The weather is getting pretty, pretty nice here. There is some rain for all the blooming flowers, but the temperature is not hot and the sun shines quite a bit. Everyone is just getting used to not wearing coats, or wearing them in the morning and carrying them in the afternoon. It’s similar to the way the beginning of a new market cycle can feel—temperamental but it slowly starts to put a smile on your face. 

There’s quite a debate, in the media and on various research platforms, about whether we are about to start a new cycle or we’ve still got to bottom in this one. As discussed in my post from April 5, on the one hand, inflation, which has driven rates higher, has improved. And from a technical perspective, stock market positioning is favorable to a potential move higher – BofA noted investors have put $538B into cash in the past eight weeks, which could be supportive if they came back.

However, the trajectory of inflation is subject to ups and downs, while core inflation (e.g. shelter, transportation) has been pretty sticky. Thus the Fed’s path for interest rates is still very data dependent (inflation vs economic growth), which is in disagreement with the market’s expectations of them cutting rates later this year. And let’s not forget the risks still in the regional banking sector. This will likely either act like a tightener (aka, less lending and support for economic activity), that does the Fed’s job, cooling the consumer and inflation just enough, or goes too far, creating greater volatility and risks.

On that point, earnings season is getting into full swing, with the kick-off in the banking sector. 

So far, the banks that have reported, underwrite a few themes:

• We have two official banking systems: The global systemically important banks (GSIBs) and the rest (regional banks, etc.).  → The former are heavily regulated given their size, and have been seen as safer as a result, especially in a time of stress. Case in point, in a flight to safety, the top 25 largest banks saw net inflows of $18B in March, while the rest saw net outflows of over -$200B.

• No matter their position of strength, there’s a strong uptick in cost cutting and preparing for a tougher future. → Better expense management was a common theme in the results, including decisions to pause or reduce stock buybacks. In addition, many of them added to their reserves in anticipation of a softening growth environment. This is like adding to a savings account instead of investing to increase your financial cushion.

• They are preserving cash (like adding to a rainy day fund). Many cited their own economic models looking worse and are either setting cash aside in reserves or are slowing or pausing the pace of their share buybacks to retain cash.

• Commercial real estate loan exposure is top of mind.  → Given the rise of interest rates and the maturity of some loans happening this year, investors are on high alert to banks that may carry risks of their loans in commercial real estate—in office, in particular—not getting paid back. 70% of these loans are held by regional banks and it’s estimated that $270 billion of these is set to expire this year. What will happen to them in this higher interest rate environment – will these borrowers be able to refinance and afford the higher costs? Will the banks make these loans again now that they are under more pressure?

Based on this last point, I am currently in the “too far” camp, where it may create greater volatility and risks, rather than being just enough to cool inflation. Though much of this depends on the coming economic data, and how well other sectors are faring (banks make up close to 12% of the S&P 500 Index, so 88% does other things). But I can’t help but feel we’re not quite in Spring for the market yet.

Source: Federal Reserve, Trepp, Inc.