5 Risks Could Derail the Market’s Hot Start

The capital markets have a funny way of making the consensus forecasts look foolish. The most popular prediction headed into 2023 was that markets would suffer through a rough first half but rally by year’s end.

After six consecutive calendar years of US large-cap stocks outperforming US small-cap stocks, many investors thought this might be the year for small caps to outshine large caps. Most market observers expected value stocks to beat growth stocks again this year. US stocks were predicted to continue their decade-long dominance over international stocks. Everyone knew that with higher interest rates and still stubborn inflation, bonds were toast — especially below investment-grade securities. And investor enthusiasm for gold had rarely been lower.

But the exact opposite of almost everything that investors anticipated has happened, at least through the first four months of the year.

The Economy Is Not the Market

The economy appears to be on some preset course, hurtling towards recession in the next 12-18 months. S&P 500 companies have experienced two consecutive quarters of negative year-over-year earnings-per-share (EPS) growth. And small cracks are starting to appear in the labor market data. Yet stocks and bonds are admirably climbing the proverbial wall of worry.

For the past three quarters, I have constantly reminded investors that the economy is not the market and vice versa. Now, as markets inch closer to the second half of the year, the economy is slowing, earnings are falling, and the labor market is weakening.

5 Risks Facing Investors Now

Naturally, investors are on edge and eager to protect their unexpected gains. But one or more of the following five risks could finally produce capital market turmoil in the second half of 2023.

1. Looming credit crunch
2. Overtightening by the Federal Reserve (Fed)
3. Increased competition for capital
4. Declining earnings
5. Debt ceiling debate

Here’s my take on these five risks as the second half of the year gets underway.

Credit Crunch Could Cool an Already Slowing Economy

Easy access to credit is the lifeblood of the US economy. And rising interest rates and tighter financial conditions have made credit considerably more difficult to get this year. 

For example, the Fed’s quarterly Senior Loan Officer Opinion Survey (SLOOS) on Bank Lending Practices released February 6 revealed tighter lending standards and weaker demand for both consumer and business loans. In addition, the Fed survey reported banks’ expectations for lending standards to tighten, demand to weaken, and loan quality to deteriorate across all loan types for the remainder of the year.

Incredibly, that was before the recent failures of Silicon Valley Bank, Signature Bank, and First Republic Bank. Now, in the aftermath of those failures and amid the ongoing regional banking crisis, there’s a bigger package of data that indicates access to credit has become increasingly more difficult. In the Fed’s latest quarterly SLOOS report from May 8, banks reported tighter lending standards and weaker demand for both consumer and business loans across all categories.

Unsurprisingly, given the regional banking crisis, the Fed focused its special set of survey questions on banks’ expectations for changes in commercial real estate loans. And banks cited an expected deterioration in the credit quality of their loan portfolios and in customers’ collateral values; a reduction in risk tolerance; and concerns about bank funding costs, bank liquidity, and deposit outflows as reasons to expect tighter commercial real estate lending standards over the rest of this year.

The SLOOS data also underscores that credit conditions are deteriorating for commercial and industrial, commercial real estate, residential real estate, home equity lines of credit, auto, credit cards, and other consumer loans. But that’s not all. The latest Federal Reserve Bank of Dallas Banking Conditions Survey and the American Bankers Association’s Credit Conditions Index also point to a weakening credit environment

Widening Credit Spreads Point to Weakening Environment

This raises the risk of a credit crunch, with many market observers identifying commercial real estate as the likely culprit. At the very least, tightening credit conditions will cool an already slowing economy.

Perhaps the silver lining is that inflation will continue to fall, allowing the Fed to end its tightening cycle. But a growing chorus of market participants think the Fed may have already overdone it. Let’s examine risk #2 to find out.

Overtightening, Rate Cuts Typically Mean Decline in Risk Assets

On May 3, the Fed raised rates for the 10th time since last March, bringing the target fed funds rate to 5-5 ¼ percent, its highest level since August 2007. Despite ongoing challenges in the US banking system and fresh signs that the economy may be slowing, robust job gains and elevated inflation persuaded Fed policymakers to keep tightening in early May. However, subtle but important changes to the FOMC statement language combined with Chairman Powell’s post-meeting press conference remarks hinted that the Fed’s tightening cycle may soon be coming to an end.

