Jobs With Little Growth Means Less Productivity

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

June 5, 2023

We have used the word “unprecedented” to talk about the economy during and after COVID. We have never before locked down economic activity, while printing trillions of new dollars to help finance trillions of extra government borrowing to pay people not to work. But now, it’s all over…the Federal Reserve has lifted rates, M2 is falling, and we’ve stopped paying people not to work.

We can’t look at history for help, we’ve never done this before. At the same time, we cannot see a way to avoid paying a price for these policies…a recession seems almost inevitable. But after Friday’s employment report, and the new fascination with Artificial Intelligence (AI), the markets are acting like everything is perfectly fine.

The S&P 500 jumped 1.5% on Friday and is now up 11.5% this year after a strong headline jobs report with signs of moderating wages. Nonfarm payrolls increased 339,000 in May and the US has added 1.57 million jobs this year, a 2.5% annualized growth rate. In the past year, total jobs have increased 2.7%.

One would think that with 2.7% more people working the economy would grow by at least that much, yet, real GDP is only up only 1.6% over the past year and rose just 1.3% at an annualized rate in the first quarter. In other words, productivity is falling. At the same time that AI is making so many people think technology will lift profits and economic activity, the actual data on the economy say the US economy is pumping the brakes.

For seven months in a row the ISM manufacturing index has been below 50, meaning contraction. Gross Domestic Income (GDI) has declined for two quarters in a row and is down 0.9% in the past year. GDI is often overlooked, but it shouldn’t be.

What is GDI? It’s the other side of the GDP accounting sheet. GDP measures what is spent, on construction, imports, consumption, and investment,…etc. But every dollar that is spent can also be thought of as income/revenue to someone else. Technically, GDI and GDP should equal, but income is measured with a different set of statistics, and the US economy is huge and diverse, so the numbers don’t always add up.

While real GDP rose 1.3% at an annualized rate in the first quarter of 2023, real GDI fell at a 2.3% annualized rate, the second consecutive quarterly decline. We don’t think this is impossible to understand. During COVID, Amazon doubled its workforce (from roughly 800,000 employees to 1.6 million). Its business model was made for COVID, delivering things directly to people’s homes. Jobs in transportation and warehousing jumped 9.0% in 2021 and 8.4% in 2022 and are today well above pre-COVID levels.

The real pain of lockdowns fell on the services sector, specifically hotels, restaurants, and bars. Jobs in the leisure & hospitality industries today are still lower than pre-lockdown levels by roughly 350,000. More importantly, if COVID had never happened, we would have seen more growth in the number of restaurants and bars, etc. In the three years prior to lockdown, leisure & hospitality jobs rose by about one million. But, now that pandemic unemployment benefits have ended, these jobs are picking up. In the first five months of 2023, leisure & hospitality jobs have risen at a 4.2% annualized rate, while transportation & warehousing jobs have grown at half that rate, 2.1% annualized.

So, while it may appear that wages are slowing, it is really the mix of jobs, back toward lower hourly pay positions (but with more earnings from tips) that is changing. In other words, the economic data are not as clear as many seem to think.

Now that we are getting back to pre-COVID levels it is hard to imagine where more growth will come from. If people normally go to three baseball games or two movies a year, they aren’t likely to double down to make up for what they missed during COVID.

In other words, the economy may be finally seeing the end of COVID distortions, but the data suggest that growth is getting a lot harder to come by. Many companies have likely been hoarding workers and if GDI is sending the correct signals this can’t last.

We still expect a recession starting sometime in the next twelve months, but with productivity falling that recession may not be the long-term fix for inflation that many seem to believe. This is hard for us to say, but the market seems to be ignoring a whole lot of economic problems and pain that aren’t really that hard to see.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Discount the Happy Talk

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

May 30, 2023

The stock market finished Friday on a high note, with the S&P 500 index just north of 4,200 for the first time since August 2022 and up 17.6% versus the market bottom in October.

Part of recent gains are related to optimism about the effect of Artificial Intelligence on some high-tech stocks. Another part might be due to signs that Congress and the White House are closing in on a budget agreement that might limit spending growth for the next couple of years while averting a debt default.

But the recent rally also seems related to a general sense of increasing optimism about the broader economy, with investors getting more confident the economy will avoid a recession this year and next.

For the long-term, we remain optimistic about the US economy and the stock market. But we don’t share the stock market’s optimism about the next year or so and think recent data support the case that the US is still headed for a recession.

Economy-wide corporate profits declined 5.1% in the first quarter of 2023, the fastest drop for any quarter since 2020 during the early days of COVID. As some analysts have pointed out, the drop appears to be driven by large and unprecedented losses at the Federal Reserve, a result of the Fed paying banks higher interest rates for them to hold reserves, combined with the Fed’s massive balance sheet.

But appearances can be deceiving. Yes, the Fed is losing more money than ever before, but those losses are due to payments to banks that should lift those banks’ profits. And despite that boost to banks’ profits, economy-wide profits excluding the Fed’s losses were still down 2.7% in Q1.

These profits are important because that’s what we use in our Capitalized Profits Model to assess the stock market. That model takes these profits and discounts them by the 10-year US Treasury yield. These data go back seventy years to the early 1950s. Using a 10-year Treasury yield of 3.8% (the Friday close) to discount profits suggests the S&P 500 index is fairly valued at about 3,500, well below the Friday close of 4,205.

Meanwhile, there was trouble lurking beneath the surface of Thursday’s GDP report, which included our initial look at first quarter Gross Domestic Income, an alternative way to count economy-wide production (as opposed to GDP) that is just as accurate. Real GDI declined at a 2.3% annual rate in first quarter, not the 1.3% annualized gain counted for Real GDP. In addition, Real GDI is now down 0.9% versus a year ago, compared to a 1.6% gain for Real GDP during the same timeframe.

One last problem: The Fed delivered its monthly report on the money supply last Tuesday and it showed that M2 declined another 0.8% in April, the ninth consecutive monthly drop. We have gone from the Mount Everest of M2 increases in 2020-21 to the Death Valley of declines in 2022-23, with the largest drop since the Great Depression. It’s hard to see the economy not eventually feeling the pain caused by that drop.

We’re not trying to say the economy is already in a recession. Recent figures show the job market is still holding up and consumer spending is still expanding. What we are trying to do is show that we are not out of the woods regarding recession risk, not by a long shot.

