Applying Pressure - 1st Quarter - 2023

The Federal Reserve’s fight against inflation is becoming a serious thorn in the side of consumers and businesses. Higher interest rates result in higher interest payments and increased economic uncertainty. For consumers, this has made large purchases, such as a starter home, more difficult. For businesses, it can reduce expansionary plans or delay purchase of a new piece of equipment. Higher rates are a deterrent to investment. The goal, after all, is to slow economic growth, allowing the supply of goods and labor to rebalance. As inflation drags on, so does the monetary policy response to combat it – both forces are grinding down economic sentiment and financial markets. Indeed, some may be starting to question what’s worse: inflation or the medicine required to tame it?

In March, something big enough to grab headlines finally broke. The banking system underwent a stress test brought about in part by the rapid rise in interest rates. Banks’ assets, in the form of loans and fixed income investments, have precipitously declined in value. Silicon Valley Bank (SVB) and Signature Bank experienced bank runs and collapsed into FDIC receivership. Foreign institutions were also tested, evidenced by Credit Suisse’s failure and subsequent take over by rival UBS with help from the Swiss National Bank. It is unclear whether the worst of current shocks are now behind us or yet to come. What is clear is that financial markets have, in a short matter, adjusted expectations dramatically for future Fed rate hikes.

Source: Bloomberg LP

This change in expectations, it must be said, is just that. It is possible that markets have once again got it wrong. We’ve also witnessed a flight to safety among depositors as the health of small and mid-sized banks came into question and the fear of additional bank runs spreads. The Federal Reserve has attempted to quell these concerns with soothing words and actions. They’ve stated time and again that deposits are safe, and the banking system is sound. An economic recession may be an inevitable, but necessary event over the course of an economic cycle. Financial contagion, however, is unacceptable and will be countered at all costs.

Though each historical period of economic malaise is driven by factors unique to the time and place, the general outcome tends to be the same. First, liquidity or access to capital dries up and becomes more expensive. Lenders, to shore up their own balance sheets and mitigate losses, reduce new loan origination, and increase lending standards. And second, those in the weakest financial positions, whether it’s individuals or companies, face a reckoning under tighter credit conditions combined with slower economic growth. Those in the strongest financial positions usually not only survive but thrive and grow market share.

We are optimistic that markets are correct in anticipating a pivot in the Fed’s current inflation fighting policy. The result will lead to lower interest rates and improved liquidity in time. Historically, this kind of change has benefited investors, however, our enthusiasm is guarded since the impact from current conditions will not be fully reflected for several quarters. The stress that is emanating from the banking sector may impede valuations and growth in the near term. It is not that opportunity does not exist, but current pricing, in many cases, is not yet attractive.

The best scenario for investors in the near term is for an economic ‘soft-landing’ in conjunction with declining inflation. While we hope for this positive outcome, we do not count on it. We continue to focus on investments backed by strong fundamentals that do not rely on a robust macroeconomic backdrop.

Please reach out to continue the conversation and thank you for your confidence and partnership.

EPIQ Partners