It's back to the middle syllable of e-CON-omy

Longtime readers of this space know that from time to time, I like to remind everyone that the middle syllable of “economy” is “confidence.” Without confidence and trust, a modern economy requiring hundreds of millions of transactions big and small cannot function; it will freeze up.

Last week’s sudden failure of two large regional banks, albeit ones that were highly specialized and focused on two very risky areas of the economy (crypto in the case of Signature and tech start-ups in the case of Silicon Valley) has shaken confidence across the economy. And while the Fed’s rapid action to effectively insure all deposits of the two failed banks (but not the bond or equity holders) should quell the broader bank run that seemed to be looming, the deeper confidence hit was sufficient in our view to accelerate several of the “rocky landing” forces we cited just last Friday. Inflationary pressures ahead most assuredly will decline now, and the Fed, in our view, is most assuredly now on hold with further rate hikes. We are still hopeful this combination can allow the economy to lurch into slower growth/lower inflation mode without a full-blown recession. We’ll see. 

Here are five further thoughts post the weekend’s developments:

1. This is not 2008. The problem the banking system faced in 2008 was largely due to significant unrealized losses on its credit books, primarily a result of misplaced investments in derivatives of the burst real estate bubble. This problem was systemic because many banks had participated in these derivatives under the false assumption that “real estate prices never go down,” only to see that they do. In some ways, the sudden failures of Signature Bank and Silicon Valley Bank were not dissimilar to the 2008 problems. In the case of the first, the issue was failed investments in the crypto bubble which came undone. In the second, it was a rapid decline in the value of its government bond book of assets, theoretically credit-risk free but unfortunately not free of duration risk when the Fed suddenly and unprecedently hiked rates 450 basis points in just over 10 months. In both cases, matters were made worse by an over-concentration of funding sources that made a bank run relatively easy and quick to effect, particularly in today’s fast-moving “Twitter age.” However, the bulk of the regional banking system under pressure today has neither the credit/duration risk nor the depositor risk that Signature and Silicon Valley had. So, it seems unlikely that the rapid fall of these two banks will lead to a quick, domino-like contagion like we saw in September 2008. That may not preclude another failure or two that is off our radar screens, but again, not a broader systemic failure.
2. The FDIC and Fed have bought time for the rest of the banking system to prove its resilience. The actions by the FDIC to insure all deposits of SVB and by the Fed to provide a funding facility allowing banks in a liquidity crunch to borrow cash against their underwater Treasury bonds at par should buy time for the rest of the banks in the system to prove their resilience. Depositors seeking to withdraw cash should have little difficulty doing so over the next several weeks, and that alone should quell the panic. Time is now on the system’s side.
3. A significant tightening of credit conditions across the economy seems likely. Make no mistake, while the initial regulatory response was probably sufficient to stave off a panic, it certainly will have a sobering effect on lending activities at all banks in the near future. The deposit guarantee, for instance, should calm depositors, but not bank managers; its issuance appears to be subject to their losing their jobs first and their equity investors being wiped out. Similarly, the credit facility, while providing a useful backstop in a liquidity crunch, is not a free one; the roughly 5% interest rate it bears would eat into forward profitability for sure. All this means that the banking system is likely to accelerate the balance-sheet shrinkage already underway, draining liquidity from the economy and slowing growth.
4. Expect further pressure on the jobs market, slowing wage demands in the months ahead. Friday’s weaker-than-expected increases in wages is likely to be the first of many in our view. With credit tighter and confidence across the economy lower, it seems likely the months ahead will see reduced job growth and maybe even net contraction, along with moderating wages. We still think there is enough resilience across the economy to prevent a more severe, synchronized downturn, but as the economy lurches to a slower growth path it could at times feel worse than it is.
5. The Fed most certainly will go on hold, at least for the next several months. Readers of this space know that we’ve been less than impressed with the perspicacity of the Fed’s forward outlook models, and certainly its failure to begin the current rate-hiking cycle a year earlier than it ultimately did. Its torpidity is directly responsible for the mess we now find ourselves in. In general, a modern economy driven by millions of decisions a day needs time to gradually adjust to changing conditions, and quick lurching moves like we’ve just been through are never good. But we suspect the weekend’s crisis was enough to remind the Fed of this point. It now should wait and see if the seemingly inevitable slowdown in growth and inflation materializes, and our guess is it will at the risk of breaking anything else.

For now, we are sticking with our outlook for a rocky landing and not a synchronized, deeper recession. We think the weekend’s developments have been a big, though not fatal, hit to confidence. Time, we think, is on our side. We remain max underweight growth and tech stocks, where the forward fallout is likely to remain highest. And we’re still looking to buy the dips in the broader market from here, with 3,600 on the S&P 500 in our sights.