We are not often pessimistic about equities and think the long-term is still bright. However, we think there are still problems ahead in the near term and investors need to be prepared.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Agents of Change?

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

May 22, 2023

If you’ve been to a high school or college commencement lately, then you know the drill: at some point at least one speaker will urge the graduates to be “agents of change,” suggesting they’d like to see these students make the world a better place through some sort of social activism.

The problem with goading students to think this way is that it assumes they should be dissatisfied with the status quo. It asks students to dwell on the negative, to focus on what is wrong, to obsess on injustices, whether perceived or real. Which makes us imagine an alternative message that we rarely, if ever, hear: for graduates to go forth thinking about what is already good, to dwell on what is worthy of conserving, and why sometimes it can be important to be barriers to change.

In the context of protecting the environment, this message makes sense to pretty much everyone: let’s be careful stewards of nature. People may disagree with what this means in certain contexts and may disagree about how to weigh trade-offs, but everyone agrees that environmental concerns shouldn’t be casually dismissed.

At the same time; what does changing or reimagining the US mean? No country close to the population size of the US has wealth or income per person even close. People from around the world are eager to move here. Think about our blessings: property rights, freedom of contract and the ability to enforce those contracts, a democratic republic with a Constitution that separates executive and legislative functions, a bicameral legislature that makes it tough for temporary voting majorities to impose their will, and social institutions that foster individual rights. The list goes on and on.

And yet the academic class would like those graduating its intellectually narrow, and often overly shallow, confines to dwell on how to make our society different from what it is today.

Maybe that’s a natural consequence of living in a highincome and wealthy society. Academics, who in times past had higher status than those who run businesses, must think to themselves that something must be seriously wrong or rotten with a society in which so many others have more prestige than they have. If so, what’s being taught in schools and conveyed in commencement speeches simply reflects the status anxiety of the intellectual class and we should accept it as a symptom of longterm economic improvement (higher income and wealth) for people outside academia.

But, even if so, that doesn’t mean we should completely ignore or reject their message to be agents of change. After all, our country’s Founders were, in a sense, agents of change themselves, while also doing so in a way that conserved and expanded freedoms that had developed in certain parts of Western Civilization.

We can think of two areas in particular that are ripe for change, just in the education system itself. One would be breaking up government-run primary and secondary school systems by making school vouchers as widespread as possible. Another would be requiring colleges to have skin in the game when they get student loan money. If a student can’t repay a student loan, maybe colleges should eat half the cost. Or, instead of getting all the loan funds up-front, colleges should only get half up front, while also getting a 50% stake in all future loan payments (interest and principal) made by their students. How about that for change?

In the end, it’s also important to remember that preserving our dynamic free-market economic system is also a way to foster the kind of change that America needs, the kind that leads to less poverty and higher incomes. More entrepreneurship means more change, not less. Every single day, the US is built back better by entrepreneurs, while government flounders around making mistakes.

Look, it may be that the US is headed for a recession in the near term. But we also think that once graduating students embrace real change that also conserves what is best, while addressing the government failures that make things worse, they will help lead to the next bull market, which will be a long and strong one.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Battle of the Budget

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

May 15, 2023

It’s hard to open up a newspaper these days and not see a scary story about the debt ceiling debate. The Biden Administration is saying that a “default” is approaching if an agreement isn’t reached soon.

The US has enough revenue to pay all bondholders, but a roughly $1.5 trillion deficit this year means that if the debt ceiling isn’t lifted, it won’t be able to pay all its obligations, maybe even entitlement payments under Medicare, Medicaid, or Social Security.

We’ve been here before, and as we have seen in the past, we think an agreement will be reached and that all bond payments will be made on time. We also think it’s very unlikely that any payments on entitlements will get delayed. Much more likely is that the Congress and White House will agree on some sort of framework to hold the line on increases in discretionary (non-entitlement) spending. Maybe they’ll also agree to form some sort of bipartisan commission to review proposals to reform entitlements.

In other words, lots of smoke and very little fire. If an agreement is reached to limit discretionary spending, those limits are not likely to last. History is clear. In the past 90 years, non-defense government spending has grown ten times faster than GDP, and that trend is unlikely to change anytime soon. We’re also guessing that if an entitlement commission is formed, that the recommendations would not come up for a vote until after the next presidential election and would likely fall short of the necessary votes.

All of this is important because the path of federal spending, largely dominated by entitlements, is unsustainable. According to the Congressional Budget Office, this year Social Security, Medicare, Medicaid, and other health-related entitlement programs will cost the federal government 10.8% of GDP. Thirty years from now these same programs will cost 14.9% of GDP.

Tax revenue is scheduled to be higher, too, due to the expiration of some of the tax cuts enacted in 2017 as well as “bracket creep” (incomes tend to rise faster than inflation, resulting in a larger share of income getting taxed at higher marginal tax rates). But the gain in revenue relative to GDP is less than one percentage point, which is well below the expected increase in spending.

You don’t have to be a rocket scientist to figure out where this is heading. Simple budget accounting trends forecast a huge increase in federal debt, which means a huge increase in net interest payments by the government. In other words, the real problem isn’t whether the US raises the debt ceiling right now, it is how the US will pay for all this spending over time.

At some point the US will either reform entitlement programs or raise future taxes to pay for them. Reducing entitlements would help keep more workers in the labor force and more dollars in the private-sector, which would help boost future GDP growth.

By contrast, higher future taxes would put us on the same path as many countries in Europe, with a huge size of government. This creeping Europeanization of the US would suppress future work, saving, and investment. Worse, the process would be gradual, and much harder to notice than a tidal wave of interest payments. The frog gets boiled, slowly.

While most investors are focusing on the straightforward issue of whether debt payments due this summer get fully paid, wise investors need to keep their eye on the key longterm issue. That’s what we are watching. Will politicians make progress on limiting future spending? If not, the longterm growth path of the US will continue to slow.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Bank Problems Aren’t Over, But It’s Not 2008

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

May 8, 2023

Yes, we have banking problems. No, this is not 2008. It’s much more like the 1970s Savings & Loan problems. In other words, we do not have credit problems today, we have duration (asset-liability) problems. These are exacerbated by the fact that Quantitative Easing inflated total deposits in the banking system.

