KBRA Financial Intelligence

3 Things in Credit: Banks, Sentiment Split, and Financial Conditions

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Welcome, market participants, to another 3 Things in Credit. I’m Van Hesser, Chief Strategist at KBRA. Each week we bring you 3 Things impacting credit markets that we think you should know about.

Well, it was good while it lasted. Speaking, of course, of the everything rally—the one triggered in December by the Fed’s shocking 180-degree monetary pivot. That rally apparently has ended, with stocks and bonds suffering their worst first day of a new year performance in more than two decades. Do we care? Of course not, markets are supposed to do that in response to the rally we just enjoyed. Kind of akin to all of this “dry January” talk I keep hearing about.

In any event, welcome back to the podcast and happy new year. Let’s get at it.

This week, our 3 Things are:

1. The banks are alright. Questions as to the viability of the business model are misplaced.

2. Sentiment split. Folks are split on the recession call and risk valuations. Here’s what that means.

3. Financial conditions. They might not be as loose as you’ve heard. Here’s a measure worth considering.

Alright, let’s dig a bit deeper.

The banks are alright.

Banks need a new publicist. Over the break, I noticed a couple headlines: “Why it might be time to buy banks…just not in America,” warned The Economist. And this one from The Wall Street Journal: “Banking Crisis Plays Out at America’s Smallest Lenders.” The so-called crisis is what helped bring down Silicon Valley Bank and First Republic Bank last spring—gross mismanagement of funding concentrations and interest rate risk in the face of niche customer strategies. Two banks. Good sized. Certainly called into question shortcomings in regulatory oversight. But that’s two banks out of 4,700 banks at the time. The very definition of idiosyncratic risk.

So, the Journal article highlights a $5 billion asset community bank in Texas, where 61% of its assets are in securities. Turns out there is not a lot of loan growth in east Texas. Equity capital is negative under the weight of $1 billion in AOCI, which records unrealized profits and losses on various financial transactions, including available-for-sale securities, which is what Industry Bancshares holds. Still full of low-yielding securities, the bank is barely profitable. It is pursuing a capital raise and exploring strategic alternatives, according to the piece.

The article goes on to point out that net income at community banks fell 20% in Q3. By our calculation, we come up with -14%. In any event, while profitability for the group, as measured by return on assets, is down (from 1.4% a year ago to 1.1% in the latest quarter), we wouldn’t consider it all that concerning, given that anything above 0.8% is generally fine. Doesn’t sound like a crisis to me.

How about the FDIC’s list of problem banks? For the uninitiated, those are institutions with “financial, operational, or managerial weaknesses that threaten their continued financial viability.” Well, that group totals 44 out of 4,614 at September 30, or less than 1% of the total. By the way, that number of problem institutions is down from 51 prior to the pandemic.

So, how are investors viewing the sector? Well, shareholders decidedly rotated out after the March events. But it turns out that bank stocks have come roaring back in Q4. Off of the recent lows in October, large cap banks are up 33% to 83% of where they were before the March failures. Well, that is probably attributable to the fact that the largest banks are really not exposed to the kind of risks that undid Silicon Valley and First Republic. So, how are the regionals and community banks faring? Those facing the crisis that the Journal article references? Turns out they, too, are up smartly, 30% from those October lows to 87% of where they were pre-Silicon Valley.

Will there be a few Industry Bancshares out there? Of course. It’s a big universe of banks, and some smaller institutions are clearly limping along. Will some smaller banks struggle under the weight of the secular shift in commercial real estate? Of course. But this idea that the community and regional banking model is somehow deficient or represents a systemic issue is just not accurate. Risk markets have awakened to that reality.

Alright, on to our second Thing—2024’s sentiment split.

Combing through all of those year-end outlooks, we noticed a really interesting pattern. The world of strategists and economists and other assorted forecasters is split. Split on recession likelihood. And split on whether or not the S&P 500 grows in 2024.

Let’s start with the outlook for recession. For all the talk of a soft landing, we are more than a bit curious as to what the Fed sees that caused it to change its narrative at the December FOMC meeting from higher for longer to three cuts in 2024, where the graph of the policy rate changes from the proverbial Table Mountain—higher for longer—back to the Eiffel Tower, quickly up and quickly down.

