Emergency Edition: Market in turmoil
What a week.
If investors' number one fear in recent times has been that the economy will overheat and interest rates will rise to the limits of tolerance before a cooling recession, it now seems that a more direct fear of recession has taken over again. How are you supposed to keep up with the changes in investors' minds? Stocks are liquid and when people need cash in a crisis, stocks are often the first to go. The fall in long-term interest rates and raw materials prices such as oil are also evidence of recessionary fears.
In this second Emergency Edition of the week, I'll share a few graphs about the market turmoil, including the meltdown of Credit Suisse. Then we look at the latest inflation data, followed by a reflection on the current state of the market in the shadow of the banking crisis.
Credit Suisse at the center of the crisis again
The "usual suspects" of the European banking sector are back in the unwanted spotlight. Credit Suisse, the big Swiss bank that has been in trouble for the last 15 years, was turned down by its biggest shareholder, the Saudis, who don't want to put any more money into the bottomless pit. The bank is amid a complex tumult, as discrepancies have occurred in the accounts over the past couple of years and customers withdrawing their deposits in large numbers. In the wake of the giant, the European banking sector has been taking a nosedive. Market hedges against the company's insolvency have shot through the roof, indicating gargantuan stress in the bank's failing structures. This graph shows Credit Suisse's credit default swaps and the benchmark, Nordea, which is very stable.
This morning the bank tapped a loan from Swiss Central Bank, which pacified the situation for a while.
In the banking sector, everything is interconnected, so that's how the rates spilled over to the Nordics too. Retail investor favorite Nordea that has a very strong balance sheet has seen its share price fall by fifteen percent from its late February highs.
If nothing else, ECB interest rate meeting today will be interesting to say the least.
It should be mentioned in passing that ARK ETF, the flagship fund of the 2021 Speculative Stock Championship, saw $400 million in subscriptions, according to Bloomberg. The fund run by Cathie Wood has lost 75% of its value, but there is still a belief in hype-investing among investors. I do understand the point that if you believe in a Fed pivot and a rapid fall in interest rates, a fund full of growth companies can do relatively well. Cathie Wood also shouted on Twitter for the second coming of the Roaring Twenties if the Fed did not look at inflation but focused on what she called “a deflationary banking crisis”.
Yeah, welp... the number one observation is that speculation hasn't really left investors in the last couple of years.
Inflation continues to be a nuisance
Let's talk briefly about inflation, which has by no means disappeared under the bank hiccups. The February inflation data for the US, released on Tuesday, continues to point to a persistent problem. In turn, this forces the central bank to maintain a tight monetary policy stance, which in turn erodes the present value of equities.
Core inflation, which excludes volatile energy and food prices, rose by 5.5% year-on-year. This graph shows annual inflation with its various elements. In practice, pandemic-era energy and commodity inflation has disappeared, replaced by broad-based price rises in the services sector.
But inflation in the services sector will continue to be pushed up by the shelter costs. As my active readers know, they shouldn't be a worry for much longer.
This graph shows the year-on-year change in the Zillow rental index, suggesting that the cost of shelter is cooling rapidly. It’s driven by the change in house prices, which is plotted in blue on the graph on an annual basis. House prices are expected to fall. I have seen estimates of, for example, a 15% drop from peak prices. The fall in this huge asset class should be reflected in rents and as they cool down, the inflation figures may look a little different.
However, let’s not count our chicks before they hatch.
The problem is that even if you look turned a blind eye to shelter costs, inflation still seems too persistent. This graph shows the development of service prices, excluding shelter, on a monthly basis. It’s still above 0.4% and shows no sign of falling, suggesting wider price pressures.
The central bank's worst fear of inflation spilling over into the broader economy has been realized.
Here, in turn, are the Cleveland Fed's trimmed and median inflation as well as headline and core inflation. Median inflation measures the increase in the price category whose weight is literally in the middle of all price categories if they were lined up. It therefore reflects the typical change in price categories. Trimmed inflation doesn’t refer to hedges or beards, but to an inflation gauge from which the most volatile items have been removed. Median inflation continues to rise on an annual basis, while trimmed inflation is already cooling, but still being at an obscenely high 6.5%.
The inflation situation could be summed up like this: The worst of the inflation is behind us, but the hardest work to bring it back to the central bank's 2% target lies ahead. Unless the banking crisis escalates globally and kills economic growth and inflation at the same time.
Brief reflection on the market
This brings us to the interest rates and the market that always attract equity investors. The last week's miniature banking crisis has thrown up all sorts of arguments. Some are even predicting a cut in the policy rate at the Fed next week's meeting, others at least a more moderate increase in policy rates. When the system rattles, the central bank has to tread more carefully. In this graph, the yellow curve shows the expectation for policy rates a week ago. In turn, the green graph shows expectations now. The peaks are pretty much here or maybe there’ll be one more hike, but then the cuts start. The uncertain situation makes interest rates swing wildly and this graph is in constant change.
Personally, I would jump on the bandwagon of those who believe that the central bank can continue to beat up inflation with interest rates, but at the same time support the financial sector that’s being torn here and there with balance sheet measures. That's basically what the new BTFP program is all about, allowing banks to withdraw funding from the Fed in exchange for debt securities Of course, this in itself is not news, as this graph has been highlighted in these posts for many months now, showing that on net the Fed hasn’t shrunk its balance sheet since last summer.
If the Fed were to be timid about stifling inflation and to cut interest rates, it would likely exacerbate price pressures in the long run. This mistake was made in the late 90s, when the Fed cut interest rates because of the downfall of the infamous, super-leveraged Long Term Capital Management. Then, the stock market immediately shot into a bubble. In this confusing graph, the white curve shows the policy rate, the blue curve shows the Nasdaq stock index, the red bar outlines the LTCM crash, and the orange bar shows the inflation rate. The Fed presumably wants to avoid repeating this mistake.
The current situation on the stock market is interesting. Last week's events are a reminder of the risks lurking in the economy. Like our analyst Matias Arola pointed out the other day, the global real estate meltdown could hit banks harder. At the same time, equity valuations have recovered from last fall's low, and inflation doesn’t seem to be receding rapidly. One could almost characterize this as one of those classic end-of-cycle death rattles. But if inflation were to recede quickly, it would free up central banks to support asset classes and stocks would rocket. If not, there may be some interesting places to buy ahead.
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