Never underestimate the stock market’s ability to prioritize hope over experience.
Hope would suggest that everything will work out fine: The banking panic that began with Silicon Valley Bank’s collapse is just a blip; the Federal Reserve’s quarter-point interest-rate hike, despite the turmoil in the financial system, is sound monetary policy; and the S&P 500 index’s bounce that began in October really was the start of a new bull market. That the index rose 1.4% this past week, while the Cboe Volatility Index, better known as the VIX, fell 15%, would suggest the problems are manageable.
Experience suggests otherwise. Banking panics aren’t something to be trifled with. As Fed Chairman Jerome Powell acknowledged on Wednesday, the latest one is sure to slow the economy. He suggested that it was the equivalent of a rate hike, though some have put it at a half-point or even 1.5 percentage points. Knowing that, Powell still raised rates by a quarter-point, something that is likely to exacerbate problems in the financial system. “The Fed is making a mistake,” writes Andrew Brenner of NatAlliance Securities.
The problem, however, isn’t the possibility of more bank failures. It’s that banks are likely to curtail lending—lending they had already started to limit. Even before the failure of SVB, the Fed’s January Senior Loan Officer Opinion Survey showed that the percentage of banks tightening lending standards had risen to 44.8%, the highest reading since July 2020, at the peak of the Covid lockdowns. Given the problems at regional banks, that percentage is likely to go even higher.
History suggests that’s bad news. The tightening number was already getting close to a level that indicated a recession was near at hand. Bank of America economist Michael Gapen, using lending data from 1991 through 2022, found that a “shock to lending standards” caused declines in employment, consumer lending, and investment in structures and equipment. Gapen acknowledges that the results might be overstated by the financial crisis, as well as the assumption that all banks will tighten lending standards, not just the smaller ones. That’s not enough to make him dismiss the results.
“Downside risk to the outlook has risen,” he writes. “Adverse shocks to bank credit growth can lead to adverse economic outcomes.”
Other indicators are already suggesting as much. In the junk-bond market, the percentage of distressed issues—those with yields 10 percentage points or more above equivalent Treasuries’—jumped from 7.8% on March 8, before SVB’s collapse to 10.6% just seven trading days later, on March 17, according to Martin Fridson, chief investment officer at Lehmann Livian Fridson Advisors.
That’s a massive move in a short period, even faster than the one that occurred over the 31 trading days ended on Dec. 31, 2007, when the distressed ratio rose from 7.5% to 10.4%. Again, there are caveats—the current percentage isn’t that much higher than the median of 9.3% from 1997 to 2022—but it’s a warning that shouldn’t be ignored. “All signs are pointing to the increased probability of a recession,” Fridson says.
The stock market would seem to disagree. It has gained 11% since it last traded at a new low about 5 ½ months ago, on Oct. 12, leading some to suggest that a new bull market has started. Perhaps. But if it is a new bull, it’s the weakest in recent memory, according to Warren Pies of 3Fourteen Research. Since 1974, the S&P 500 has gained an average of 32% in the six months following a previous low. The smallest gains occurred in 1987 and 2002, when the index rose just 13%, so it’s possible for the stock market to close that gap. Still, in only one of those periods had the Fed been raising rates, and none occurred when the yield curve was still inverted, as it is now.
“In short, the last six months hold very little resemblance to a typical postbottom environment,” Pies writes. “Yet, for equity investors, hope springs.”
Of course, the Fed looks like it’s coming to the end of its tightening cycle, something that has been mentioned as a catalyst for a market rally. But investors might be applying the lessons of the past 25 years—a period of deflation—rather than those of the 15 years before that, which can be safely be described as inflationary, according to BofA’s Michael Hartnett. During the deflationary stretch from 1989 through 2018, the last rate hike was followed by six months of strength, with the Dow Jones Industrial Average returning an average 13.1%. But during the inflationary period, which ran from 1974 through 1984, the Dow dropped an average of 6.4% over the six months following the last increase.
We can only hope that this time that’s not true.
Write to Ben Levisohn at [email protected]