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Market Participant’s Seem to Disagree With Chairman Powell’s View

CAMS Weekly View from the Corner – Week ending 4/21/2023

April 24, 2023

“Our banking system is sound and resilient, with strong capital and liquidity. We will continue to closely monitor conditions in the banking system and are prepared to use all of our tools as needed to keep it safe and sound. In addition, we are committed to learning the lessons from this episode and to work to prevent episodes—events like this from happening again.” Fed Chairman Powell, March 22, 2023 https://tinyurl.com/39eje4rx

In an edition beginning the month of April we shared the above header quote highlighting specific remarks by Fed Chairman Powell relative to the general state of the banking industry and its overall health as viewed by the Federal Reserve.   At the time we offered it seemed a bit strange for an industry that is described as sound, resilient and strong that it would simultaneously be referenced as being closely monitored with preparations made to deploy all of the tools of the Federal Reserve to keep it safe and sound.  Frankly, the statement seemed like a working definition of oxymoron. To be fair though a fractional reserve banking system (of which we have) by its very nature can be standing healthy and yet be vulnerable to economic winds in light of its inherent leverage.  With this you could also offer more straightforward that a fractional reserve banking system is by its nature a vulnerable system.  (Perhaps without saying it so blatantly that is what the Chairman was offering.) Keeping it short and simple as you deposit a few coins at your preferred bank it is leveraged by being lent out with only a small fraction of it being held in reserve for potential withdrawal requests.  This is done over and over again as your neighbors deposit their coins as well.   Through this the system is financially levered and like all levered plays it works just fine until it doesn’t and when it doesn’t it can turn south in a hurry.  More specifically, as long as the securities purchased (Mortgaged Backed and Treasury securities) and loans on the books perform well all is good for the banking system at large.    The proverbial fly in the ointment comes when negative economic environments wreak havoc on said performance and hence exposes the vulnerability of the fractional reserve system.  In particular, in an embedded price inflation environment the banking system can take hits on both fronts to their balance sheets.  First, pointing to the securities holdings on their balance sheets as said securities go down in value in light of the Fed raising interest rates this in-turn places downward price pressure on bond holdings.  This becomes especially concerning if they experience depositor’s fleeing their traditional deposits in search of higher interest rate vehicles such as money market instruments.  Here the bank has to incur losses on their bond holdings as they are forced to liquidate them in order to meet the withdrawal requests.  They not only lose on the liquidation of their bond holdings but also lose deposits – a double whammy. Second, when/if economic headwinds develop their loan portfolios become vulnerable in terms of the underlying value of the assets in question coupled with their customers ability and willingness to service their loans with timely payments on assets that are going down in price. Is This What Collective Market Participants Are Focused On? With the above in mind it is also important to keep in mind we have not had a significant embedded price inflation storyline that did not end in economic recession.  This history offers additional forward concerns for the banking system in light of the inherent vulnerabilities of the fractional reserve aspect and specifically the performance of their loan portfolios. Collective market participants have offered they have little interest in bank stocks when viewing their behaviors in pricing these stocks in recent months.      

Click For Larger View:  https://schrts.co/ZpAzIvxU

The above is a weekly chart dating back several years.  The weekly aspect takes out the noise of daily trading and gives us a clearer picture of what participants are doing with bank stock pricing. To begin our black down arrow denotes the cliff-dive in pricing which began back in early to mid-February.  This began a few weeks prior to the headline grabbing Silicon Valley Bank demise.  The significance in the rapid descent is how easily it traded down through the previously developed price support area depicted with the horizontal blue line.  In addition to the blue support line being taken out simultaneously participants sent these bank stock prices hard south right through the 200 week moving average line depicted in the gradually rising red line.  This line represents the average price, on a moving basis, of the previous 200 weeks.  When price moves easily through two notable price areas with ease and holds participants are obviously concerned about the forward health of the asset under review.  In the above it has now been a month since the precipitous drop in price and participants are displaying little interest in bidding these shares back up.  When we see a cliff-dive drop and then quiet trading for some time it begins to suggest a further concern is developing. Speaking to Loan Performance Pointing to the current quality of the banking system’s loan portfolio generally we have not seen any notable increase in loan servicing issues.  Consumer loans and Credit Card debt posted an increase in their delinquency rates for the previous couple quarters and are worthy of caution and monitoring for trend.  There is a minor trend to point to but it is too early to offer it is a notable issue.

The above chart depicts the Delinquency Rate for all Loans in the Commercial Banking system.  We date this back to the mid-1980’s for a broad historical perspective.  As shown in the chart, outside of the more micro view of Consumer and Credit Card Loan delinquencies, all loans in total remain subdued. What is important is collective market participants are consumed with the forward view not what has taken place in the previous quarter, two or three.  With this and per our first chart, said participants are clearly concerned with the banking system’s ability to weather economic headwinds that they seem to be hinting at is on its way in how they are pricing bank stocks.    In light of this we consistently remind ourselves history offers rough times for stock prices as recessions come onto the scene in particular when we still have a price inflation issue the Fed is still fighting.  Currently there is no clear recession signal(s) but some clouds are gathering of which we will monitor and share accordingly. I wish you well…

Ken Reinhart

Director, Market Research & Portfolio Analysis

Footnote:

H&UP’s is a quick summation of a rating system for SPX9 (abbreviation encompassing 9 Sectors of the S&P 500 with 107 sub-groups within those 9 sectors) that quickly references the percentage that is deemed healthy and higher (H&UP). This comes from the proprietary “V-NN” ranking system that is composed of 4 ratings which are “V-H-N-or NN”. A “V” or an “H” is a positive or constructive rank for said sector or sub-group within the sectors.

This commentary is presented only to provide perspectives on investment strategies and opportunities. The material contains opinions of the author, which are subject to markets change without notice. Statements concerning financial market trends are based on current market conditions which fluctuate. References to specific securities and issuers are for descriptive purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. There is no guarantee that any investment strategy will work under all market conditions. Each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. PERFORMANCE IS NOT GUARANTEED AND LOSSES CAN OCCUR WITH ANY INVESTMENT STRATEGY.

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