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In the The Wizard of Oz , Dorothy is caught in a tornado, is whisked away from her home and eventually lands in the magical land of Oz where there is a new reality and anything is possible. The last four weeks feel like a tornado just went through the markets. Like a tornado ripping through a town, following its path shows the damage is usually quite significant, however, nearby, where it misses, it does not look like anything happened at all.
Financials.
As the sector that was hit by the “tornado” here is a snapshot of some of the key stocks. Not including the companies that went to “zero” (Silicon Valley Bank and Signature Bank) it is quite a dispersion, with the larger banks being mostly immune and the smaller banks taken the brunt of the decline:
The actions taking by the Fed that we discussed previously seem to have been successful so far in easing investor and bank customer concerns. A sign of this is that in the last week of March, the Federal Home Loan Bank system issued $37b in debt which is sharply down from $304b just two weeks before.
What could be the next area of concern? Analysts are focusing on commercial real estate (CRE). Morgan Stanley estimates that almost a third of the $4.5t US CRE debt is coming due by 2025, with the biggest area of concern being in low investment grade companies since refinancing at higher rates has the potential to significantly impact earnings at a time when the economy could be in recession. Focusing on high investment grade companies, where their cash flows more than cover any debt obligations despite higher interest rates is the preferred option.
Technology.
Not so dissimilar to the Financials, Technology stocks (which are amongst the largest companies in the market) have been a safe-haven, despite negative earnings revisions. This outperformance has made them “expensive” versus recent history.
…additionally, within technology, semiconductors (SOX) which are typically early indicators of a recovery have also been strong despite the recent spate of negatives…
Interest Rates/Inflation.
This continues to move down the list of things we write about. Inflation is moving in the right direction and the impact of the interest rate increases in the last year have been successful in tightening lending and credit (albeit not without causing a little bank scare). Whether there are one or two more increases is mostly irrelevant for markets at this point. The only question that remains is how long is it until the Fed lowers rates.
Recession.
With the recent deposit crisis in the regional banks, tighter lending conditions are likely to impact small and medium businesses (SMBs) disproportionately. With SMBs generating 40% of US GDP and employing 50% of the workforce (while responsible for creating 2/3 of jobs), most industry executives and investors believe that a recession is inevitable. The base case is a recession later this year, or early in 2024. Consensus is calling for a “mild” recession. What we will continue to monitor closely is the potential risk for something deeper or prolonged.
What does all this tell us? "There's no place like home."
Several things stand out as I write this. The main one is, this might be the most anticipated recession in several decades. With that being said, while there may not be significant downside in the market as investors anticipate interest rates to be CUT some time in the next 12 months, the upside also seems somewhat limited as we use market valuations AND upside to growth expectations as our guidepost as to what type of upside there could be. In this “Land of Oz” where the market has been treating bad news as good news, eventually bad news will be treated as bad news which is what puts a ceiling on markets in the near term.
We will end on a positive note. Over the long term, the market is usually positive…
…so while we expect it to be bumpy over the next several quarters, we will “click our heels” and look forward to getting back to a more “normal” reality.
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