A better-than-expected earnings season has helped support equities since April, especially as the regional banking crisis subsided. Through the first week of May, roughly 85% of companies on the S&P 500 have reported earnings with 79% reporting a beat on earnings for a blended earnings decline of –2.2% for Q1 2023, well above the expected –6.7% at the start of the earnings season.1 While the bar was very low coming into this earnings period, the better-than-expected results have provided a cushion amidst an uncertain macroeconomic environment.
Today’s Consumer Price Index (CPI) inflation report helped clear up some of these macroeconomic concerns as it showed that both headline and core inflation continued to moderate in the month of April. Year-on-year headline inflation has now slowed for the tenth straight month, and now stands at 4.9%, the lowest level in over two years.2 On a component level, services and goods continue to trend lower with shelter inflation – arguably the stickiest component – increasing at its slowest monthly pace since January 2022.3 However, as the market moves past today’s inflation print, and with earnings season now mostly behind us, we see reasons to be cautious due to the potential downside risks to the market in the near term. The underlying strength of the economy (i.e., the consumer which we wrote about here) should help stave off a deep drawdown; but near-term risks centered around the ongoing banking turmoil and the upcoming debt ceiling showdown may pressure the market.
Risk 1: Regional bank turmoil persists and could lead to a credit squeeze for the economy.
The ongoing turmoil in regional banks presents a heighted risk to the credit landscape of the economy. Monday’s release of the Federal Reserve Senior Loan Officer Opinion Survey (SLOOS), conducted between March 27 and April 7 (post-SVB collapse), showed a modest tightening in credit conditions from levels seen in the January’s survey, and confirmed a trend that was largely in place even before the March turmoil.4 Still, given close to 40% of all lending is done by small regional banks and 30% of all deposits are made with these banks, this banking segment is still facing unresolved issues and lending from these smaller banks could contract sharply down the line.5 Interestingly, net new lending actually rebounded at these small banks at the end of April after contracting to multi-year lows in March, though the risk of further contractions remains (Exhibit 1).6
That said, we still remain concerned that as long as these banks are under pressure from slumping share prices, deposit outflows and credit contraction are likely to continue.7 Regional banks are a perfect target right now. Fundamental investors don’t want to own regionals because net interest margins are squeezed and the competition for deposits is severe and costly. At the same time, investor sentiment is pushing these banks into a vicious cycle: shares come under pressure, further loss of confidence ensues, deposit outflows occur, and that leads to further selling pressure (Exhibit 2).
A couple of things could break this vicious cycle. First, the Fed could cut rates alleviating pressure on cost of funds for banks, and second, the FDIC could expand its deposits coverage to currently uninsured deposits. Unfortunately, neither of these seem likely in the near-term. And we don’t expect Global Systemically Important Banks (G-SIBs) to buy many more troubled regional banks. With roughly 4,800 commercial banks in the U.S. and the aforementioned concerns unresolved, there is likely more scope for bank failures.8
Risk 2: Debt ceiling showdown is imminent with the potential for severe and historical implications.
Previously thought to be in July, the “X-date” for which the U.S. is expected to exhaust resources and default on its debt has now been pushed forward to as early as June 1.9 Currently, the White House and Republican lawmakers are in a stalemate over lifting the debt ceiling past the current limit of $31.4 trillion (Exhibit 3). This has left policymakers with a limited number of days in May to prevent a standoff akin to that of 2011, in which a near failure to compromise on a debt ceiling increase caused the U.S. to almost default on its debt and led to the country’s credit rating being downgraded by Standard & Poor’s. Of course, as it was in 2011, it is in everyone’s best interest to ensure that a breach does not occur, but the path to getting there might be rocky.
Late last month, House Republicans passed a bill that would raise the $31.4 trillion debt limit by $1.5 trillion and delay the risk of a default until next year.10 However, the proposed bill includes deficit cuts and the rollback of recently passed provisions such as IRS funding and energy tax incentives – all of which are unlikely to be accepted by Democrats who want a clean increase in the debt ceiling.11 However, Republicans may want to stay firm on budget cuts, given the outlook by the Congressional Budget Office (CBO) has debt to Gross Domestic Product (GDP) rising from 97% today to 195% by 2053, as a result of budget deficits of 5-7% in the coming years.12 Most of this budget deficit increase is now attributed to net interest outlays which, as a percentage of GDP, are set to nearly double over the next decade from 1.9% to 3.6% (Exhibit 4).13
The bottom line is that there are no easy fixes, and with Democrats wanting a “clean” debt ceiling increase versus Republicans wanting deficit cuts, the progress may be volatile. If policymakers can’t agree on a solution and the U.S. indeed briefly defaults, that could result in a decrease in real GDP, loss of almost 2 million jobs, and the unemployment rate rising to nearly 5%. In our view, the market is not well positioned for this, or the potential rise in volatility. The credit default swap (CDS) markets are pricing in the risk of default much higher than in 2011.However, equity volatility has only moved marginally higher for the June time-period and has yet to meaningfully react. And we believe that is a risk worth paying attention to.
The ongoing turbulence in the banking sector and the impending showdown over the debt ceiling may exert downward pressure on the market.
With near-term risks rising, the S&P 500 sitting only 1- 2% above key technical levels and positioning no longer as negative as it was coming into April, we see risk of a near-term pullback. Amid this, mega-cap tech and the Nasdaq will likely continue to be more resilient as investors continue to rotate away from financials, cyclicals, small-caps and sectors negatively impacted by high rates in favor of those with low debt, high margins, and secular tailwinds.
1. Source: FactSet, iCapital Investment Strategy, as of May 5, 2023.
2. Source: Bloomberg, iCapital Investment Strategy, as of May 10, 2023.
3. Source: Bloomberg, iCapital Investment Strategy, as of May 10, 2023.
4. Source: Bloomberg, Federal Reserve, iCapital Investment Strategy, as of May 8, 2023.
5. Source: Bloomberg, Federal Reserve, FDIC, Goldman Sachs, iCapital Investment Strategy, as of May 8, 2023.
6. Source: Bloomberg, Federal Reserve, iCapital Investment Strategy, as of May 8, 2023.
7. Source: Bloomberg, Federal Reserve, iCapital Investment Strategy, as of April 26, 2023.
8. Source: FDIC, iCapital Investment Strategy, as of May 8, 2023.
9. Source: US Treasury Secretary Janet Yellen, iCapital Investment Strategy, as of May 1, 2023.
10. Source: U.S. House of Representatives, as of April 26. 2023.
11. Source: Wall Street Journal, as of May 2, 2023.
12. Source: Congressional Budget Office Budget and Economic Outlook, as of February 15, 2023.
13. Source: Congressional Budget Office Budget and Economic Outlook, as of February 15, 2023.
14. Source: Bloomberg, iCapital Investment Strategy, as of May 8, 2023.
15. Source: Bloomberg, iCapital Investment Strategy, as of May 8, 2023.
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