In this commentary we discuss the indicators that suggest inflation may be easing, and how that will help the financial markets. We will also address many client’s questions on regional banks. Specifically, we will address lingering issues that the withdrawal of deposits from regional banks around the country will have on the economy going forward. In the third week of March, we sent out an email to clients talking about the regional bank’s safety (if you did not receive this letter or would like another copy, please let us know). Briefly in that letter we described how your assets are held at custodian banks. As a review, custodian banks can only hold your assets, charge transactions fees, send statements and tax documents; they cannot make loans, nor can custodian banks take your securities out of your account. This makes custodian banks very safe as compared to commercial and regional banks that make loans, or investment banks that invest in private equity, or bring companies public.
On March 8th, one of the nation’s largest regional banks, Silicon Valley Bank (SVB) announced that it took a loss of $1.8 billion selling its reserves to meet client redemptions. The reserves were down in value because the safe treasury bills the bank had in its reserves only yielded 1.9%, and had lost value since the new treasury bills in March were yielding 5%. Worse, SVB value had locked up almost all of its reserves in very long-term bonds at low interest rates, while its clients were mainly large venture capital firms and their startups who needed money on a constant basis. SVB had incorrectly assumed that the tech boom would continue and that new deposits into the bank would more than make up for client withdrawals. Over 85% of SVB deposits were uninsured (over $250,000 in cash at the bank). When these uninsured depositors learned that SVB lost money in its reserve capital, $46 billion was withdrawn from the bank on 2 March 9th, and another $100 billion was set to wire out on Friday, March 10th before the regulators shut the bank down. Unfortunately, the SVB had mismatched its reserves to its deposits. The fear of uninsured depositors has since spread to other regional banks, even though the banking system has no bad debt problem at the moment.
Because of the fears at regional banks, investors who are not FDIC insured (Federal Deposit Insurance Corporation), those with over $250,000 in assets at a bank, have been transferring their assets out of regional banks and into larger, bigger banks that are perceived to be safer, and into money market funds. Indeed, the Wall Street Journal reports that banking deposits have fallen by $363 billion since the beginning of March to $17.3 trillion dollars. All of the lost deposits have come from smaller regional banks. (WSJ April 6, 2023)
The problem with deposits leaving regional banks is that it affects future lending. The capital for bank loans comes from deposits. Currently the banks are the best capitalized that they have been in over two decades, and most are more capitalized than even regulations demand (banks have more deposits than they need to support their current levels of loans). However, as deposits leave, regional banks are fearful to make new loans because if enough deposits leave, the banks will not have adequate deposits to cover their existing loans. This is not a systemic problem as the biggest banks are actually taking in billions of new deposits; however, the regional banks deposit outflows will be an obstacle for the economy because it will affect the regional banks ability to make future loans. The regional banking deposit outflow affects the economy because a local banker understands their community better than a big, impersonal bank, and would make loans that the big bank would not. Wall Street has attempted to quantify the problem. Economists Manuel Abecasis and David Mericle at Goldman Sachs estimate that lenders with less than $250 billion in assets (generally considered regional banks) account for about 45% of total consumer lending, 3 including 60% of local residential home lending. Without regional banks, these loans may not occur, or would be harder to get, which will slow future growth.
The regional banks have an even more outsized effect in commercial real estate lending. Lisa Shalett, the chief investment officer for Morgan Stanley Wealth, wrote in a recent report that “more than 50% of the $2.9 trillion in commercial office mortgages will need to be renegotiated in the next 24 months when new lending rates are likely to be up by 350 to 450 basis points.” Shalett noted that regional banks accounted for 70% to 80% of all new loan originations in the past cycle. To put that in perspective, a study by NAREIT (National Association of Real Estate Investment Trust) primarily using data from CoStar estimates the total dollar value of commercial real estate was $20.7 trillion (See Chart Below). Most of the commercial real estate market is doing well (data centers, warehouses for ecommerce, healthcare, etc.), however, the market is concerned about the office space sector which comprises 15.4% of the total commercial real estate sector. COVID, remote and hybrid work, and layoffs have caused vacancy rates to increase from 9.5% in 2019 to over 12.8% today, according to the National Association of Realtors. Commercial Edge, another trade group, estimates that with subletting the current vacancy rate is closer to 16.5%. Both studies agree that the bigger cities have higher vacancy rates, and that newer buildings have better occupancy than older buildings. Good news for the banks is the newer buildings are more likely to have loans against them, and the older, less occupied buildings are likely already paid for.
With regional banks worried about deposit losses, the worry is that rolling over these loans will cost more for building owners because regional banks will not be able to make new loans. Building owners include many pension funds, hedge funds, private equity, and endowment funds. If the values of property fall far enough the banks themselves could be left holding non-performing loans. However, if you look at the chart below of some of the more exposed regional banks, Commercial Real Estate (CRE) loans are still a minority of their total loans, and the office loans as a percentage of commercial real estate loans are a smaller percentage yet. Most importantly, delinquent commercial loans are still under 1% for most banks. So, the regional bank deposit outflow and the refinancing of office loans will be a headwind to the financial sector and the economy this year. However, it is not a crisis and may in fact force the Federal Reserve to end its monetary tightening program sooner than expected. We will be watching this closely in the coming months.
