What happened this week? 

On Sunday evening last week, in response to the fall-out of Sillicon Valley Bank (SVB), the Federal Reserve and the US Treasury announced a lending program that virtually guarantees all deposits at this bank will be made whole. This was a necessary move to prevent bank-runs on other regional banks. On Monday, market was very volatile, swinging between 1% loss and 1% gain, with the volatility index jumped up close to 30.

The February consumer price index was released on Tuesday, matching analysts’ expectations. Most importantly, it showed a deceleration in the annual rate of inflation, both at the headline level and also with food and energy stripped out, known as the core index. On Wednesday, the February producer price index came in weaker than expected, with a month-over-month decline versus expectations of an increase. February retail sales, also released Wednesday, matched expectations. These data points buoyed the market, as they suggest inflation is indeed heading down.

On Wednesday, the global market was uneased with another banking news. This time was the ever-troublesome Credit Suisse (of Switzerland), dropping double-digit percentage points after its Saudi Arabia investor says they will not invest any more. In fear of a recession, US stocks dropped across the board, with the hardest hit sectors being industrials, oil and energy, while technology and defensive stocks outperformed the rest. 

On Friday, the US stock market was hit again with financial stocks at the center of selling pressure with worries about yet another regional bank, First Republic (FRC). Following the collapse of SVB, First Republic attracted particular scrutiny from investors and customers, as it has an unusually large 111% liability-to-deposit ratio (according S&P Global). Despite a consortium of large U.S. banks depositing $30B into First Republic as a vote of confidence, the stock market appeared very worried about the economy heading into a recession very soon. 

Disinflation or Recession? What will the Fed do?

In the past few months, banks have been increasing their deposit rates in order to better compete with Treasury yields. Furthermore, as a result of SVB’s meltdown, they have also begun to tighten lending requirements. These moves, coupled with negative public sentiment, reduce the velocity of money, leading to dampening of economic growth. However, it should help bring inflation back to the Fed's target sooner. 

The market is currently pricing in a slightly higher likelihood that the Fed hikes interest rates by 25 basis points on Wednesday, versus keeping leaving them unchanged (about 60/40 split as of Friday’s close). In a matter of days, the market moved from pricing in three rate hikes and zero cuts for the rest of 2023 to pricing in one final rate hike and three rate cuts. The 2-year treasury yield has been seen as not only the market's expectations of the Feds Funds Rate, but also what the Fed likely follows. In the past 30 years, whenever the 2-year yield fell below the federal funds rate, it has signaled the end of fed hiking. Similarly, when the yield curve — the difference between 2- and 10-year yields — has started to steepen after being inverted, a Fed pivot has followed.

There is an argument to be made for the Fed to pause rate hikes. This would buy the FOMC some time to digest the collapse of SVB, give lifeline to small banks that are "in the ICU" and gather more inflation data as the February core PCE price index — the Fed’s preferred measure of inflation — will be out on March 31. The pros to this would be a perceived relaxing of monetary conditions, likely will spur buying of technology, growth stocks. The cons would be that since the Fed is pausing the inflation-fighting campaign that it has been so set on for the past year, perhaps the Fed sees a lot of trouble ahead for economic activities, which could bring down industrial and economically-sensitive stocks.  

There is also a strong argument for a raise of 0.25%. The message the Fed would send is that they don't see the SVB event causing a wider problem. If the Fed goes this route, we don't see it as negative, and we actually think this would be the best case scenario for the stock market. The Fed have made it clear with the emergency lending program provided to regional banks last weekend that they have the tools to maintain stability of the financial market. Continuing to raise rates means they believe SVB was an one-time event which was well contained. 

Just another wrinkle in an aging bear market.

While the banking sector presents a new worry for investors, it should be framed in the context of the ongoing bear market, which started 15 months ago. For perspective, the average bear since 1945 has lasted about 13 months. In 2022, technology and growth stocks led the leg lower in major indexes, but it’s encouraging to see they’ve recently found their footing, supported by peaking yields and potentially peaking Fed Funds Rate. Over the past month, the tech and communication services sectors have been the only ones to post gains as financials have declined about 12%.

We continue to overweight defensive sectors like healthcare, consumer staples, and move higher on the quality curve with companies having strong balance sheet, profitability and growth. Defensive sectors can help portfolios navigate the choppy waters as traditional cyclical sectors are held back, while growth-oriented sectors can potentially benefit from a shift in the Fed’s tone in the months ahead.