- The Fed raises rates again as the focus continues to be inflation despite problems in the banking sector.
- Banking contagion threatens a credit crunch and a more severe recession than predicted.
- Two recommended opportunities are both well-capitalized banks that have managed their portfolios to come out on top.
Dear NEO Report Reader,
The market is trying to digest the problems circling around the financial industry, which is very fluid at the moment.
UBS “officially” purchased Credit Suisse (CS) following additional support from the Swiss Central Bank. CS has struggled with multiple restructuring and bailouts/ lines of credit since the 2008 financial crisis. It isn’t surprising to see UBS absorb CS. But, the question becomes can UBS handle the unwind of Credit Suisse exposure?
UBS has seen its Credit Default Spreads (CDS) blow out as investors are concerned CS could weaken UBS to a large degree. CDSs are essentially insurance packages in case of default by a company, country, or bond.
Pressure Is On Small Banks
There is hope that the latest bank contagion will be contained, but there is renewed pressure on the small banks in the U.S. as First Republic Bank comes under pressure again. There is an ongoing battle because Silicon Valley Bank (SVB) and Signature Bank (SBNY) haven’t traded since being halted on March 9th and 10th respectively.
This has sparked renewed fears around short covering and options expiry, which is creating more chaos in the other small/medium banks and regionals. We believe that the pain is far from over given the pressure at the regional bank level. Small banks are some of the largest underwriters of commercial and industrial loans (C&I loans) as well as commercial and residential real estate.
The consumer piece is also coming under pressure since those loans are usually by way of credit cards or lines of credit against homes or other hard assets. I think that asset prices have a long way to fall, which will put more pressure on the loan books at these banks.
It will be very difficult for the Federal Reserve or the U.S. government to backstop all the unsecured deposits. There is about $18 trillion in deposits with only $125 billion in the FDIC (Federal Deposit Insurance Fund). The Fed has assembled the potential to backstop about $2 trillion, but that would just be another massive QE injection that would send inflation surging again.
Bond volatility has surged to new heights as it approaches levels not seen since 2008. As global volatility increases, there will be bigger reductions in risk assets as companies and consumers pull back more aggressively.
The additional stress across the market is going putting more downside pressure on earnings, and we expect to see another shift lower in the stock market. This will setup more “fear” and reduce economic activity further.
In the U.S., we have final sales of private domestic purchases falling rapidly, which will weigh on earnings and margin. The next down wave will be rapid, and result in more fear permeating the system as many investors (especially retail) remain long equities.
A Credit Crunch Is Coming
As the bad debt expense rises, the banks have less money to lend out as they need to keep more cash on the balance sheet to account for the write-downs. This has created a broad freeze in new loans and underwriting, which will take the credit impulse down significantly in the near term.
Here’s the problem.
The willingness to lend was already in recession territory the past couple of weeks BEFORE the regional bank chaos began. The shifts in liquidity, concern around deposit bases, illiquidity of hedges, and weakening loan portfolio is going to shrink that even faster.
Just like everything else in today’s financially manipulated world, loans and leases in bank credit are at record levels. So, any shift in asset valuation can have huge ramifications. Leverage is great when it’s all sending us higher. But the moment it turns lower, the losses added up rapidly.
As credit growth dries up, we are going to see a sizeable drop in real credit growth, which will take GDP down with it as well. In the chart below, essentially what matters for growth (black line) is the credit impulse (blue) with the second derivative being credit. If we assume stabilizing credit and avoid an outright credit crunch, the second derivative turns very negative regardless and still risks a broad U.S. recession.
We have pointed out in the past that a recession was unavoidable, and we believed it would be a shallow and prolonged drawdown. We are still keeping that as our base case, but the stress is growing which can send us lower much faster.
The Fed is launching initiatives that will “slow” the drop, but it won’t by any means reverse the problem. The bank failures are the SYMPTOM and not the CAUSE! We have highlighted from day one that banks/investors were failing to do the necessary due diligence in evaluating risk and hedging appropriately. This is all because of their access to ZIRP and endless QE.
The moment many of these zombie companies could no longer roll their debt, it would all come crashing down. As we have said, rising rates fix a lot of problems and we need to purge the system.
The U.S. is now a classic credit impulse story. Usually, it’s hard to disentangle demand vs supply in the credit impulse – the change in the flow of credit – but SVB and ensuing pressure on U.S. regional banks is a true exogenous shock that will drive the impulse sharply negative.
The Fed dumped a ton of liquidity into the market recently and added about $297 billion in assets on its balance sheet. This essentially erased half of the QT that has taken place since April’22 and all of it was done in a single week.
We also saw a surge of U.S. banks borrowing from the Fed’s discount window to a level that dwarfs the GFC and COVID shocks. It totaled about $152 billion with the recent record being in 2008 at $112 billion.
Financial Conditions Are Worsening
This tightening scenario is a key reason why the Financial Conditions index took a HARD turn lower and is the tightest since March 2020.
The yield curve inversion reached its steepest levels going back to the early 1980s and has now started to snap back higher as the market starts to price in underlying rate cuts being pulled forward.
During the last six U.S. recessions, we saw the yield curve (10 years minus 2 years) steepen aggressively as the Fed entered a rate-cutting cycle. The market is pricing in the same today, pointing to a Fed Funds rate of 3% by the end of 2024.
