Regional banks are rattling markets. While the stress warrants caution, we think investors should stick to their long-term plans.
Our Top Market Takeaways for May 05, 2023
Bank angst. Where do we go from here?
Everything is coming to a head at the same time. Bank stress continues to rear its head, the Federal Reserve probably just concluded one of its most aggressive rate hiking cycles in history, and the U.S. debt ceiling is also looming. Stocks have felt the heat this week—the S&P 500 is down over 2% heading into Friday, and the KBW Bank Index has seen its worst week since March. Meanwhile, bonds are proving a worthy ballast, as yields (particularly on the short end) have fallen across the board.
Futures this morning point to some stress abating, and markets do seem aware of where the greatest risks lie. While regional banks have seen a deep selloff (with acute losses this week from PacWest, Western Alliance and First Horizon), larger banks have seen less pain, and broad U.S. markets are still +6% higher so far this year.
Yet even with the risks known, it’s hard to keep track of a puzzle with rapidly moving pieces. As the Fed signaled a pause could be in store after hiking 25 basis points at its meeting this week (to a target range of 5.00–5.25%, the highest since 2007), even policymakers painted a complicated backdrop—inflation remains hot, but growth is incrementally slowing and financial stability is still under threat.
Today, we hone in on the ongoing stress in regional banks and how policymakers could act to mitigate the pain.
The problem: The worry, at least to some extent, seems to have moved on from deposit flight: Both PacWest (which is now considering a sale of its business) and Western Alliance noted they’ve actually seen deposits grow over this period of bank stress. Instead, the biggest concern looks like a question about the right valuation for banks that have made lots of loans at low interest rates (see Michael Cembalest’s explainer on this), and the future of the regional bank industry at large.
When growth slows, default rates tend to pick up as it gets harder for companies to turn a profit. Banks simultaneously face higher costs (from needing to offer more competitive deposit rates) and lower revenue growth (from a slowdown in loans), putting pressure on margins. It’s unclear how much damage might be in store, especially given that regional banks have outsized exposure to the troubled commercial real estate sector, and there are still several players that have big duration bets in their portfolios. On top of that, regional banks may be less able to return value to shareholders, as they’re facing the rebuilding of capital buffers to meet more stringent regulations.
All of this makes it really hard for investors to figure out what the right price is for banks that are looking more vulnerable. Again, the selloff has been deep, suggesting a lot of worry is already reflected—but there still could be more pain to come.
But what can be done to stop the bleeding? Five options for policymakers come to mind:
- Lowering interest rates. This could help troubled banks get a handle on the mismatch between their assets (loans and bond portfolios that have lost value as the Fed hiked) and liabilities (deposits that are competing with money market funds offering higher rates). The issue: The Fed said it’s not considering rate cuts right now with inflation still high—even as markets continue to bet on it.
- Increasing liquidity: The Fed kept quantitative tightening (QT) unchanged this week. Even as the Fed’s Bank Term Funding Program (BTFP) and discount window ensure that the banks in need can get liquidity, QT still drains money from the financial system. This translates to pressure on deposits and tougher lending conditions, but ending QT probably won’t come until the Fed also cuts rates.
- Deposit insurance reform: A number of industry leaders have called for enhancing the FDIC’s deposit insurance, which currently guarantees that deposits are safe if a bank fails—but just up to a limit of $250,000. Upping or extending insurance could reduce the risk of further bank runs, but it’s politically contentious and would require action from Congress. Possible, but a tall feat.
- Banning short-selling on bank stocks. Losses in bank stocks have been compounded by short-sellers betting on lower prices. This means that even large banks on stronger footing have been caught up in the crosshairs. The SEC could ban short-selling without congressional approval as it did in 2008, but there’s some worry about the unintended impact of interfering in markets.
- Supporting consolidation across regional banks. Most expect some consolidation in regional banks. That might be why the First Horizon-TD Bank deal breakdown this week stirred up so much angst, especially as regulatory hurdles were cited as the cause. With the deal abandoned, investors took it as a sign that consolidation might not be all that easy if regulators draw strict lines.
In all, concern around regional banks is likely to keep swirling until policymakers forge a better path for the weakest links. Cutting rates seems to be the easiest solution, but as long as rates remain as high as they are, questions around future bank profitability and valuations of banks’ loan books may wear on. Yet, with inflation as high as it is, it’s not that straightforward.
But while these worries are all valid, investors should stay focused on the bigger picture.
The cracks are evident, but based on what we know now, this episode doesn’t look like another 2008. Not all banks are under duress. Earnings season has also shown impressive resilience from Corporate America: S&P 500 earnings growth looks to contract by -2.3% in Q1 over the prior year—still a slowdown, but a far cry from the over -7% expected heading into the quarter.
That said, continued bank stress does signal that things should slow down from here. Banks will probably lend less moving forward, and the ongoing credit crunch may be a slow burn—already, small businesses are reporting that credit is harder to find. That, in turn, should pressure growth, and eventually the jobs data (today's report showed the labor market is still too strong).
We remain focused on investments that are more defensive and that can offer protection in a downturn. The quick collapse in yields this year—and just this week—demonstrates why bonds are essential. Strategies such as structured notes can help you stay invested in both the good days and the bad through protecting gains and building in a buffer from adverse moves lower. Given U.S. markets will probably be choppy for the remainder of this year, sectors such as reasonably priced technology, healthcare and industrials, as well as opportunities in Europe and China, could offer relative strength. Alternative assets are also well positioned to diversify portfolio risk.
Above all, stick with your investment plan. History suggests that investors who stick to their plans through periods of volatility and uncertainty are better positioned to grow their wealth over time. Your J.P. Morgan team is focused on helping you build portfolios to last, and despite all the consternation, we still see attractive opportunities in today’s market.
All market and economic data as of May 2023 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
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