Welcome Relief

Risk assets offered us solid returns against a backdrop of banking-sector uncertainty. The winner? Developed economies outside of the U.S. The Dow Jones Developed Markets ex-U.S. Index posted an almost 7% return for the first three months of the year. The Standard & Poor’s 500 Index was close behind, delivering a 6% return, and the MSCI Emerging Markets Index rose nearly 3.5%.

In the U.S., growth trounced value with the Russell 1000 Growth Index returning 12.5%, in sharp contrast with the negative return for the Russell 1000 Value Index.

Bond markets also provided positive returns across the board, from Treasury indices through investment grade — both taxable and tax-exempt. Despite the headwind of credit spread widening, high yield saw returns supported by falling interest rates particularly at the shorter end of the yield curve. This first quarter of 2023 has been tumultuous, of course, and very confusing as the interest rate market and the risk asset market seem at odds.

It is always helpful to look under the hood to see what is really being reflected in markets, and that view is interesting as it pertains to equities. For the first quarter, ending today, the gains in the S&P 500 seem at odds with the view expressed in the bond market — that recession risk is high.

Taking a closer look reveals that this rising equity tide has not lifted all boats — not by a long shot. The equity performance so far this year has been extremely narrow, concentrated in some very large tech and tech-adjacent companies that dominate the index. As a capitalization-weighted index, the largest capitalization companies carry the most influence.

Seeing stocks like Apple, Meta, Microsoft and Tesla gaining 25%, 75%, 19%, and 65% respectively, the market performance was less like a rising tide and more like a tidal wave hitting only a chosen few. Include the outsized performance of Nvidia, which has gained nearly 90% and is now the fourth-largest company in the index, and the influence is undeniable. Another easy way to observe the super strength of these growth stocks is by looking at the 15% advance of the NASDAQ composite for the quarter. Adjusting the S&P return to mitigate the influence of these large companies by creating an equally weighted index of the 500 constituent stocks presents a very different picture. The equally weighted S&P has gained about 2%.

During the height of the turmoil resulting from Silicon Valley Bank’s failure and concerns of contagion across other small and regional banks, attention focused on the Fed’s balance sheet to assess the extent to which banks were taking advantage of the lending facilities set up to stabilize deposit flows. Almost immediately after the SVB failure, we saw that the Fed’s balance sheet had expanded primarily as a reflection of the specific banks caught in the turmoil. 

Signs of broader contagion are not present, however, as this weekly release of balance sheet data show a stabilization. The use of the newly created Bank Term Funding Program ticked up just over $10 billion to $64.4 billion, compared with the previous week. The program remains an important backstop, offering banks the ability to post high-quality collateral — which may be underwater — for loans made at face value.

Conversely, borrowing at the Fed’s discount window fell by more than $20 billion. Seeing a stabilization in the aggregate need for funding is a good sign, perhaps signaling that depositor fears are abating.

While fears of deposit safety and stability may have abated, we continue to see meaningful deposit flight as households seek the higher yields available from money market funds. Flows into money market funds remain robust, with $66 billion added in the last week, lifting the total balance across money market funds to over $5 trillion. While we had grown concerned about some banks’ balance sheets amid the recent volatility, now that concern has shifted to the income statement. This magnitude of deposit flight presents some unique problems for banks that have relied on cheap deposits to fund investment and lending activities.

While the worst of the depositor fears may be behind us, we have yet to determine the extent of the broader damage wrought by the SVB collapse. Like a pebble in a pond, the repercussions will be felt across the small and regional banks, and the expectation is that the regulatory oversight will be more acute; the overall cost of doing business will be higher with potentially higher FDIC insurance rates; and while the Fed’s emergency facilities have been enough (at this point) to engender confidence in the banking system, these facilities are not without cost. 

It is likely that we will see a credit contraction over the next several months, and importantly this only adds pressure to an environment where senior loan officers were already reporting tighter credit standards. We believe that the brunt will be felt across small and mid-sized banks, and this presents a particular problem for the U.S. economy as this sector provides the bulk of lending to small businesses including commercial real estate, and to consumers through the mortgage channel. 

In an unfortunate “Main Street vs. Wall Street” dilemma, we don’t anticipate that this credit tightening will have a meaningful impact on larger public companies — those in the S&P 500 for example — as these borrowers have access to other sources of financing including the public markets. Our economics team continues to monitor any potential impacts to our growth forecast. For now, we maintain our base case that the U.S. economy can skirt an outright recession.