Hard or Soft Landing?

The last week has reminded everyone that the consequences of much higher rates and tighter financial conditions are not all behind us. For some time, we’ve noted that markets will move between the outlook for a soft or hard landing. The difference being the magnitude of the slowdown in economic activity. Many times in the last 12 months, we’ve highlighted the fact that higher interest rates and tighter financial conditions take time to have impact, and the banking sector events of the last week are a good reminder of that.

Regional Bank concerns

Before the Silicon Valley Bank (SVB) became a bank failure headline, the only industry to reel from the change in monetary policy was the cryptocurrency brokerage industry. This relatively unregulated and leveraged marketplace for Bitcoin and other cryptocurrencies came unglued last fall, with the crescendo coming from the collapse of FTX. Unfortunately, it seems that every financial downturn has to begin and end with a perp walk.

SVB reminded us that the impact of last year’s interest rate hikes has not completely come to light. To summarize what happened, this California bank, grew very quickly over the last 2 years, adding over $60 billion in deposits, largely from a narrow group of customers in a common industry. It appears that they used that liquidity to buy longer dated Treasury, agency and mortgage-backed securities to try to improve their earnings. As interest rates rose, the value of those bonds declined last year, and when depositors all headed for the door at the same time ($42 billion withdrawn in a week), they were left having to take losses on their bonds, reducing their capital position, something the Federal Reserve could no longer tolerate. They were closed, and Sunday, the Fed put in place the Bank Transfer Fund Plan which allows any FDIC insured institution to pledge their bond portfolio at 100 cents on the dollar to create liquidity to meet depositors demands.

Using the regional bank spider (ticker – KRE) as a proxy, you can follow investor sentiment as this played out. You can see from the chart below that before this all transpired the fund was trading above $60 and quickly fell to $45, a drop of 25%! While the fund has recovered modestly, the contagion fear remains in the market.

In addition, bond investors pulled yields much lower believing that the Federal Reserve, which meets next week, would no longer hike rates. If today’s European Central Bank meeting is any indication, that might not be the case, since they raised rates by .50% at today’s meeting.

The 6-month Treasury Bill yield has moved from 5.09% on March 8th to today’s yield of 4.71%. Investors have lowered the probability of a hike from near 100% to 50% and the likelihood of a .5% hike even lower.

For those interested in following investor sentiment as it relates to concerns over the regional bank industry, these two things, the KRE fund and the 6-month T-bill are proxies.

Hard or soft?

Meanwhile, we must keep track of the economic data that is coming out to determine whether the economy’s landing will be a soft or hard one. The stock market, after the rally of the first 6 weeks, was preparing for better data and a soft landing. This bank issue and more meaningful slowdown in producer prices has people wondering.

This week, the producer price index dropped from 5.7% to 4.4% on an annualized basis. The Fed tracks the PPI because price increases here end up at the consumer level. It is somewhat of an early warning measure for inflation. If this decline holds, then we can expect inflation to continue on its downward path and the interest rate hiking cycle to be over.

Does that mean we have nothing to worry about? No. A hiking cycle of this magnitude has the tendency to create a recession and break some things, as we’ve seen.

Investing strategy

So, what do we do? Several things. We’ve taken a more defensive position with our stock portfolio, focusing on companies with more consistent growth, better free cash flow, and under leveraged balance sheets.

We’ve reduced the amount of corporate credit we have in our bond portfolios relative to the benchmarks we follow. We will continue to monitor credit quality closely.

We recognize that cash and money market funds now provide a 3 to 5% return. As a result, we will review our financial plans with clients and ask to discuss how liquid they need to be and whether they are comfortable with their plans positioning, given the expectation for higher volatility as the see saw between a hard and soft landing plays out.

We can’t know about every black swan. That’s why they are named so. We can however, play defensively at a time when the outcomes for economic growth and the lagging effect of higher interest rates suggest that a strategy of this nature makes sense.