Silicon Valley Bank Highlights Why the Fed Should Focus on More Than Just Employment

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

The job market has long been recognized as a lagging indicator for the economy. Employers are typically slow to rebuild staffing levels until well after a post-recession economic expansion has taken root. Likewise, layoffs are often considered a last resort for businesses trying to cut costs during a period of slowing or even contracting economic activity. The reason for the delay is straightforward: Hiring and laying off employees is challenging, time consuming and costly. As such, businesses avoid making significant swings in staffing levels until their hands are forced. This approach makes sense for companies that understandably conclude it is better to act late and adjust staffing levels to economic realities than to act too soon and be forced to deal with the result of payroll decisions made based on false economic signals. However, for this same reason, it makes managing monetary policy based on lagging jobs numbers less than ideal for navigating an economic soft landing.

The potential pitfalls of the Federal Reserve’s ongoing focus on the job market were on display last week as headlines painted two very different views of where we are in the business cycle. Employment numbers suggested a still strong economy, according to a pair of reports from the Bureau of Labor Statistics, while signs of cracks in the business climate began to appear in the financial sector. The employment reports showed that while there was modest easing in demand for labor, overall, businesses are still hiring, and available job candidates remain scarce. Given the Fed’s insistence on seeing sustained weakening of the job market, we believe the latest report could provide further incentive for the Federal Open Markets Committee to maintain its stance of higher rates for longer. However, the cumulative effects of the already enacted rate hikes are beginning to take hold and contributed to the failure of Silicon Valley Bank (SVB) last Friday and Signature Bank on Sunday.

SVB, which serves a concentrated client base that is focused on tech and venture capital firms, failed after it was forced to sell bonds at a loss to meet the withdrawal demands of its customers. The cash needs of its clients were the result of dwindling corporate valuations that resulted from the Fed’s aggressive rate hikes during the past year. As the Fed has drained liquidity from the economy, speculative portions of the market, such as the types of businesses that the bank served, have found it increasingly difficult to raise money from sources that were plentiful when the Fed was flooding the economy with easy cash. It is important to note we don’t view the failure of SVB as representative of underlying issues with the broader banking industry. Larger, more diversified financial institutions are heavily regulated and financially strong, and they have undergone stress testing for years following the Great Financial Crisis.

Furthermore, the Department of Treasury, Federal Reserve and Federal Deposit Insurance Corporation (FDIC) announced late Sunday evening that all SVB depositors will be protected and will have access to their money starting Monday, March 13. Shareholders and certain unsecured debtholders will not be protected. No losses associated with resolution will be borne by the taxpayer. A similar resolution was announced by New York regulators late Sunday evening for Signature Bank.

Importantly, the Federal Reserve simultaneously announced the creation of the Bank Term Funding Program (BTFP), which will allow institutions covered by FDIC deposit insurance to borrow against eligible collateral at par value for up to a year. SVB had poor asset liability management, investing in higher-quality but longer-term securities, which had to be sold at losses that resulted from rising interest rates. The sales were required to meet nearer-term needs. This Fed program will allow institutions to borrow against these high-quality securities at par, rather than sell them at losses. This is an important step.

As such, we do not believe there is a systemic risk of cascading bank failures spreading throughout the economy. However, we believe that the underlying challenges that forced SVB to close its doors are reflective of the impact of tighter financial conditions brought on by the Fed’s actions. While we don’t view SVB as representative of the strength of the broader banking system, we believe it should serve as a warning to the Fed that the already enacted rate hikes are taking a toll on the economy. While the employment market continues to appear robust, and this week’s Consumer Price Index will likely remain elevated, the Fed needs to increasingly weigh the potential damage further rate hikes will do to the economy. We believe SVB provides an important reminder to the Fed that while backward-looking employment numbers may look resilient, financial cracks are beginning to show elsewhere, and the broader economy is likely to continue weakening.

The Fed’s insistence on focusing on the lagging employment picture is why we continue to view a recession as the likely outcome in the months or quarters ahead. However, given the relative financial strength of consumers and businesses, we believe a potential downturn will be shallow, short and uneven. Importantly, as we noted in our latest Asset Allocation Focus, 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

Consumer debt rises: Household debt increased at an annualized pace of 2.3 percent in the fourth quarter, driven by a 7 percent annualized increase in consumer credit and a 4.4 percent annualized rise in mortgage debt. For the entirety of 2022, household debt grew by $1.015 trillion. While household net worth rose by $2.9 trillion in the fourth quarter, it fell by $4.1 trillion for the entirety of 2022.

