After the U.S. debt ceiling is resolved we expect issuance of a very large amount of Treasury securities that should “drain” liquidity from financial markets. In our opinion, less liquidity should increase volatility. After analyzing Powell’s and Yellen’s comments towards the end of this week we now feel more strongly in our forecast that the regional banking crisis is not over and that we foresee further tightening of credit conditions.
Given all of the uncertainties surrounding economic growth rates and possible inflation trajectories, we were not surprised that the Fed decided to cease its forward guidance and substitute instead a data dependent approach that provides a “blank space” where the Fed can “write” its next policy decisions. The continuing instability of regional banks is but one of many uncertainties confronting investors.
We believe that we have not seen the end of “problems” emanating from regional banks. We continue to assume that lending standards will be further tightened and that credit will contract further in an uneven manner. We believe that these trends will lessen U.S. economic growth. We expect that high yield spreads will widen further later this year.
Due to the many distortions stemming from pandemic related developments, it is often difficult to “properly” decipher economic data. Changes in the economic environment are often subject to very rapid changes. We could soon be entering a period where changes might accelerate, leading to surprising outcomes. Investors should keep an open mind and maintain a “flexible” mindset.
For the time being we are maintaining our basic investment approach as expressed in last week’s commentary. We continue to prefer high quality stocks that offer good balance sheets, as well as relatively stable cash flows and profit margins. We prefer a global diversified portfolio for long term investors. We continue to stress that stock selectivity in this current environment is of paramount importance. We forecast continued financial markets volatility.
We continue to remain concerned that there could be more disruptions stemming from issues relating to smaller regional banks. Hopefully we will develop a clearer picture of credit availability as regional banks report their earnings, reserve allowances and their proclivity to lend. We found it striking that uncertainties surrounding consumers’ year ahead expectations appear to sometimes mirror fixed income volatility even while their longer term expectations remain well anchored generally.
We expect the Fed to hike the federal funds rate by 25 bps at its next meeting and then “pause” for quite “some time.”
The cracks in the high inflation, tight labor market and relatively robust economy narrative have begun to accelerate seemingly. In this context, we were reminded of Linkin Park’s song “Castle of Glass.”
The banking crisis depicted in our last two commentaries commanded mostly the attention of Congress and various government officials this week as they tried to discern who the “bad guy” was – or who the bad guys were – who helped precipitate this crisis. In her song “bad guy”, Billie Eilish made it easy as she identified herself as the “bad guy.” We thought that one phrase in particular captured the essence of her persona in the song: “I do what I want when I’m wanting to.” We surmise that this might have been the attitude of many people who were involved in laying the foundation that could turn into the crisis that transpired.
Late Thursday morning, we thought that it was highly likely that U.S. equities traded at a level that could be at least a short-term peak. We thought that the risk-reward no longer justified full positions in many stocks. We also detected what we would characterize as much complacency in regard to economic trends, which many investors and analysts viewed as perhaps predictable and evolving slowly. We suppose that future economic and inflation trends could evolve in a sudden and non-linear pattern.
The Fed will have a difficult task in balancing the risks of tighter monetary policy to rein in inflation against the risk of financial instability. To what extent are these objectives compatible? To what extent will the Fed become a chameleon? To what extent will this change the Fed’s “karma?”