The question that has to be asked, one that seemingly got lost in all of the market drama, is, is the Fed signaling rate cuts because …

Its work is done and it’s time to go back to normal? Or …

It may have overdone it (as it typically does), and it will have to stimulate the patient?

The answer to that question gets at soft landing versus hard landing. And for what it’s worth, 50% of economists surveyed by Bloomberg in December after the latest FOMC meeting see a harder landing—recession—in 2024. The Bloomberg consensus estimate for full-year growth in 2024 is 1.3%, a meaningful drop from 2023’s estimated 2.4%, and below the Fed’s longer-term growth estimate of 1.8%. Still, it is growth, even if a recession pops up for a period along the way.

So, maybe it’s not surprising then that about one-half of Wall Street strategists (55% for those keeping score) believe the S&P 500 index will grow in 2024, according to another survey conducted by Bloomberg in December. The median of the 18 strategists surveyed works out to be 4,850, which would be a rather lackluster year-over-year gain of 1.7%. I suppose part of a gain that might have occurred in 2024 got pulled into 2023.

Now, here is what’s interesting. None—none!—of those 18 strategists are calling for a contraction in earnings growth for the S&P 500 in 2024, assuming 2023 comes in at FactSet’s consensus of $221 per share. Still, the group on average is not expecting much in the way of growth, with the median estimate coming in $231, a mere 4.5% better than 2023’s expected level. This is, by the way, a top-down view. From a bottom-up perspective, analysts are more bullish as you would expect. They are looking for earnings of $246, some 11.6% above 2023’s result.

So, all of this helps to frame out what market expectations are for 2024. We would summarize as follows:

Growth is slowing, and whether or not we actually meet the Bureau of Economic Research’s definition or not is not the point. The point is market participants believe that we are likely to approach stall speed for a quarter or two in what figures to be a sub-potential year. And the possibility of a more significant growth contraction continues to feel like a tail risk.

The earnings recession is in the rearview mirror. Earnings, at least with regard to the S&P 500, reflect the long lead time managements have had in preparing for downturn, as well as a belief that inflation is under control and demand will remain reasonably strong. And that, of course, feeds into our third point …

… Risk valuations are full. Priced for perfection? Not quite, but we would expect volatility to pick up as markets digest what the effects of all of that monetary tightening are shaping up to be.

Alright, on to our third Thing—Financial conditions.

Throughout much of the fourth quarter, much was made over the fact that financial conditions were actually loosening, despite the Fed’s best efforts to tighten. All of that talk of a soft landing on better-than-expected economic data as well as improvement in taming the inflation scourge had a hand in this.

Unlike some, we have long been in the camp of believing in the long and variable lagged effects of monetary tightening. And we were more than a bit concerned that tightening beyond just raising the policy rate was taking place. After all, the Fed was continuing to run down its balance sheet and the banks were tightening lending standards post the March bank failures in order to size up and shore up their funding bases.

So, simply looking at the policy rate doesn’t capture fully the effects of tightening, broadly defined. We find it to be more insightful to look at the Proxy Funds Rate published by the San Francisco Fed. This measure (think of it as fed funds plus) uses 12 market variables that take into account things like the Fed’s forward guidance and balance sheet operations.

The Proxy Funds Rate peaked this past summer at 7.1% at a time when the effective fed funds rate was 5.1%. By year-end, the Proxy Funds Rate had fallen to 6.3%, but was still a full point above the fed funds rate.

This still restrictive environment is consistent with the slowing growth we, and plenty of others (including the Fed), see in 2024. That should be good news on the all-important inflation front, but less welcome for growth. At this stage of this cycle, investors should take that trade. Safe to say that just about all of us are tired of the inflation story.

So, there you have it, 3 Things in Credit:

1. The banks are alright. Loan quality is holding up well, and concerns over contagion from the March failures seem to be misplaced.

2. Sentiment split. Folks are split on the recession call and risk valuations. But strong consensus on earnings growth strengthens the argument for a soft landing.

3. Financial conditions. The Proxy Funds Rate is a reminder that taming inflation remains job one.

As always, thanks for joining. Welcome back, and best of luck in the new year. See you next week.