In the 1970s, the Federal Reserve held interest rates too low for too long. From 1974 through 1978, the federal funds rate was below inflation most of the time, and the “real” federal funds rate averaged -1%. At the same time, because of strict regulations on lending, branch banking, and other issues, S&Ls only made, and held, long-term fixed rate mortgages.

So, S&Ls were paying relatively low short-term rates to depositors (even though they slowly rose as inflation picked up), while earning higher returns on long-term mortgages. As the 1970s progressed, and with Paul Volcker taking over the Fed, short-term rates rose above rates on loans. By the end of the 1970s, the entire S&L industry had negative net capital.

Today, in some ways, we are facing the same problems. Between 2008 and 2021, the Fed held the federal funds rate at close to 0% for nine years, and below inflation 84% of the time. At the same time, because of QE, the M2 measure of money has increased 188%. And because of COVID and financial panic (2008/09) borrowing; total government debt has grown massively as well.

In other words, banks got stuffed with deposits at the same time government debt (of all kinds) exploded. And banks, because of the Fed, could pay depositors very little, while favorable capital rules on Treasury, FNMA, GNMA, and SLMA debt encouraged them to hold long-term bonds.

Now that the Fed is lifting interest rates, two things are happening: 1) bank assets bought at lower rates are worth less and 2) rates paid on deposits are now much higher than rates earned on many of these assets. For example, in 2020, the 10- year Treasury yield was 0.6%. If a bank thought the Fed would not raise rates above 0%, then they could anticipate positive cash flow, even from that low rate. But now, short-term rates are 5%. The result: huge losses.

Before going into what this means for the economy, it is important to say that this didn’t need to happen. Today’s problems are because of a combination of QE, abundant-reserve monetary policy, and ultra-low interest rates. The Fed told market participants that inflation was “transitory” and therefore many banks expected any increases in short-term interest rates to be short-lived as well. If you believed the Fed, you now have an un-balanced balance sheet.

So, what can the Fed do? If it lowers short-term rates, inflation may be more of a problem, and it doesn’t want to do that. So, instead, it is backstopping the problem by going in and taking back, at par, government debt, which in essence is restarting QE. We think this policy helps the government at the expense of private sector loans, but this has been going on for many years now.

The other thing the Fed and FDIC can do is insure “all” deposits, not just up to a $250,000 limit. If they don’t do this, money will continue to move to the very large banks, and it is highly likely that more small, medium and regional banks will get in trouble. In other words, the Fed (like in the 1970s) is finding its way through the problems it created by making new policies up as it goes along. It’s not 2008. We are not seeing widespread credit problems and markets are not freezing up.

Finally, in the past year, M2 has contracted by 4.1%, the fastest drop the US has experienced since the Great Depression. However, in spite of this decline, M2 is still up $5.4 trillion from where it was pre-pandemic. The decline in M2 will show up as a decline in deposits at some banks, but the bulge in money has still not worked its way entirely through the economy. Hence, for the time being, some modest continued economic growth.

In other words, inflation is likely to remain elevated this year and the Fed is unlikely to cut rates anytime soon. The end of the story is not written. We fully expect more banking problems, but also anticipate these problems to be dealt with by policies that kick the can down the road. The stock market appears to be saying “no problem” – we think it may be overly optimistic about that.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

All Eyes on the Fed

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

May 1, 2023

For nine of the last fifteen years, few people thought about the Fed. Sure, we discussed QT and QE, but the Federal Reserve held interest rates at zero year after year. In 2017 and 2018, they lifted rates and it was all anyone talked about. Then they cut them to zero and the noise went away. Now, with rates headed up, all eyes are again on the Fed, and investors are parsing every word of its statements and the Powell press conferences.

As of Friday, the futures market expects a quarter-point rate hike on Wednesday, but then a series of rate cuts that start in the third quarter.

Why the market expects rate cuts is unclear. The next key inflation print – the consumer price index for April, which arrives, May 10 – is coming in hot. At the same time, longer term bond yields are drifting down, and stock prices have been rising. That’s not a tightening of “financial conditions” that some models of monetary policy watch. And we have yet to see the kind of weakness in the labor market that would get the Fed to stop hiking rates.

At the same time…yes, banks are in some trouble because of mismatched liabilities and assets…but the Fed has used the FDIC and a bond buyback program to wall off these problems.

Meanwhile, too few policymakers or investors are following what’s happened to the M2 measure of the money supply. After surging about 40% in the first two years of COVID, M2 hit a plateau in early 2022 and then started dropping last summer. M2 is down 4.1% in the past eight months, the steepest decline since the early 1930s.

If this decline is real (there are some reasons for skepticism given that the Fed releases these data less frequently than in the past and with less detail) and if it continues through 2023, then by 2024 the economy could be in for not only a recession but also a sudden and sharp decline in inflation. Why the press never asks about a decline in M2 that we haven’t seen since the Great Depression is a mystery.

Also a mystery, is whether anyone in the press corp – even just one journalist – has the bravery to ask Powell in public how the Fed is financing its day-to-day expenses now that it’s paying banks more to hold reserves than it earns on its portfolio of Treasury and mortgage-backed bonds. The Fed has negative cash flow and has lost more than its actual capital. Is the Fed letting some of these bonds mature and using that cash for expenses? Is it printing money?

So far this year, we think most investors have convinced themselves of overly pleasant narratives about the economy and the path for monetary policy. One of them is that the Fed will cut rates this year. We don’t think this happens and maybe a re-thinking of those pleasant narratives starts soon.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Closer to a Turning Point

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

April 24, 2023

In spite of weakness in some economic data, problems in the banking sector, and much higher interest rates, real GDP in the first quarter will almost certainly show moderate growth. Meanwhile, the S&P 500 is 15% higher than its low point in October 2022. And, now, many are starting to believe that a recession isn’t going to happen.

But we still think a recession is coming. Ultimately, recessions are about mistakes. In particular, there’s too much investment broadly throughout the economy or in some important segment of the economy, like technology back in 2001 or housing several years later. Once businesses realize they made a mistake – that the return on their investment will be too low – they ratchet back economic activity to bring the capital stock back into line with economic fundamentals.

Almost always, it is government policy mistakes that cause this over-investment (or “malinvestment”). Then, when imbalances become too great, and policymakers change course after realizing their prior mistakes, the economy contracts and a recession becomes nearly inevitable.

