Higher for Longer

by Shawn Narancich, CFA
Executive Vice President
Equity Research and Portfolio Management

Higher for Longer

That a notable Silicon Valley bank failure could overshadow significant developments in the labor market is a testament to how attuned investors remain to the unpredictable consequences of the Fed’s ongoing campaign to raise interest rates. With the banking industry suddenly in focus, investors had plenty to consider this week as an action-packed sequence of reports portraying puts and takes in the labor market left blue chip equity markets with their worst weekly losses of the year. Largely unresolved is whether the Fed will reprise larger rate hikes when they next meet on March 22. One narrative that appears to have disappeared with Fed Chair Powell’s Humphrey-Hawkins testimony to Congress this week is that our central bank will be cutting rates by the end of this year. Tighter monetary policy is unlikely to be reversed anytime soon amid a robust jobs market.

Reading the Tea Leaves

Investors digested the monthly Job Openings and Labor Turnover Survey (JOLTS) and the February payroll report for clues about Fed policy. Two key readings came in stronger than anticipated, as U.S. employers added a larger-than-expected 311,000 net jobs in February while job openings of 10.8 million fell less than forecast — the good news is still bad for the capital markets. Job creation fell from surprisingly robust January levels, with retail, construction, healthcare and professional service industries hiring the most, more than offsetting job losses in manufacturing. While the jobs number came in above expectations, so did the unemployment rate. It rose two-tenths of a percentage point to 3.6% and exceeded estimates as the labor force and its participation rate expanded. The Fed will like the fact that the supply of labor is growing because more people looking for jobs increases the economy’s productive capacity and helps take the edge off wages, which rose in February at a sequentially slower than anticipated rate.

Two key data points remain for the Fed before it meets next – the February Consumer Price Index report next Tuesday and the retail sales report afterward. If inflation and retail sales prove more robust than anticipated, the Fed will likely raise short-term interest rates by another half a percentage point.

Collateral Damage?

Despite recent headlines portraying a surprisingly strong economy, the Fed’s dashboard of economic indicators is becoming more mixed as layoff announcements rise and corporate earnings fall. Additionally, the Fed now must consider what signal, if any, to draw from this week’s failure of Silicon Valley Bancorp (SVB). Pushed into FDIC receivership this morning after it failed to raise capital earlier in the week, SVB appears to be a case of poor liquidity management. With a unique customer base concentrated in venture capital and development stage companies that use cash even in the best of times, the bank’s reserve assets proved to be a duration mismatch with the call on its customers’ deposits. Losses on the resulting sale of longer-term Treasuries and an attempt to raise capital precipitated a loss of confidence by depositors, creating a run on the bank that ultimately proved to be its undoing. Importantly, SVB’s failure does not appear symptomatic of larger credit quality issues with the banking industry overall. Banks are generally well-capitalized today despite having increased credit reserves in anticipation of a weaker economy. We believe the U.S. banking system is sound and do not expect widespread contagion from SVB’s failure.

While we recognize that banking stocks declined in sympathy with this event, a higher-for-longer interest rate environment being deployed by the Fed will likely be more impactful to bank earnings than either bank solvency or liquidity issues. At a banking industry conference this week, KeyCorp warned of lower-than-expected net interest income. To attract more deposits in a higher-interest-rate environment, the bank is offering higher CD and savings account rates. The issue is that as customers borrow money, loan-to-deposit ratios are rising to the extent that banks are having to pay more to fund their lending. This is the stuff of a typical banking cycle and not, we emphasize, a systemic threat to the U.S. banking system.

Staying the Course

More broadly, we observe a stock market at present that is hewing more closely to the heightened volatility we had anticipated in the first half of 2023. The fourth quarter earnings season is complete, and we witnessed the first decline in profits since the fall of 2020. Earnings revisions are likely to bottom out later this year. As the Fed ultimately stops raising interest rates, we look forward to a more productive environment for equities in the second half of 2023. In the meantime, our stock selection has become more defensive, emphasizing less cyclical exposure to industrials and more exposure to healthcare stocks, less impacted by what we expect will be a slowing economy.

Finally, we are happy to observe that long-term bonds are beginning to act like they should – as a key diversifier of client portfolios. While the S&P 500 declined over 4% this week, bond prices rose.

Our Takeaways from the Week

  • Key labor market reports and Fed testimony point to additional rate hikes ahead

  • Silicon Valley Bank’s failure is not symptomatic of broader banking industry distress

Disclosures