Market Update

The S&P 500 rose 1.43% last week to finish at 3916.64. The Nasdaq gained 4.41%. The Dow Jones lost 0.15%. It was the first week the Nasdaq rose at least 4% while the Dow fell since 2001. Meanwhile, the two-year Treasury yield fell 0.74% to 3.85%. It was the biggest weekly decline for the two-year bond since the week ending 23 October 1987, according to Dow Jones. That was the week of the Dow's Black Monday crash.

We wrote last week that, “A good CPI report on Tuesday may save the market for now. A bad CPI report will almost certainly lead to a test of 3,800 at a minimum.” We got the test of 3,800 but the market didn’t wait for the CPI report. The S&P bottomed in the first 15 minutes of trading Monday. It touched 3808.36 before rocketing higher to peak at 3905.05. by noontime. The S&P gapped up Tuesday following a stronger-than-expected CPI report. Not the response from investors one would expect given core CPI was higher than expected. Presumably, investors were more focused on the banking news than inflation.

Uncertainty is high. Volatility rises when investors are scared. The volatility index (VIX) peaked Monday at 30.81. It hasn’t been over 30 since early October of last year, around the time the S&P 500 was putting in its low for the bear market. The bond market has been even more volatile. The ICE BofAML MOVE index, a VIX for bonds, spiked to its second-highest reading ever, according to Barron’s. The highest reading was during the bond and stock market meltdowns during 2008. The two-year yield has dropped by 1.2% since March 8th. It started from above 5%. The decline included the largest one-day fall since 1982, according to Barron’s.

The Federal Reserve was expected to hike by 0.5% this week until Silicon Valley Bank (SVB) went bust last week. Futures priced in no hike and June cuts once the body count rose to three (SVB, Signature Bank, and Silvergate). Then the government backstopped deposits and big banks sent $30 billion to New Republic. The futures backtracked. A 0.25% rate hike is back on the table. Futures are still pricing in rate cuts by the June meeting though. That seems unlikely given that core CPI is at 5.5% year-over-year and core CPI month-over-month rose in February. Yet here we are.

A bit more than a week ago the futures implied an 85% probability the fed-funds rate would end the year between 5.25% and 6%. Today pricing indicates a fed-funds rate at year-end between 2.75% and 3.25%. Expectations have changed drastically. A lower peak rate and aggressive rate cuts in the second half of the year is the new forecast.

The market likely will be disappointed again. The Federal Reserve will find it difficult to stop raising rates, let alone cut them, with inflation running hot. And it is running hot. Core CPI came in at 0.5% in February up from 0.4% in January. Core CPI year-over-year ticked down to 5.5% from 5.6%. Still, 0.5% annualized is 6.0%. The Fed might be able to justify pausing for a time given the banking turmoil, but cuts? Hard to justify and remain credible inflation fighters.

Uncertainty is high (it bears repeating). The interest rate environment has changed drastically. The free-money era is gone, at least for now. It isn’t only the banking system that is impacted by rising interest rates. Insurance companies, hedge funds, and private equity firms, all have taken advantage of free money for over a decade.

“…there are many carry trades that will be under pressure and it will not be possible to backstop all of them,” J.P. Morgan’s Marko Kolanovic wrote this past week. Kolanovic knows that carry trades only work if there is a low-cost funding source. Carry trades become unprofitable otherwise. And it isn't always easy to stem the losses when a carry trade goes bad.

It is time for caution. Perhaps there will be no more surprises in the banking system. Perhaps real estate, private equity and venture capital firms will figure out how to adjust. Maybe they will adapt instead of blowing up. Maybe the Fed will figure out how to engineer a return to 2% inflation without a recession. All that is possible, but it isn’t the most likely outcome. Instead, we are more likely to see more financial turmoil and a recession later this year.

Economic Indicators

Leading indicators point toward recession. But not for a while yet. The Atlanta Fed’s GDPNow forecasting tool is pointing to robust first-quarter growth. The latest estimate on March 16th predicted 3.2% real GDP growth for Q1. Of course, leading indicators are just that, leading. The fact that coincident indicators aren't breaking down yet doesn't mean they won't. The Conference Board’s Leading Economic Indicator (LEI) fell for the eleventh month in a row, dropping by 0.3%. The LEI is screaming recession is on the way. Retail sales fell in February, falling by 0.4% after rising 3.2% in January.

The Empire State manufacturing survey dropped to negative 24.6 in March. It was negative 5.8 in February. Likewise, the Philadelphia Fed manufacturing survey was minus 23.2 in March. Industrial production was flat in February after rising 0.3% in January. Consumer sentiment declined to 63.4 from 67. It’s likely that Q1’s strength will give way to weakness in Q2. The second half of 2023 might well bring recession.

Charles Schwab is Safe

Received a phone call from a concerned client today. She said she is hearing that Charles Schwab is in trouble and might go bankrupt. I told her I didn’t think that was likely. We use Charles Schwab to custodian our client's assets. Charles Schwab is one of the largest custodians of Registered Investment Advisors (RIAs). It rivals Fidelity in size. Total client assets were $7.38 trillion across 34 million accounts as of the end of February. Schwab does have a bank with over $120 billion of deposits, 80% of them insured by the FDIC.

And the bank is well-capitalized. The bank had $366.7 billion in bank deposits at the end of 2022. But $333.8 billion worth of those deposits were deposit sweeps for brokerage accounts. In other words, money that is likely to stay in place and continue to be used for investing. Only $19.7 billion worth of deposits are related to checking accounts with another $6.1 billion related to savings.

Schwab has $40.2 billion in cash and equivalents on its balance sheet. It also has $43 billion of cash and investments segregated for regulatory purposes. It has $66.6 billion of receivables on its balance sheet from brokerage clients. Total available for sale securities amount to $147.9 billion. Held-to-maturity securities total $173.1 billion. Schwab also has access to $300 billion in borrowing capacity from the Federal Home Loan Bank. Its balance sheet carries an A rating.

Schwab does have unrealized losses in its held-to-maturity bond portfolio. The losses don’t appear nearly enough to threaten Schwab bank’s solvency. And that's assuming they must sell some held-to-maturity bonds for liquidity needs. Otherwise, the held-to-maturity securities will be redeemed at par when they mature. Schwab is not Silicon Valley Bank. Schwab is safe.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist