Stocks, bonds, and commodities all finished higher last week as authorities worked to contain the fallout from recent bank failures. The week began with news that UBS would absorb rival Credit Suisse in somewhat controversial fashion, with Credit Suisse AT1 bondholders facing a total write-down of their principal value while the company’s common shareholders received 3 billion Swiss francs in the transaction (~$3.2 billion). Faced with the prospect of a buyer’s strike in the AT1 market, the ECB and the Bank of England both immediately issued communiques indicating that any future bank resolutions in their jurisdictions would be handled in accordance with the established order of capital structure seniority, meaning common shareholders would be wiped out before subordinated bondholders took losses.
With that as a backdrop, the FOMC announced a 25bp rate hike at the conclusion of its March meeting on Wednesday afternoon. Tweaks to the language in the press release opened the door to a pause in the hiking cycle as soon as the next meeting in early May, and during the ensuing press conference Fed Chair Jerome Powell acknowledged that the real economy had slowed significantly while also reiterating that the US banking system is “sound and resilient.”
However, Powell also stated emphatically that the Fed does not anticipate cutting rates at all in 2023, and on that point the market clearly disagrees. As of Friday’s close, the Fed Fund Futures market was pricing in at least three 25bp rate cuts by year-end, in stark contrast to the Fed’s own “dot plot” projections (see Chart of the Week). This dichotomy suggests that market participants believe there is significant risk of a US recession in 2023, a scenario that could force the Fed’s hand on rates.
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 17x 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. The equity risk premium has expanded slightly over the past few weeks on concerns regarding the financial system.
Rates rose in 2022 in response to a sharp pivot in monetary policy, but have fallen significantly (except for the very front end) so far in 2023. Futures markets are currently pricing in three 25bp cuts to overnight rates by year-end.
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 of 2023.