Despite the increase in debt in 2022 and the drop in net worth that resulted from falling stock, bond and housing prices, the latest data shows that at the end of 2022, the debt-to-net worth ratio for consumers was 12.8 percent, up from 11.8 percent at the end of 2021. However, the current levels are still down significantly from the peak of 23.8 percent in early 2009 and are at lows not seen since 1976. A recession that includes jobs losses and the potential for falling asset prices would likely lead to some continued deterioration in balance sheet strength, but in aggregate there remains a “cushion” in the U.S. economy. The continued relative strength of U.S. consumer balance sheets is one reason we believe any potential recession is likely to be mild.

Job market holds steady: Overall, the data last week showed the U.S. labor market remains strong, with both job openings and the non-farm payrolls report showing strength. However, both weekly jobless claims and the Challenger U.S. Job Cuts report showed signs of slowing.

The Job Openings and Labor Turnover Survey from the Bureau of Labor Statistics (BLS) showed a slight monthly drop of 410,000 job openings in January. The latest measure pegs the number of openings at 10.82 million positions, or approximately 1.9 openings for each person currently looking for work.

The BLS’s other employment gauge — the Nonfarm Payrolls report — showed the economy added 311,000 jobs last month. While the number was down from January’s surprising 517,000 new positions, it was still above Wall Street estimates. It’s worth noting that the services side of the economy continued to see job growth, which is consistent with the transition in spending we’ve highlighted away from goods and toward services. The unemployment rate rose from 3.4 percent to 3.6 percent as an additional 419,000 Americans re-entered the workforce, which drove the labor force participation rate up a tick to 62.5 percent. Wages rose a modest 0.2 percent and are now up 4.6 percent year over year. While the 311,000 jobs gained in the month will likely be viewed as too many for the Fed’s comfort, the good news is that more individuals re-entered the labor market, and wage growth was modest. As we highlighted in our recent Asset Allocation focus, the Fed is most fearful of a wage-price spiral driven by a lack of labor supply that will result in continued wage elevation. This report showed additional supply and modest wage growth.

The Challenger Job Cuts report showed a continued rise in layoff announcements as 77,770 job cuts were announced in February, up from only 15,425 for the same period last year. The latest figure combined with January’s 102,943 cuts brings the two-month total to 180,713, marking the worst start to a year since 2009. Reflecting the recent stress in the technology sector, more than a third of the job cuts year to date have been by technology companies.

Weekly jobless claims inched up last week to 211,000, up 21,000 the prior week. Importantly, continuing claims (or those remaining on unemployment benefits) are now at 1.7 million, well above the level of 1.3 million recorded in May 2022. We view the rise in continuing claims as an early sign of softening in the labor market as it is becoming more difficult for job seekers to land positions.

The week ahead

Tuesday: All eyes will be on the Consumer Price Index report from the Bureau of Labor Statistics. Data continues to show progress in the disinflationary process, although the latest reading of the Personal Consumption Expenditures Price Index raised some concerns that the decline in inflation was beginning to slow. We will be dissecting the data to see if the pace of disinflation has regained its momentum.

The NFIB Small Business Optimism Index readings for February will be out before the opening bell. The report should provide insights about the state of the labor market for small companies and expectations related to price increases at the consumer level in the year ahead.

Wednesday: The U.S. Census Bureau will release the latest numbers on retail sales before the opening bell. The data should yield insights into whether consumers are pulling back on discretionary spending in the face of rising costs. We will also be watching for changes in the trend of consumers turning away from buying goods.

The latest readings from the U.S. Bureau of Labor Statistics on its Producer Prices Index will offer a front-line view of changes in costs for buyers of finished goods. It can provide insights into how easing input costs, such as raw materials and wages, are impacting the prices of goods bought by end consumers.

A week heavy on housing reports kicks off mid-morning with the Home Builders Index from the National Association of Home Builders.

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

We will get February housing starts and building permits from the U.S. Census Bureau. This data, along with the Homebuilders Index released on Wednesday, will provide a clearer picture of demand for housing as mortgage rates have retreated modestly in recent weeks.

Friday: The Conference Board’s latest Leading Economic Index survey will be a key release during the week. Recent reports have suggested the U.S. economy may be on the cusp of a recession. We will be scrutinizing the data for any indications of a change in the pace of softening.

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