Sound familiar? We think so. The Fed opened the monetary spigot in 2020-21 while Congress and two different presidents passed out enormous checks to try to smooth over the damage done to the economy by COVID Lockdowns. Inflation has been the result. Now both fiscal and monetary policy have turned tighter. The unprecedented nature of policies during the COVID Era makes the timing of a contraction in activity difficult to predict, but, in our opinion, this contraction is almost certain.

If anything, the notion among some businesses and investors that recession risk is declining may, by itself, contribute to greater risk, as it’s also consistent with less of a pullback in investment. It means businesses are not as widely coming to terms with past mistakes, which, in turn, means more problems ahead.

This is why we think no one should get excited about a positive first quarter GDP report. As always, it tells us where the economy has been recently, not where it is going. The economy grew 2.9% in 2000; we had a recession in 2001. And, real GDP grew 2.4% in the year ending in mid-1990, right before a recession.

Most importantly, recent data show some early signs of weakness. Jobless claims have risen. Manufacturing production in March was lower than a year ago. Real (inflation-adjusted) retail sales are down from a year ago.

In addition, keep in mind that the Fed used policy measures (like insuring more deposits) in the wake of the banking problems in March in order to prevent any widespread crisis in the financial system. In turn, that makes the likely path for short-term interest rates, for at least the next several months, higher than most investors anticipate.

We think the futures market is correct in anticipating another 25 basis point hike in May, just like we had in February and March. But the markets are not as prepared for another rate hike in June, which we think is more likely than not. Inflation remains a problem and the April inflation print, arriving May 10, should confirm that problem. The federal funds futures market expects the Fed to end the year with short-term rates lower than they are today; we think they end up higher than today at year-end, instead. Where does that leave equity investors? We understand the desire for optimism, but our model still says equities are overvalued. There will come a time to get bullish, but that’ll be after the recession starts, not before.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

January Surge Kept Q1 Positive

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

April 17, 2023

The US economy is being tugged in two different directions right now. On the positive side we have the lingering effects of the massive stimulus of 2020-21, the renormalization of the service sector after COVID Lockdowns, and, as always, the entrepreneurial and innovative spirit of the American people. On the downside we have the early stages of a drop in the money supply that started last year and too much government spending.

The problem with forecasting the economy right now is we have never been in this position before, where an unprecedented two-year surge in the money supply (plus massive temporary transfer payments) were closely followed by a dive in the money supply unlike anything we’ve seen in decades.

Eventually, we believe the balance of these forces will tilt the US economy into a recession. However, largely due to a temporary surge in consumer spending in January, Real GDP growth remained positive in the first quarter. As we set out in a Monday Morning Outlook two months ago, January came in strong due to odd factors like unusually warm weather, a big Social Security cost-of-living adjustment, and seasonal-adjustment issues due to the timing of COVID stimulus payments in 2020-21.

As we set out below, we think the economy grew at a 2.3% annual rate in Q1, although we may tweak this forecast slightly in the next ten days based on reports on housing, inventories, and international trade.

In addition, we think the second quarter will likely be weaker than Q1, and very possibly negative. The ISM Manufacturing index has been below 50 for five straight months and, at 46.3, is at a level often (although not always) associated with a recession. Manufacturing production is down 1.1% from a year ago. The ISM Services index is barely north of 50. Continuing unemployment claims are up 37% from six months ago. Retail sales are down in four of the past five months, the lone exception being the January surge.

Don’t look for Real GDP growth to remain positive much longer. But, in the meantime, our calculations show economic growth at a 2.3% annual rate for the first quarter.

Consumption: “Real” (inflation-adjusted) retail sales outside the auto sector grew at a 1.7% annual rate in Q1 while sales of autos and light trucks surged at a 29% rate and it looks like real services, which makes up most of consumer spending, should be up at a moderate pace. Putting it all together, we estimate that real consumer spending on goods and services, combined, increased at a robust 4.3% rate, adding 2.9 points to the real GDP growth rate (4.3 times the consumption share of GDP, which is 68%, equals 2.9).

Business Investment: We estimate a 5.1% growth rate for business investment, with gains in intellectual property and commercial construction leading the way. A 5.1% growth rate would add 0.7 points to real GDP growth. (5.1 times the 13% business investment share of GDP equals 0.7).

Home Building: Residential construction is still absorbing the pain of higher mortgage rates and looks like it fell at a 13.0% rate, which would subtract 0.5 points from real GDP growth. (-13.0 times the 4% residential construction share of GDP equals -0.5). Government: Only direct government purchases of goods and services (not transfer payments) count when calculating GDP. We estimate these purchases – which represent a 18% share of GDP – were up at a 1.7% rate in Q1, which would add 0.3 points to the GDP growth rate (1.7 times the 18% government purchase share of GDP equals 0.3).

Trade: Looks like the trade deficit expanded in Q1, as imports rose faster than exports, thanks to re-opening in China and better growth in Europe than many expected. We’re projecting net exports will subtract 0.4 points from real GDP growth.

Inventories: Inventories look like they grew slower in Q1 than in Q4, suggesting a subtraction of about 0.7 points to the growth rate of real GDP. Look for continued slower inventories in 2023, which could be a significant drag on economic growth later this year.

Add it all up, and we get a 2.3% annual real GDP growth rate for the first quarter, juiced by a temporary spike in consumer spending in January that is unlikely to be repeated.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

How to Lose Reserve Currency Status

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

March 10, 2023

History is full of economic and societal collapses. The Incan and Roman societies disappeared, the Ottoman Empire fell apart, the United Kingdom saw the pound lose its reserve currency status. So, anyone who says the US, and the dollar, couldn’t face the same fate doesn’t pay attention to history.

The question is: will it? Russia, China, Brazil, and others, including Saudi Arabia, all seem to think they can find a way to replace the dollar and undermine US dominance on the world economic stage.

They may try. And they may cause many to fret, but we highly doubt these countries will succeed. In order to understand why we think this, it is important to understand the ascendance of America. In the late 1700s, the US was a patchwork of colonies barely clinging to the Atlantic Seaboard.

But it wasn’t victory in the revolutionary war that made America strong, it was the writing of the Constitution and the culture that created that Constitution. The rule of law, private property rights (especially to inventors through patents), democracy (and free elections) made America different and ushered in two centuries of supercharged human progress.