The Federal Reserve easing interest rates would help ease the outflow of money from regional banks because part of the outflow from regional banks to money market funds is that money market funds are paying interest rates of close to 4%, and regional banks are offering on average of only 0.5% interest rates. Even without the Federal Reserve potentially trying to help regional banks, we are seeing evidence that the Federal Reserve tightening cycle of raising interest rates is getting closer to an end.
We think many indicators are pointing to an easing or at least a pause in the Federal Reserve interest rates hikes. For starters the Personal Consumption Expenditures (PCE) (which excludes food and energy prices) tallied 4.6% in February, 2023. The PCE index is the Federal Reserve’s preferred inflation gauge and it is now below the 6-month treasury interest rate of 4.7%. Once interest rates move above the inflation rate, the Federal Reserve has historically been near the end of its rate hiking cycle. Inventories are also high at retailers (meaning it is hard for retailers to increase prices if you cannot 6 sell what you already have), and the Bloomberg Commodity Price Index is down -24.4% from its 52-week high, which suggest input costs are easing (Bloomberg.com). Money supply growth has also turned negative for the first time in over 60 years. Money supply growth usually leads inflation rates by 16 months. When the money supply decreases, the amount of funds available for loans decreases. This causes interest rates to rise, making it more expensive for businesses and individuals to borrow money, and, consequently, making them decrease expenditures on consumption and investment. This results in the economy shrinking and inflation falling.
In addition, we are starting to see easing pressures in the job market, which is what Jerome Powell, current chair of the Federal Reserve Bank, said the Federal Reserve was looking for before ending this current monetary tightening cycle to lower inflation. With the Jobs report on Friday, April 7th the year over year wage growth slowed to 4.2% gain.
Wage growth has now been in a 13-month declining trend. Typically, economists want to see wage growth, but in a high inflationary environment, the opposite is true. Wage growth is a cost input to business and contributes to inflation. Economists want to break the inflation cycle where wage growth leads to higher spending, which leads to higher inflation. Lower wage growth also indicates that employers are finding it easier to attract employees.
Perhaps one of the biggest signs that year over year inflationary pressures may be easing is housing cost. High interest rates make houses less affordable, and housing and rent prices have been dropping for over five months (National Association of Realtors). The largest weight in the calculation of the Consumer Price Index is housing and rental cost, but its calculation by the Bureau of Labor statistics is lagging. The Bureau of Labor statistics collects data on rent for 50,000 residences through personal visits or phone calls. One sixth of their sample is replaced each year to keep it representative. However, since rents do not change frequently, the rent of each unit is asked only once every 6 months (see red line on chart below). This system worked well pre-internet, but with national databases like rent.com, it is easy to see that both rent and home prices have been falling for several months nationally in realtime (see blue line on chart below). Since the credit-shelter component accounts for almost 33% of the CPI (Consumer Price Index), inflation rates should continue to decline as we move forward this year as the delayed sampling of the Bureau of Labor Statistics catches up to the actual numbers.
So far, the Federal Reserve has done a good job of engineering their desired “soft landing”, in which economic activity slows enough to bring inflation down, but not hurt the economy so much that they create a recession or throws millions of people out of work. The stock market sold off in part last year due to fears of a “hard landing” in which the economy gets thrown into a deep recession and unemployment skyrockets. Fortunately, the worst-case scenario has not occurred, but as we can see pressures are building in the economy and regional banking sector that suggest if the Federal Reserve continues its strict stance on fighting inflation, a difficult recession could be expected. Since the Interest Rate Futures Market also suggests that inflation is easing, it is possible that later this year the Federal Reserve will stop their interest rate hikes, and possibly begin cutting interest rates late this year or early next year.
Once the Federal Reserve begins to cut interest rates, the economy will likely begin a new business cycle to the upside as houses, cars, and durable goods become more affordable and consumption increases followed by increased investment by businesses. 9 The stock market will also rise in tandem with expectations of higher corporate earnings. This current cycle is also starting with a very high level of money market funds. When the Federal Reserve does eventually cut interest rates, these assets will start to go into the stock market seeking higher returns, which will set the stage for a new Bull Market. Likewise, once interest rates are lowered regional banks will not have to compete so hard for deposits, and local lending constraints will likely ease as well.
In conclusion, rising inflation and the corresponding rising interest rates wreaked havoc on financial markets worldwide last year. Nevertheless, there are signs that inflation is beginning to slow. In addition, the current Bear Market in financial markets has dropped to levels in both duration, and depth of the selloff that stock valuations are now back to historical fairly valued levels. The small recovery so far this year is also matching historical trends (see SCM Commentary of 3rd Quarter 2022 where we mention that according to Guggenheim Investments, the average sell-off of more than 20% in the S&P 500 has lasted 11 months, which 10 occurred last October, which was the bottom of this market so far, and that the average recovery lasted 14 months, which is still in progress.) The good news is the best stock market returns have come after market pull backs when stocks come back to more attractively priced levels. The Fed has stated that they are focused on bringing wage pressures under control, meaning that they are aiming to bring the unemployment rate up (this would be a sign that wage pressures are easing), not just commodity prices coming down. We believe the Fed will be successful in their goal, but probably not until well into 2023. The ride will continue to be bumpy. News events like the upcoming debt ceiling battles will roil the markets, but we do think the year will end positive. In the meantime, we continue to like companies who are returning cash back to investors from both dividends and share buy-backs, and who provide goods and services which consumers need to use on a daily basis as the best way to ride out a turbulent market.
We thank you for your continued support.
Sincerely,
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