The Best Offense Is a Good Defense - April 2023

The fastest pace of monetary policy tightening in almost 50 years has finally exposed cracks in the foundation of the financial economy—cracks yet to be detected in the “real” economy. The failure of three banks in the month of March was the result of multiple factors, including poor liquidity management, concentrated business risk, and a clear failure of the regulatory safeguards to do their job. However, the spark that lit the flame was the rapid increase in interest rates over the last 12 months. While we are encouraged by the improvement in the banking situation—given no additional bank failures and some ebbing of deposit flight—the bank stress, along with a tighter credit environment in its aftermath, points to a weaker economy. We are positioning portfolios defensively, expecting a mild recession at the end of 2023 or early 2024, with risks skewed to the downside for equities.

The fallout from bank stress: financial conditions

Panic has receded and an industrywide banking liquidity crisis appears to have been averted, thanks to expeditious action taken by the government. First, the FDIC stepped in to backstop all deposits at Silicon Valley Bank and Signature Bank; and second, the Fed rolled out generous liquidity facility aimed at ensuring banks’ access to cash, based on the full par value of the securities held on their balance sheets. While the ramifications for the industry and the broader economy will take some time to come into focus, we expect them to be decidedly bearish on the economic outlook. Risk of deposit flight will remain an overhang and serve to rein in bank lending. At the same time, regulatory scrutiny of small and midsize banks will increase. Bank customers pulling deposits in search of either absolute safety or marginally higher rates has sent total money market fund assets to a new all-time high of more than $5 trillion. This contraction of the bank capital base will force many to either raise deposit rates, curb lending, or both. For banks, this means compressed margins. For the economy, it means tighter financial conditions.

Aggregate financial conditions will play a key role in the economic picture as we move away from these bank failures. The fed funds rate is but a single element in the mosaic of how overall monetary conditions affect corporate and consumer borrowing rates, lending conditions, and access to liquidity. In our view, more restrictive lending standards as a result of the current stress on banks serves to tighten financial conditions considerably further than previously accomplished by fed funds rate increases and quantitative tightening alone.

One of the most telling pieces of evidence that points to the degree of tightening in financial conditions is the Senior Loan Officer Opinion Survey. Even before the stress in the regional banking sector, banks were reporting stricter lending standards consistent with previous recessions. Based on the current data, we now expect a total pullback in lending that could reduce overall GDP growth by 0.25% to 0.5% in 2023. This reduction would mostly stem from weaker capital expenditures, as we don’t expect that bank stress will directly impact consumer credit.

The greatest contributor to tightening financial conditions will stem from reduced lending at small and midsize banks, given their sensitivity to the latest stresses. Small banks are quite important to the overall economy. Roughly 40% of total lending in the U.S. is generated by small banks. Within that, the real estate sector—both commercial and residential—has an outsized dependence on small banks. Office occupancy rates are still just 50% of prepandemic  levels, raising concern about spillover risks to a part of the economy still reeling from COVID-19.

Please see important disclosures at the end of the article.