The problem with the view that the Fed will cut is the presence of inflation still in the system, and we are still well below “full employment.” The ECB raised rates by 50bps earlier this month and the Federal Reserve followed with another 25bps hike on March 22. Jay Powell reiterated that inflation was still the central bank’s main focus despite the banking crisis.
The uncertainty surrounding the world is also playing out in U.S. CDS’s as the value of them surged.
The Fed’s Conundrum
The Fed finds itself in a tough spot as they have trained people to believe in a “Fed Put.”
Greenspan started the party back in 1987 as the introduction of ZIRP or at least very low rates would create a way to “break the business cycle” and not have down drafts the same way we did in the early part of the century.
The Fed and U.S. Government doesn’t or at least SHOULDN’T backstop all losses. But we have created an entire generation of individuals that take blind risks and think they will be bailed out when everything evaporates. Low rates and free money created a playground for terrible portfolio, risk, and hedging management.
The Fed is currently constructing a “new” backstop that could have a scope approaching $2 trillion. But early indications show they would want to use it to protect the six banks with the highest number of uninsured deposits- which is closer to $460 billion.
“The usage of the Fed’s Bank Term Funding Program is likely to be big,” strategists led by Nikolaos Panigirtzoglou in London wrote in a client note Wednesday. While the largest banks are unlikely to tap the program, the maximum usage envisaged for the facility is close to $2 trillion, which is the par amount of bonds held by US banks outside the five biggest. The Fed has also opened up the liquidity swap lines for international use, which is tapped for shortages of USD abroad.
There is a common factor talking about how M2 has shrunken after massive increases over the last 20 years, and we still have over $2 trillion sitting in the RRP.
We have done nothing but increase the money supply for the last 60+ years, expanding the amount of liquidity in the market steadily. We need to pull some of this froth from the market, but as you can see from the insanity, many banks, investors, and corporations aren’t prepared for the party to end just yet.
“Just one more hit” seems to be the view from around the world. But at some point, we need to end this monetary experiment as the law of diminishing returns catches up to us rapidly.
The below chart puts into context just how “small” that money supply shrinking was and yet people have now lost their minds.
Indicators Point To Recession
Even before all of this unfolded, the leading economic index has been dropping with its eleventh straight month of declines. The streak has never been seen without an economy already being in or heading into a recession.
The shift in the banking world and underlying economic headwinds are sending CAPEX expectations through a floor after already assumed to be lower.
Even before the banking sector chaos unfolded, we had more negative prints from the Philly and NY Fed. New orders component of the Philly Fed Index sank further into contraction in March and now are at levels firmly consistent with prior recessions.
The broader index “rose” to -23.2 from last month’s -24.3 but was well below estimates of -15 as pressure continued to grow outside of the current problems unfolding.
The March NY Fed Business Activity data recorded something similar after “rising” to -10.1 vs last month’s -12.8.
Many of these data points don’t reflect the problems that still remain in the system- including the exposure to unsecured deposits. The regional fed data has signaled a broad range of pressure, and many of these readings were taken BEFORE the banking system buckled.
Our Recommendations
But there is a way to try to capitalize on the current banking crisis.
There is some opportunity for the best banks that have managed their portfolios to come out on top. The best place companies remain MTB (M&T Bank) and PNC.
They have the least exposure to deposits over $250k and don’t have unrealized losses like the rest of the group. These two banks will be able to balance the next few months and pick up valuable assets. There were more rumors that FRC (First Republic Bank) will be selling more assets to raise capital to secure deposits. We expect to see more portfolios come to market, and it will only strengthen the banks that have managed their risk and loan books.
Our recommendations are two of the most well-managed banks in the country.
M&T Bank Corp. (NYSE: MTB) is an American bank holding company headquartered in Buffalo, New York. It has 1,000+ branches in 12 states in the Eastern United States.
M&T Bank has been profitable in every quarter since 1976 and also has the distinction of being only one of two banks in the S&P 500 that did not lower its dividend during the 2008 financial crisis.
In 2022, MTB acquired People’s United Bank in an all-stock transaction valued at approximately $8.3 billion. MTB’s market cap is $19.83 billion.
The recent market selloff is an attractive entry point from a risk/reward standpoint as MTB trades above the median implied cost of equity.
M&T Bank is well positioned in the current environment with approximately 50% of deposits FDIC insured.
The bank’s capital position is also strong given prudent balance sheet management resulting in lower unrealized losses relative to peers with the optionality to extend duration at higher rates. We recommend buying.
PNC Financial Services Group Inc. (NYSE: PNC) is an American bank holding company and financial services corporation based in Pittsburgh, Pennsylvania. Its banking subsidiary is PNC Bank, and it operates in 27 states and the District of Columbia, with 2,629 branches and 9,523 ATMs.
The bank is ranked ninth on the list of the largest banks in the U.S. by assets and its market cap is $50.04 billion.
PNC Financial outperformed its peers in the iShares Regional Banks ETF, demonstrating the market’s confidence in its leadership prowess. We believe PNC can outshine its competitors during this banking crisis and emerge stronger than ever, which will cement its market leadership. We recommend a buy.
Action to Take:
***BUY MTB up to $122***
***BUY PNC up to $127***
Good Hunting,
Freedom Financial News