Yet bond market yields suggest the Fed may have already tightened too much.

The target fed funds rate of 5-5¼ percent is notably higher than the yields across every maturity on the curve. For example, the target fed funds rate is more than 1% higher than the US 2-year Treasury yield and 1.5% greater than the US 10-year Treasury yield. Concerned that the Fed has overtightened, bond market participants are anticipating a recession, capital market meltdown, or possibly both in the second half of the year. As a result, investors are aggressively pricing in Fed rate cuts by year’s end. Wildly, some investors expect rate cuts as early as July.

Fed Rate Cuts? Careful What You Wish For

Investors should be careful what they wish for when it comes to Fed rate cuts. Historically, during the monetary policy transition period from the last rate hike to the first rate cut, risk assets perform reasonably well. In fact, that may reflect the current investment environment. But when the Fed begins to cut rates, risk assets typically decline. Afterall, the Fed is lowering rates for a reason — usually in response to a recession or capital market breakdown.

The monetary policy risks to the market’s year-to-date rally share a strange connection. On the one hand, if investors are right and the Fed has already tightened too much, when it begins cutting rates, risk assets are likely to fall. On the other hand, with inflation still well above the Fed’s target and a tight labor market, policymakers just might unexpectedly raise rates for an 11th time on June 14.

Neither outcome — rate cuts or a hike — seems particularly good for the short-term outlook for risk assets, especially now that there’s greater competition for investors’ capital from more conservative money market instruments.

Competition for Capital Dampens Enthusiasm for Risk Assets

In the ultra-low interest rate environment of the past 15 years, there was very little competition for capital. Investors had no choice but to invest in riskier financial assets, spawning the acronym TINA — There Is No Alternative to risky assets. Low rates bolstered the relative attractiveness and valuations of essentially all risky financial assets — stocks, bonds, private equity, real estate, IPOs, SPACs, NFTs, and cryptocurrencies.

Allocating capital to low-yielding money market instruments became an afterthought for investors. That is, until the Fed started aggressively raising interest rates 14 months ago.

Today, certificates of deposit (CDs), money market funds, Treasury Bills, and short term (1-3 years) Treasurys offer yields of 4-5%, more or less. Last year there were precious few places to hide as practically all investments declined and volatility surged. Most investors are expecting a recession, falling earnings, and mounting job losses in the next 12-18 months.

Capital on the Sidelines Waiting for a Better Opportunity

Given last year’s losses and the bleak economic outlook, the perceived safety and stability of money market instruments has become more appealing to investors. Flows into CDs, money market funds, Treasury Bills, and short term Treasurys have soared in the past 12 months. On May 4, the Investment Company Institute (ICI) reported that money market fund assets hit a new record, surpassing $5.3 trillion.

This renewed competition for investor capital has some messy consequences. Significant capital flows into money market instruments saps investor demand for riskier financial assets, putting downward pressure on their valuations. In addition, bank demand deposits continue to yield very little. As a result, depositors are withdrawing their money from savings accounts and placing it in higher-yielding money market funds and Treasury Bills.

According to Strategas Research Partners, commercial bank deposits have fallen by roughly $1 trillion while money market mutual funds have taken in $751 billion since the hiking cycle started.¹ A massive decline in demand deposits could exacerbate banking industry challenges by lowering earnings and reducing loan growth. It will be difficult for the economy to gain traction without a healthy banking environment.

For the glass half full crowd, there’s a tremendous amount of capital on the sidelines just waiting for a better opportunity to come back into riskier financial assets. Perhaps once the anticipated recession begins, investors’ appetite for risk assets will return. Until then, investors lie in wait, comfortably collecting stable, reliable income from CDs, money market funds, Treasury Bills, and short-term Treasurys.

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Footnotes

¹ “Headwinds To Persist For Financials,” The Daily Macro, Strategas Research, May 9, 2023.

² “Debt Ceiling Negotiation Have Started, Now Comes the Hard Part,” Strategas Research Partners, May 10, 2023.

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Originally Posted May 16, 2023 – 5 Risks Could Derail the Market’s Hot Start

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