Last week was calm at the start, with rates relatively stable through Wednesday’s close while equities were only slightly lower. That all changed on Thursday, however, as market participants watched the rapid descent of Silicon Valley Bank into receivership. In the span of barely 24 hours, investors went from worrying about inflation and Fed policy to wondering how many small technology firms might suddenly have liquidity challenges and grappling with the possibility of a wider crisis of confidence within the banking system.
Asset price changes were consistent with a broad-based increase in risk aversion:
- Treasuries rallied
- Credit spreads widened
- Commodities fell
- Equity prices moved lower
Predictably, financials were the worst performing sector, while defensives such as staples and utilities were less impacted. Small caps underperformed, as one might expect given their greater dependency on banks for liquidity and financing.
This episode has radically altered investor expectations regarding the forward path of Fed policy, under the assumption that the Fed is less likely to further tighten policy if the banking system appears wobbly. One week ago, futures markets were pricing in 3 or 4 additional rate hikes in 2023, and no rate cuts prior to year-end. Futures now suggest that the Fed will hike 25bp in March and then stop, and that as many as three rate cuts could occur by December. As a result, the implied year-end Fed Funds rate has fallen nearly 150bp, from 5.56% to 4.10%, in just three days.
Albion’s “Four Pillars”:
Economy & Earnings
The US economy enjoyed a strong second half of 2022, but corporate operating margins have been gradually falling as labor and input cost pressures bite. Albion’s base case expectation is that the US economy will enter recession in 2023, putting downside pressure on earnings.
The S&P 500’s forward P/E of 18x is above the long run average. More predictive metrics like CAPE, Tobin’s Q, and the Buffett Indicator (Mkt Cap / GDP) suggest that compound annual returns over the next decade are likely to be in the single digits. Most or all of 2022’s P/E multiple compression was driven by rates, rather than an expansion of the equity risk premium.
Rates rose across the curve in 2022 in response to a dramatic pivot in monetary policy. Fed Fund Futures are pricing in one more 25bp hike in March, followed by a pause and then several rate cuts in the back half of the year.
After reaching 40yr highs in spring of 2022, inflation moderated in the second half of the year. Goods inflation has fallen due to softening demand and excess inventory, while services inflation remains elevated, in part due to shelter costs which are somewhat lagged. Real-time inflation data ticked higher sequentially in February.