The stock market continues to grow. Risks keep happening.
Never underestimate the stock market’s ability to prioritize hope over experience.
Experience suggests otherwise. Banking panic is not something to be trifled with. As Fed Chairman Jerome Powell acknowledged on Wednesday, the latest one will certainly slow the economy. He suggested it was equivalent to a rate increase, although some put it at half a point or even 1.5 percentage points. Knowing this, Powell still raised rates by a quarter point, something that could exacerbate problems in the financial system. Andrew Brenner of NetAlliance Securities writes, “The Fed is making a mistake.”
However, the problem is unlikely to be more bank failures. It’s that banks are likely to freeze lending – lending they’ve already begun to limit. Even before the SVB failure, the Fed’s January senior loan officer opinion survey showed the percentage of banks tightening lending standards had risen to 44.8%, the highest reading since July 2020, when the COVID lockdown was at its peak. Given the problems in regional banks, this percentage is likely to go even higher.
History tells us that’s bad news. The tightening numbers were already approaching a level that indicated a recession was imminent. Bank of America economist Michael Gapen, using lending data from 1991 to 2022, found that the “shock to lending standards” caused declines in employment, consumer lending, and investment in structures and equipment. Gapen acknowledges that the consequences may exceed those of the financial crisis, as well as the assumption that all banks will tighten lending standards, not just smaller ones. That’s not enough to dismiss the results.
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“Downside risks to the outlook have increased,” they write. “An adverse shock to bank credit growth could have adverse economic consequences.”
Other indicators are already suggesting as much. In the junk-bond market, the percentage of distressed issues – those with a yield higher than 10 percentage points or equivalent Treasuries – jumped from 7.8% on March 8 before the SVB collapse to 10.6% just seven trading days later, on March 17. According to Martin Fridson, chief investment officer at Lehman Livian Fridson Advisors.
That’s a big move in a short period of time, occurring in the 31 trading days ended December 31, 2007, when the distressed ratio rose from 7.5% to 10.4%. Again, there are caveats—the current percentage isn’t much higher than the 9.3% average from 1997 to 2022—but it’s a caveat that shouldn’t be ignored. “All signs are pointing to an increasing likelihood of a recession,” says Fridson.
The stock market would seem to disagree. It has gained 11% since trading at a new low on October 12, nearly five and a half months ago, which some are suggesting is the start of a new bull run. Perhaps. But if this is a new bull, it is one of its weakest in recent memory, according to Warren Pye of 3Fourteen Research. Since 1974, the S&P 500 has gained an average of 32% in the six months following its previous low. The smallest gains occurred in 1987 and 2002, when the index rose just 13%, so it is possible for the stock market to close that gap. Yet, in only one of those periods was the Fed raising rates, and none occurred when the yield curve was still inverted, as it is now.
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“In short, the past six months bear little resemblance to a typical postbottom environment,” Pai writes. “Yet, for equity investors, there is hope.”
Of course, the Fed looks like it is nearing the end of its tightening cycle, something that has been cited as a catalyst for the market rally. But according to BofA’s Michael Hartnett, investors can apply the lessons of the past 25 years — a period of deflation — rather than the 15 years that preceded it, which can safely be described as inflationary. During the deflationary stretch from 1989 to 2018, the last rate hike was followed by six months of strength, with the Dow Jones Industrial Average returning an average of 13.1%. But during the period of inflation, which lasted from 1974 to 1984, the Dow declined an average of 6.4% in the six months following its previous rise.
We can only hope that is not true this time.
write to Ben Levisohn at [email protected]