While the US ran up large debts to fight wars, it managed to grow its way out. At the same time, our monetary system kept the value of the dollar fairly strong and stable relative to other currencies. The combination of all of this led to deep and robust capital markets, and a dominant 60% representation by the dollar in foreign currency reserves and nearly 90% of global financial transactions.

If the US reverses course, printing too many dollars, undermining entrepreneurship with high taxes and regulations and growing government too much, then the dollar’s standing will diminish. Clearly, we are on that path today. Federal government spending has reached an all-time high of 25% of GDP in the past three years, state and local spending is near 20%...so, combined, government controls 45% of US output.

As Milton Friedman said, the more the government is involved, the higher the price of things and the lower the quality. More importantly, for the dollar, the Federal Reserve has embarked on an experimental “abundant reserve” monetary policy that has flooded the financial system with more liquidity relative to GDP than at any time in US history. In 2007, the Fed’s balance sheet was 5% of GDP, today it is more than 30%.

Massive government involvement in the economy, combined with excessive money creation is a perfect recipe for the decline of a currency. But, before you become convinced that this will happen to the US anytime soon, think about what might replace the dollar. It would have to be a currency managed by a country that had better policies.

What made America strong is not its natural resources (which it definitely has), but its human resources and freedom. China, Saudi Arabia, and Russia may have resources, but they are not free. It will not be any of these countries that replaces the dollar and it is highly unlikely to happen in our lifetimes. However, that’s not to say it won’t happen in our children’s lifetimes. Bad policies beget bad outcomes. King Dollar will only stay that way if the US keeps its fiscal and monetary house in order. Limiting government spending, keeping tax rates low, and returning to a “scarce reserve” monetary policy are our suggestions.

The problem we see is that politicians have used the last two “crisis” periods to expand the size and scope of government, not shrink it. With government so big, we are likely to face another crisis. It’s past due time to head that off.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Still Bearish

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

April 3, 2023

If you were bullish for 2023…congratulations! The S&P 500 rose 7.0% in the first quarter and, although we still have more data to analyze before we finalize our prediction, it looks like real GDP grew at about a 2.0% annual rate in Q1. No drop in stocks, no recession. At least not yet.

While we wish we hadn’t been bearish when this year began, our forecast for a drop in stocks and a recession hasn’t changed. Using corporate profits for the fourth quarter and the current 3.5% yield on the 10-year Treasury Note, our Capitalized Profits Model suggests a fair value for the S&P 500 of 3,891, which is lower than where stocks are today.

The economy is still absorbing and responding to the 40% surge in the M2 measure of the money supply during COVID. Think of that enormous surge in the money supply as installing a furnace built for a 10,000 square foot mansion into a home that’s only 2,000 square feet, and then running it full blast.

Even when you have finally turned the furnace off – like the Federal Reserve did with the money supply in the past year, with the largest drop since the Great Depression – that 2,000 square foot home doesn’t immediately get cold. It takes time for the home to gradually cool off and eventually get cold. Given the drop in the money supply, we are headed for a much colder economy; we’re just not there yet.

And when the US economy cools off, we expect profits, which were artificially boosted by easy money and government handouts, to fall. This means our model will eventually move stocks’ fair value lower, too. The only thing that could change that forecast is if interest rates fall at the same time profits do.

At present, the stock market seems priced for both multiple expansion (the price-to-earnings ratio moving up) as well as higher profits. This is unlikely. The Fed and federal banking regulators have ring-fenced the banking system to prevent losses for depositors. In turn, because the Fed feels like rate hikes won’t break things, future rate hikes will likely exceed current expectations and long-term interest rates will move higher, too.

No one knows for sure. COVID policies were unprecedented. Of prime importance to us is the historical increase in the money supply, which is the best explanation for 40-year highs in inflation. Equally important is the sudden decline in the M2 measure of money. If we are correct, this will hit the economy soon…and just like so many times in history, the drop in activity will take many businesses and investors by surprise. That means more layoffs, lower profits, and lower stock prices.

COVID-related shutdowns were a catastrophe for the US economy, more man-made than anything else. The policy measures taken to ease the pain of the shutdowns were unprecedented, too. Now those policies are wearing off and we expect a period of economic and financial pain. Given the unprecedented nature of the problems, it’s the timing of the pain that’s tough to forecast, not predicting that the pain will eventually come. Clearly the market is having a hard time digesting or believing that in 2023.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance.

The Fed Waffles

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

March 27, 2023

The Federal Reserve raised short-term interest rates by another quarter point on Wednesday. That, by itself, was clear, with the Fed now targeting a range for short-term rates between 4.75% and 5.00%. The problem was that the Fed continues to ignore the most important issue in monetary policy.

That most important issue is the money supply, which surged by 40% in the first two years of COVID, the fastest since the 1940s, and has since dropped by the most since the Great Depression. You would think a central bank would pay attention to the amount of money its policy measures create, but apparently that’s still not a priority for the Fed or the Washington, DC Press Pundits that cover the Fed.

Neither the Fed’s statement on monetary policy nor Fed Chairman Jerome Powell’s post-meeting press conference mentioned the money supply. Nor did anyone in the press ask him one question about it. Which is weird because it’s the most obvious explanation for what happened with inflation the last few years.

If low short-term interest rates, all by themselves, caused high inflation we would have had very high inflation in the aftermath of the Great Recession and Financial Panic of 2008- 09, back when short-term rates were kept lower for even longer than during COVID. If “supply-chain disruptions” were the key reason for high inflation then why has inflation remained so high even as the number of ships waiting at ports is back to normal and inventories have recovered?

By contrast, if you follow the M2 measure of money you would have seen the inflation surge coming.

Instead, the Fed continues to dwell on its target for short-term rates and where it might be headed in the next few years. The new “dot plot” from the Fed suggests one more quarter-point rate hike this year, although seven of eighteen policymakers thought rates would peak even higher.

Keep in mind that between now and the next meeting in early May the Fed will not see much key new information on the path of the economy. We think the Fed pays the most attention to the employment report and the CPI report and we only get one of each between now and that meeting. Yes, we get a GDP report for Q1 but that’s based on data that’s mostly behind us.

Meanwhile, it looks like the federal government has “ringfenced” the financial system against a run on the banks anytime in the near future. Treasury Secretary Yellen may suggest otherwise, but we think it’s highly unlikely they’d let a bank fail if they think it would generate a massive flight of deposits to the largest banks or into money market funds. Instead, policymakers are content to let problem banks keep operating, like they did in Japan in the 1990s.

