A lot has changed in the last month, so I wanted to provide you with an update on recent events in the financial markets. Notably, there have been failures of some regional and international banks, which, combined with ongoing uncertainty about the economy and Federal Reserve interest rate policy, has led to remarkable volatility in financial markets, especially in bond markets. Some US Treasury notes experienced more volatility over the last month than you might expect to see in a period of years, reminding us that while Treasury bonds are guaranteed if held until maturity, their values can swing quite a bit prior to maturity.
The fallout from the bank situation is still unknown, but I do not believe that this is a moment like we experienced with Lehman Brothers in 2008. However, the risks in the market that caused the failures are still present. Regulators have taken steps to backstop depositors and create short-term lending solutions for banks, which should help stem the risks for now. However, investors must remain alert to the risks that have been brought on by the Federal Reserve’s policies over the past few years, during which they created a very loose monetary policy and then followed it with a very restrictive one. These bank failures are, in my opinion, a result of these policies.
Despite all this, the stock market has performed well, with the S&P 500 Index gaining about 7.5% in the first quarter. However, participation in the move has been weak, with performance dominated by large, growth-oriented stocks, especially in the technology sector. Outside of about 10 of the largest stocks, the S&P 500 is roughly flat for the year. The equally-weighted S&P 500 index is only up about 1.8% in the first quarter, illustrating that it’s really just the largest stocks fueling most of the gains. If you didn’t happen to own those, your performance was probably muted. I do not think this means that the market is set for a big drop, just that it is not ready for a sustained move to the upside.
I have previously discussed my view that the economy may be heading towards a recession, and in the aftermath of the bank issues, bank lending is likely to tighten, which will further slow economic growth. Smaller banks were responsible for 57% of total loan growth last year, and they are expected to pull back on credit more than their larger peers. Less lending may mean less business growth, which could apply an additional brake to the economy.
However, a silver lining is that tightening in financial markets has helped bring the Federal Reserve closer to where it wants to be. In fact, the bond market is indicating that the Federal Reserve’s rate hike cycle is nearly over. So, the economic slowing that resulted from the Fed’s restrictive monetary policy, combined with the impact that the bank failures are likely to have on lending and growth, may allow the Fed to take a break from interest rate hikes and other tightening measures. This is news that the stock market would like, once it digests it. Additionally, the Federal Reserve is now in a position where it could step in and add support, a position they were not in a couple of years ago. Now that short-term rates are higher, the Fed could lower rates if it felt it needed to stimulate the economy or step in to prevent an emergency.
I have mentioned before that I believe that markets will start to focus more on corporate earnings and less on inflation and the economy. Over time, stock prices tend to follow the earnings of the underlying companies, so it is important that earnings do not fall too much. So far, I’d say corporations have done well, with results released in the first quarter coming in better than feared. The next few weeks of earnings releases will be very important, as we’ll be waiting to see if the gradually slowing economy will be reflected in lower corporate earnings, and therefore in lower stock prices.
I’ve fielded a few questions recently on the possibility of the US Dollar losing its status in global trade. I suppose that this is inevitable, as currencies have come in and out of favor for millennia. However, I don’t think it’s imminent. I believe that the Dollar is the most trusted global currency, and only the Euro is closely positioned. According to Eugenio Aleman, the Raymond James Chief Economist, the Dollar represents about 60% of global banking claims and liabilities, is used in 88% of currency transactions, and over 60% of foreign exchange reserves are held in Dollars. My understanding is that these numbers are actually up, not down, suggesting that the Dollar is still the preferred currency. Meanwhile, the Euro is in second place at 20%, and Chinese currency stands at about 3%. For now, we can put this Dollar concern to bed.
In closing, the current bear market is already 15 months long and was down 27% at its lows. For context, recessionary bear markets historically have averaged 33% declines over 13 months. This suggests that while the economy may slow down or even contract, most of the damage may already be done to stocks. Investors can use pullbacks as opportunities to put cash to work.