that ensued, the Fed raised rates 450 basis points – more quickly than ever before – while also slashing its bond portfolio.
- This reversal of policy and abandonment of incremental action in 2022 saw the worst combined stock and bond market performance since 1931. The fact that banks have $620 billion in aggregate mark-to-market losses on their securities portfolios is, in part, a reflection of the Fed’s actions.
- In our view, the US banking system will stabilize when the US government provides clear and unambiguous support for the system as a whole. The longer it takes for the government to provide clear guidance in support of depositors and the wider banking system, the less safe many depositors will feel.
- We think it likely that the US economy will show an output contraction around mid-year, though timing of the particular quarter it will bottom cannot be precisely determined. Once labor markets shift to net contraction, the Fed will likely begin to reverse course. These views leave us significantly overweight US Treasuries and defensive industries such as large-cap pharmaceuticals along with strong dividend growers in equities markets.
- A silver lining amidst the present banking uncertainties is that we are likely in the final stretches of the bear market. Asset markets are now more likely to quickly price the economic weakness to come with the Fed recognizing this as well. Just as asset prices fell in 2022 when economic growth and profits rose, history suggests markets can find a bottom in the trough of an economic contraction.