In addition, it’s important to recognize that current financial problems are very different from those of 2008-09. Back then, the main issue was credit risk (primarily regarding residential real estate loans and securities) and how markets were pricing that risk. Today the primary issue is interest-rate risk (or duration risk) on high-quality bonds. But the Fed has set up a new facility for banks that lets them, in effect, offload those securities to the Fed for a small fee, papering over balance sheet problems for banks able to take a small hit to earnings.

The oddest part of the Fed’s actions on Wednesday was issuing an economic forecast that included a recession starting later this year but not talking about it. That’s right, the Fed is now forecasting a recession that starts later this year.

How do we know this? Because the Fed is forecasting 0.4% growth in 2023 even as the Atlanta Fed’s GDP Now model projects a 3.2% real GDP growth rate in Q1. Even if you plug in 2.0% for Q1, the only way to get 0.4% for 2023 with 2.0% in Q1 is if the level of real GDP is lower in the fourth quarter than it is in the first quarter. Factor in the Fed forecast that unemployment averages 4.5% in Q4 (versus 3.6% in February) and it looks like a recession forecast.

The Fed could do a better job by refocusing on M2 and being clear about its forecast. But don’t get your hopes up. The bottom line is that we think the Fed is right about a recession, which means earnings will take a hit and investors should remain wary.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

All Mixed Up

First Trust Economic Research Report

Brain S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

March 22, 2023

The Fed raised short-term rates by another 25 basis points (bp) today and made no changes to the expected peak for short-term rates later this year. That peak is still 5.125% – 25 bp higher than they are today – just like the forecast back in December.

However, there were other significant changes, both explicit and otherwise, to the Federal Reserve’s statement and outlook on monetary policy, as well as the economy. In particular, the economic forecast from the Fed shows real GDP growing 0.4% this year. What’s odd about that forecast is that the Atlanta Fed’s GDP Now model currently projects growth at a 3.2% annual rate in the first quarter while we are estimating growth at a roughly 2.0% rate. Even if you take our slower growth rate for Q1, the only way you’d get to a 0.4% growth rate for 2023 as a whole would be for real GDP to be lower in the fourth quarter than it is likely to be in Q1.

In other words, the Fed is likely now forecasting a recession starting later this year even as it continues to say it will not cut rates later this year. Meanwhile, the Fed ticked up the median dot for the end of 2024, suggesting short-term rates will end next year at 4.3% versus a December forecast of 4.1%. Put it all together and we have a Fed prepared to not reduce rates as rapidly during the next recession as it did in 2020 or 2008-09.

Although the Fed noted recent problems in the banking system and that these problems might impact the economy and inflation, the Fed went out of its way to end that portion of the statement with language that it “remains highly attentive to inflation risks.” Notice the emphasis on inflation risks, not downside risk to the economy, which seems like is already built into its forecast.

However, the Fed also opened the door to dovishness if banking problems intensify. Previously, the Fed had said that “ongoing increases in the target range will be appropriate…” That was replaced by “some additional policy firming may be appropriate...” Notice the “ongoing” replaced by “some additional” and “will” replaced by “may.” We interpret that to mean the Fed will be in no rush to raise rates at the next meeting and will instead sit back and watch how events in the economy and banking system unfold before May 3.

Ultimately, we believe investors need to focus on the M2 measure of the money supply, not the target level of short-term rates. It is M2 that will tell us what the net effects of all the Fed’s policies and the banking situation are. The Fed and other policy authorities in Washington, DC have, at least temporarily, ring-fenced traditional banks, guaranteeing all deposits in FDIC-insured accounts, no matter how high. This will prevent a bank run, kicking the can down the road for future policymakers to deal with the problem.

Meanwhile, a new bank term funding program will allow banks access to potentially huge injections of capital from the Fed while the banks pay very small fees to the Fed for the service. And yet, while expanding its balance sheet this way, the Fed will simultaneously continue its passive version of Quantitative Tightening, letting a portion of its balance sheet decline as some securities mature. This is like a car with two steering wheels with the driver turning them in opposite directions at the same time. The Fed is all mixed up. The reason it’s mixed up is because in the 2008-09 crisis it abandoned its long tradition of implementing monetary policy through scarce reserves and imposed a new policy based on abundant reserves. They didn’t know where it was heading at the time; now we’re finding out. The turmoil in the markets isn’t over. We remain cautious on equities and think a recession is on the way.

Brian S. Wesbury, Chief Economist

Robert Stein, Deputy Chief Economist

Text of the Federal Reserve's Statement:

Recent indicators point to modest growth in spending and production. Job gains have picked up in recent months and are running at a robust pace; the unemployment rate has remained low. Inflation remains elevated.

The U.S. banking system is sound and resilient. Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation. The extent of these effects is uncertain. The Committee remains highly attentive to inflation risks.

The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. In support of these goals, the Committee decided to raise the target range for the federal funds rate to 4-3/4 to 5 percent. The Committee will closely monitor incoming information and assess the implications for monetary policy. The Committee anticipates that some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time. In determining the extent of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments. In addition, the Committee will continue reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities, as described in its previously announced plans. The Committee is strongly committed to returning inflation to its 2 percent objective.

In assessing the appropriate stance of monetary policy, the Committee will continue to monitor the implications of incoming information for the economic outlook. The Committee would be prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee's goals. The Committee's assessments will take into account a wide range of information, including readings on labor market conditions, inflation pressures and inflation expectations, and financial and international developments.

Voting for the monetary policy action were Jerome H. Powell, Chair; John C. Williams, Vice Chair; Michael S. Barr; Michelle W. Bowman; Lisa D. Cook; Austan D. Goolsbee; Patrick Harker; Philip N. Jefferson; Neel Kashkari; Lorie K. Logan; and Christopher J. Waller.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Heading Toward a National Bank?

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

March 20, 2023

The late great Supreme Court Justice Antonin Scalia was often in dissent in key legal cases during his long career. Almost thirty years ago, he wrote that “Day by day, case by case, the Supreme Court is busy designing a Constitution for a country I do not recognize.” This quote comes to mind because it seems that crisis by crisis – the Federal Reserve, lawmakers, and regulators – are busy designing a financial system that looks a great deal like a national bank.

