Banking Concerns Shine a Light on Economic Strains

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

Stocks moved mostly higher for the week despite a surge in volatility spurred by the failure of Silicon Valley Bank (SVB) and the struggles facing Credit Suisse and First Republic. There were some positive developments over the weekend as UBS Group AG agreed to buy Credit Suisse, and a group of 11 major U.S. banks agreed to deposit $30 billion in First Republic to shore up its financial stability. While many people remain concerned about the strength of the U.S. banking system, investors also grew optimistic that the latest events would force the Federal Reserve to reconsider its tough stance on rates. At one point last week, the futures markets suggested the odds that the Fed would leave rates unchanged when it meets this week amounted to little more than a coin flip. As of this writing, we anticipate the Fed will raise rates 25 basis points but expect Fed Chair Powell to soften his stance on rates going forward. Consistent with our outlook, following Fed action later this week, market participants expect the Fed to spend the back half of 2023 cutting rates by 1 percent.

As we noted in last week’s commentary, we do not believe there is a systemic risk of cascading bank failures spreading throughout the economy. While the strain revealed by SVB is widely viewed as too big for the Fed to ignore, it is only the latest sign that the economy is starting to crack in the face of higher rates and liquidity slowing to a trickle. Given the latest developments in the banking sector, we anticipate that already stringent lending standards will become even tighter, leading to a further reduction in liquidity. Businesses and consumers have already had to adjust to a lending climate that is consistent with levels typically experienced during recessions. Reduced liquidity typically first impacts more speculative, interest-rate sensitive areas of the market, but as money supply continues to dry up, other areas of the economy typically also begin to struggle.

As we’ve catalogued over the past several months, the pace of inflation continues to fall, with the bulk of progress made on the goods side of the economy as demand has waned and supply chains have been rebuilt. While inflation on the services side of the economy has remained resilient, the overall number is deceiving in our view, given that lagging indicators such as shelter are driving a significant portion of the elevated reading. Against this backdrop, we believe the Fed has an opportunity to reconsider its insistence on seeing the labor market weaken before pausing this rate hike cycle.

If the Federal Open Markets Committee heeds the warning SVB represents, we believe the likely coming recession will be shallow and short-lived. And given the already considerable progress made on the inflation front, as well as still tempered inflation expectations and slowing wage growth, the Fed will have room to cut rates should the economy contract more rapidly than is currently expected. Regardless, we don’t believe the current financial challenges warrant wholesale portfolio changes. Instead, it is important to remember that over intermediate and longer periods, the impact of a recession on a well-diversified financial plan can fade quickly.

Wall Street Wrap

More progress on the inflation front: Headline inflation, which includes all tracked items, fell to 6 percent year over year in February, down from January’s reading of 6.4 percent. On a month-over-month basis, headline prices rose 0.4 percent. Core inflation, which excludes volatile food and energy readings, was up 0.5 percent month over month and came in at 5.5 percent year over year, down from last month’s reading of 5.6 percent. Shelter was the primary contributor to the gain in the Consumer Price Index (CPI), accounting for more than 70 percent of the gain.

The latest CPI report shows that prices for goods rose just 1 percent year over year, well down from the 12.3 percent year-over-year growth recorded in March 2022. Consumer demand has shifted away from goods to services as supply chains have healed. Much as we expected, the result has been a significant drop in goods inflation.

Services inflation has risen as demand has continued to climb; however, the majority of the rise is tied to the lagging shelter calculation. Overall CPI after removing the lagging shelter component is up a scant 0.72 percent since June 2022, equating to an annualized rate of 1.08 percent.

Given the 12-month or more lag for shelter prices showing up in CPI data, we believe the decline in home prices over the past several months will begin to push the overall services rate of inflation lower.

Wholesale prices ease: Producer input final demand costs fell 0.1 percent in February, according to the latest Producer Price Index from the Bureau of Labor Statistics. This measure peaked on a year-over-year basis in March 2022 at 11.7 percent and has since slowed dramatically. Producer prices have been flat for the past three months and, like CPI, are up a modest 0.66 percent (0.98 percent annualized) since June 2022. We expect the steady decline in producer prices will continue to lead to easing prices for consumers.

Builder confidence ticks higher, but pessimism remains: According to data out last week from the National Association of Home Builders, optimism crept higher for home builders. The latest sentiment reading in its Home Builders Index came in at 44, still in contraction but up two points from the prior month (readings of 50 or above indicate expansion). The report showed an uptick in home sales; however, the increase was spurred by price cutting, with 31 percent of respondents noting they had reduced prices or offered buyer incentives.

Consumer sentiment remains weak: Concerns about the direction of the economy weighed on consumer expectations, according to the latest data from the University of Michigan Sentiment survey. The gauge of economic expectations for six months into the future dropped for the first time in four months, registering at 63.4 percent, down from February’s reading of 67. Sentiment on the current state of the economy dropped to 66.4 from the prior month’s reading of 70.7. It’s worth noting that the majority of the surveys (85 percent) were completed before the announcement of the closing of Silicon Valley Bank. As news of concerns about the banking industry begin to permeate news coverage, we believe sentiment (and corresponding buying behavior) will decline further.

Inflation expectations remain well anchored, with respondents expecting prices to increase by 3.8 percent in the coming year, down from February’s expectations of 4.1 percent and the lowest reading since April 2021. Despite the current heightened inflation, respondents do not expect it to persist into the future, with expectations for price increases in the next five to 10 years checking in at “a historically normal” 2.8 percent. As a reminder, inflation expectation is one of the things the Fed watches as it strives to control price pressures.

More signs of a stalling economy: The Conference Board’s latest Leading Economic Index (LEI) dropped 0.3 percent in February, marking the eleventh consecutive month of decline. The reading is now down 7.4 percent on an annualized basis over the past six months. For context, each time during the past 63 years that LEI readings have been at the levels we are seeing today, the economy has either been in or on the verge of a recession. As we’ve noted in the past, we don’t believe inflation will be able to withstand a recession. Given our belief that inflation is set to continue to wane, and with inflation expectations still well anchored, we believe the Federal Reserve will be able to cut rates if need be to keep the economy from falling into a deep recession.

The week ahead

Tuesday: The week kicks off with a look at existing home sales released mid-morning by the National Association of Realtors. This report, along with the new homes data released later in the week, should provide a clearer picture of whether the rapid cooling of the real estate market has stabilized.  

Wednesday: All eyes will be on the Federal Reserve as it releases its statement following its monthly meeting. We expect a hike of 25 basis points and will be watching for signs the Fed is beginning to take into consideration the increasingly tight financial conditions that are having an impact on the economy.

Thursday: Initial and continuing jobless claims will be announced before the market opens. Initial filings fell last week, and we will be watching for signs that the employment picture is weakening.

New home numbers for March will be released before the markets open. We’ll be watching to see if easing mortgage rates have made an impact on demand for new homes.

Friday:  We’ll get an update on the health of manufacturing and services in the U.S. when S&P Global releases its Flash Purchasing Manufacturers Index reports for March. Activity for manufacturing continues to show weakness; however, the services side has been relatively resilient. We will be watching for signs that growth on the services side has plateaued or begun to wane.

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