Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, March 13th at 11 a.m. in New York. So let's get after it.
The speed and size of the Silicon Valley bank wind down over the last week was startling to many investors, even those who have been negative on the stock for months on the basis of exactly what transpired- a classic mismatch between assets and liabilities and risk taking beyond what a typical depositor does. To be clear about our view, we do not think there's a systemic issue plaguing the entire banking system, like in 2007 to 2009, particularly with the FDIC decision to backstop uninsured deposits. However, last week's events are likely to have a negative impact on economic growth at a time when growth is already waning in many parts of the economy.
Rather than do a forensic autopsy of what happened at Silicon Valley and other banks, I will instead focus my comments and what it may mean for equity prices more broadly. First, I would remind listeners that Fed policy works with long and variable lags. Second, the pace of Fed tightening over the past year is unprecedented when one considers the Fed has also been engaged in aggressive quantitative tightening. Third, the focus on market based measures of financial conditions, like stock and bond prices, may have lulled both investors and the Fed itself into thinking policy tightening had not yet gone far enough. Meanwhile, more traditional measures like the yield curve have been flashing warnings for the past 6 months, closing last week near its lowest point of the cycle.
From a bank's perspective, such an inversion usually means it's more difficult to make new profitable loans, and new credit is how money supply expands. However, over the past year, bank funding costs have not kept pace with the higher Fed funds rate, allowing banks to create credit at profitable net interest margins. In short, most banks have been paying well below market rates, like T-bills, because depositors have been slow to realize they can get much better rates elsewhere. But that's changed recently, with depositors deciding to pull their money from traditional banks and placing it in higher yielding securities like money markets, T-bills and the like. Ultimately, banks will likely decide to raise the interest rate they pay depositors, but that means lower profits and lower loan supply. Even before this recent exodus of deposits, loan officers have been tightening their lending standards. In our view, such tightening is likely to become even more prevalent, and that poses another headwind for money supply and consequently economic and earnings growth. In other words, it's now harder to hold the view that growth will continue to hold up in the face of the fastest Fed tightening cycle in modern times. Secondarily, the margin deterioration across most industries we've been discussing for months was already getting worse. Any top line shortfall relative to expectations from tighter money supply will only exacerbate this negative operating leverage dynamic.
The bottom line is that Fed policy works with long and variable lags. Many of the key variables used by the Fed and investors to judge whether Fed policy changes are having their desired effect are backward looking- things like employment and inflation metrics. Forward looking survey data, like consumer and corporate confidence, are often better at telling us what to expect rather than what's currently happening. On that score the picture is pessimistic about where growth is likely headed, especially for earnings. Rather than a random or idiosyncratic shock, we view last week's events as just one more supporting factor for our negative earnings growth outlook. In short, Fed policy is starting to bite and it's unlikely to reverse, even if the Fed were to pause its rate hikes or quantitative tightening. Instead, we think the die is likely cast for further earnings disappointments relative to consensus and company expectations, which means lower equity prices before this bear market is over.
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