We aren’t calling this a hidden political conspiracy, nor do we believe there are some sort of puppet-masters pulling the strings behind the scenes. We are not wearing tin foil hats. What we are asserting is that the more the government tries to take risk out of the financial system, the more they are moving the country in the direction of a national bank, whether intentionally or not.

After the absolutely awful monetary policy of the 1970s, and the Fed’s fight against the inflation that it caused, S&L’s and banks failed across the country. One regulatory response to this mess was risk-based capital rules. Different loans or bonds had different capital requirements based on “riskiness.” Included with this was a much lower capital requirement on Treasury debt. This worked fine as long as interest rates were falling, but clearly doesn’t make sense when rates are rising. Banks had an incentive to hold more Treasury debt, which subsidized government borrowing and encouraged more spending.

Then came the bailout of Long-Term Capital Management (LTCM) in the late 1990s, which showed that policymakers considered some financial firms, whether regulated or not, too big or too intertwined with other institutions to be allowed to fail without government intervention.

Then the Financial Panic of 2008 caused massive changes in our monetary and banking system. These changes included a huge increase in the size of the Fed, the Fed paying banks interest on reserves, extremely low short-term interest rates for an extraordinary period of time, and even more stringent regulations on banks.

Few people talk about the extent of these changes, or even focus on them. But, before the Panic of 2008 the Fed had total assets of about $875 billion; that’s “billion”, with a “B.” As of Wednesday last week, its assets were around $8.6 trillion; that’s “trillion,” with a “T.” The Fed increased its balance sheet by buying Treasury debt, which allowed government spending to soar. The Fed also held interest rates artificially low, making that increased spending cost less.

Meanwhile, the Fed started paying banks interest on reserves. At first, this policy didn’t mean much; after all, banks were only earning 0.25% per year on the reserves. But now that banks are earnings 4.65%, it’s a much bigger deal. In fact, given the increase in short-term rates in the past fifteen months, the Fed is now paying banks more in interest than it earns on its bonds.

Banks own about $3 trillion in reserves on which the Fed pays interest. So, if short-term rates reach 5%, banks could earn about $150 billion per year. And what do the banks have to do to earn that money? Nothing; literally, nothing. Just sit around, keep the reserves on their books, and collect “rent.” Think how the public and lawmakers will react when that becomes more widely understood.

And now think about the implications of the recent failures and rescues of Silicon Valley Bank, Signature, and First Republic. In spite of all the new bank regulations, and a massive Fed balance sheet that supposedly protects the system, banks are failing.

Now the government has stepped in and, in effect, guaranteed all FDIC-insured deposit accounts no matter the size. Adding to the perverse incentives, the Fed is valuing government sector debt at par value for collateral, even when that debt is trading at a discount. The same treatment is not being extended to private debt, another special for public sector entities. And as depositors now know they’re protected, they will seek the highest deposit rates no matter the riskiness of their bank, while the banks’ managers generate outsized earnings until they go bust, at which time they’ll get rescued if they play the political game of supporting the right causes. And if banks instead remain unsafe, deposits will flee to the very largest institutions, deemed “too big to fail.”

But that system is not sustainable. If taxpayers are losing money, many of them will want the government to have more control, not less. And if capital is already being allocated for political reasons, there will be calls to just cut out the “private sector” middlemen.

There is time to short-circuit this process and change direction. But, if there’s one thing true about government, they never let a crisis go to waste. Unfortunately, with each new crisis, the window of opportunity to act grows narrower.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

The Soundness of the Banking System

Raymond James Thoughts on the Market

Larry Adam, CFA, CIMA®, CFP®, Chief Investment Officer

March 13, 2023

It is often said that the Federal Reserve (Fed) tightens until something breaks. In fact, history is peppered with examples of financial accidents caused by past Fed tightening cycles— Orange County’s default (1994), the collapse of Long Term Capital (1998), the bursting tech bubble (2000) and the housing crash (2008). That is why the market has been concerned about the Fed, particularly as the it has raised interest rates at the fastest pace in over 40 years and the full impact—which occurs with a lag—has yet to be seen. Last week’s sudden collapse of Silvergate Capital and Friday’s failure of Silicon Valley Bank sent shockwaves through the markets, driving the S&P 500 down -4.5%, sending US Treasury yields sharply lower, and wiping out nearly $300 billion market capitalization in the S&P 500 financial sector. The biggest question for investors: are the recent failures manageable events or is there a significant risk of financial contagion that could have downside economic implications?

Before we delve into these questions, let’s review what led to demise of Silvergate Capital and SVB Financial, the parent of Silicon Valley Bank. The two banks had a lot in common:

• Niche Banks | Both banks were niche players that benefited enormously from areas of the market that flourished during the pandemic tech boom. Silicon Valley Bank catered to venture capital firms and tech start-ups. Silvergate Capital was a major banking partner for the crypto industry.

• Concentration Risk | The lack of diverse deposit bases and their concentrated loan books left both banks in a vulnerable position. Once venture capital funds started to struggle to raise capital, liquidity tightened as new deposit flow slowed dramatically. In fact, the bank’s clientele started to draw down their deposits at an accelerating pace while they waited for the venture market to recover. The banks were unprepared for this. In addition, with so many companies having large deposits at the bank in excess of $250,000, the vast majority of the deposits were uninsured.

• The Pace of Interest Rate Moves | The speed of the Fed’s rate hikes over the last year caught the banks by surprise. This exposed a huge mismatch between their assets (investments) and liabilities (deposits), and they were negatively impacted on both fronts. Deposits were getting more expensive to attract as short-term interest rates rose. Meanwhile, as their assets were invested in safe, liquid, high quality Treasurys and mortgages, these long duration bonds were sitting on huge markto-market losses due to the sharp rate increases over the last year. For reference, the 10-year Treasury yield increased 237 basis points over the last year alone. When the banks needed to raise cash to meet client deposit withdrawals, they were forced to sell these long duration securities at a loss that reduced their capital base. To be clear, this was not like the Great Financial Crisis where lax lending standards and leverage exacerbated losses. This was a mismatch of asset and liabilities where interest rate moves caught them off guard.

• Social Media Mania | The proliferation of social media likely accelerated the failure of Silicon Valley Bank and Silvergate Capital. The speed at which they collapsed felt much like the meme stock mania of late, where investor psychology and rapid-response money flows drive the fate of the company. The hysteria-induced bank run caused clients to withdraw a staggering $42 billion of deposits from Silicon Valley last Thursday, sealing its fate the next morning.

Where Do We Stand Today?

Silicon Valley Bank was taken over by the FDIC on Friday, leaving many tech companies and start-ups scrambling to make payroll and wondering about the fate of their uninsured deposits (above the FDIC’s $250,000 threshold) over the weekend. In addition, the third bank in a week, Signature Bank, failed yesterday.

The Government Reaction to Stabilize Markets:

• New Facility | To prevent further financial contagion and to ensure public confidence in the banking system, the Fed, Treasury and FDIC introduced a new loan facility—the Bank Term Lending Program (BTLP)—on Sunday evening. This emergency facility will provide loans up to a period of 12 months to help banking institutions access capital when needed. One important dynamic of this facility is that banks can pledge their bonds (that are enduring unrealized losses) as collateral March 13, 2023 THOUGHTS ON THE MARKET 1 The Soundness of the Banking System and receive the par value of those investments as a loan. This helps avoid banks selling their investments at depressed levels.

• Full Depositor Access | The Fed, Treasury and FDIC announced they will be making the depositors of Silicon Valley Bank and Signature Bank whole as they will be able to access their full deposits as of today.

• Restoring Confidence in Banking | These swift actions should arrest concerns that there may be other banks lurking in the shadows with similar hidden risks. At a minimum, it should help reduce the potential of significant outflows of bank deposits at some institutions.

Implications for the Fed and the Economy?

The failure of SVB is a true game changer for the Fed and could change not only the narrative from the central bank but has the potential for changing the path as well as the direction of interest rates, depending on how these events play out in the coming days, weeks, and months. For now, the probability of a March increase in the federal funds rate is less certain than it was last week and the end result will depend on the evolution of this crisis up until the Federal Open Market Committee (FOMC) meeting on March 21-22. Despite current uncertainty, we still believe that the Fed will raise rates by 25bps next week as bringing down inflationary pressures remain a priority.

Although the characteristics of the failed banks are highly particular to their niche markets as we mentioned above and should not create systemwide contagion, bank runs are unpredictable. However, the central bank, that is, the Fed, remains as the “lender of last resort” and will be ready to backstop any potential run against the banking system. The Fed has already created the BTLP program to inject liquidity for banks that need it and will continue to assess the risks to the system and provide resources as the system needs them.

For the US economy, the potential effects are less clear, as they will depend on how the current crisis evolves over time and what the Fed decides to do with interest rates. We will continue to monitor the events and make the necessary changes to our forecast.

Implications for the Fixed Income Market?

The collapse of Silicon Valley Bank and the new Bank Term Lending program are game changers. The creation of the Bank Term Lending Program should relax concerns about broader financial contagion. However, it also shows that the Fed is becoming increasingly concerned about financial stability risks in the wake of the three bank failures over the last week.

While Chairman Powell opened the door for a potential 50 basis point rate hike during his testimony to Congress last week, the recent strains in the financial sector have taken this off the table for now. Market expectations for the peak fed funds rate continue to whip around—climbing to a cycle high of 5.7% after Powell’s hawkish testimony early last week to ~5.1% as of this morning. Rate cuts by year end are once again a possibility. While past crises have historically led to easier monetary policy, the Fed does not have the same flexibility today with inflation remaining elevated. But it does tell you that the Fed will need to tread carefully from here.

Meanwhile, the SVB crisis sparked a huge flight to quality across the entire yield curve, sending the 2-year Treasury yield down ~90 basis points from a peak above 5% last week and the 10-year to 2-year spread reversing some of its extreme inversion. These moves highly suggest that the market thinks the Fed may be done and a recession could be nearing. This does not bode well for lower-quality credits like high yield bonds. Our preference remains for higher quality bonds. It also suggests that the cyclical peak for yields is likely in.

Implications for the Equity Market?

Patience remains a virtue as we reiterate our 4,400 2023 yearend target on the S&P 500 that has held through multiple narrative shifts in the first quarter. The year started with a soft-landing narrative with the Fed pausing and eventually cutting, then to a no landing with heightened inflation and higher rates and now to a banking crisis. While we’ve held steady with our 4,400 target, this most recent narrative shift does not cause us to change our long-term optimistic view on the equity market. Why?

• Don’t Fight the Fed | This banking crisis has likely caused the Fed to rethink the aggressiveness of further interest rate hikes moving forward. For example, rather than the debate of 0.50% or 0.25% at the March 21-22 meeting, the debate will be staying on hold versus 0.25%. The increase in potential financial market instability should cause the Fed to modify their views moving forward. Historically, the end of a tightening cycle is a positive catalyst for the equity market.

• Lower Interest Rates | Lower short-term interest rates (as the Fed ends its tightening cycle soon) and lower long-term interest rates (as we believe the 10-year 2 Treasury yield has peaked) should be positive for the equity market. This is positive for equities for many reasons, including lower funding costs and higher potential multiples. In addition, these lower rates should provide a boost for growth stocks.

• Contagion Risk Limited, But Not Zero | Outside of the Financials sector we expect the impact of this crisis to be minimal given the backstop of uninsured depositors. Within Financials we favor larger higher quality institutions over smaller regional banks. There remains the risk that some smaller regional banks could struggle from potential deposit outflows. This crisis also highlighted the need for continued competitive deposit rates that may strain profitability in the sector. More regulation and increased oversight will also potentially hamper earnings growth for these regional banks.

• Restate $215 Earnings Forecast | Assuming no contagion, our 2023 earnings forecast for the S&P 500 remains unchanged. If anything, the early year strength of the economy, the weakening dollar and cost cutting of companies leads to upside risk to that forecast. The equity market is likely to be volatile in the near term as the market sifts through the potential impact of this recent banking crisis. But for long-term investors, prudence and keeping a long-term perspective are paramount in avoiding emotionally driven portfolio changes.

Bottom Line

The recent failure of three banks is an unfortunate result of the rapid rise in interest rates to combat the unprecedented rise we have seen in inflation. The quick response from regulators and the creation of a lending facility should limit the contagion fall-out to the broader economy and financial markets. The silver lining may be that the Fed moves more slowly in raising interest rates and may potentially end its tightening cycle earlier which should be a positive for the economy and both the fixed income and equity markets. As this is a very fluid situation, we will continue to provide necessary updates as needed.

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