Chart of stock bonds growth with a black pen over the newspaper.

Our Top Market Takeaways for March 31, 2023

Market update: Good riddance to March

This month has seen a lot—three U.S. bank failures (and one in Europe), emergency action by policymakers, hot inflation readings, more central bank rate hikes and a president indictment.

Yet, markets have, for the most part, shaken it all off. A 60/40 portfolio of global stocks and bonds has returned +5% so far this year.

Tech has been a powerful force, up an astonishing 20%, thanks to companies with flush balance sheets and strong management teams acting as high-quality havens. Stocks in Europe have outperformed their U.S. peers. And, despite wild swings in rates, bonds have proven their value as essential portfolio protection. The power of diversification is at work.

This chart shows the year-to-date performance of tech, global stocks, S&P 500, a 60/40 portfolio, global bonds, large banks, and U.S. regional banks.

Yet, that doesn’t mean the coast is clear. When central banks hike interest rates, and tighten the flow of credit to the economy, things tend to break. Different parts of the economy tend to break at different times – and this cycle has already seen corrections in housing, manufacturing and tech. Now, it’s banks, which can feel especially bad given their place at the epicenter of the economy. While markets seem keen to move on, we likely haven’t seen all the aftershocks yet.

SPOTLIGHT: The ripple effects of the bank shock

Based on what we know now, this episode doesn’t look systemic and it doesn’t look like another 2008. However, the cracks are evident, and as investors, we’re focused on sizing up the impact. Here, two questions are key: Are there signs of contagion? And what other pressure points could be lurking?

1) Are there signs of contagion?
The recent shock has left bank customers questioning just how safe the cash in their checking or savings account is. That worry has sent deposits rushing out of small banks and into both large banks and money market funds (which invest in things like low-risk cash-like instruments and short-term bonds — and often offer higher yields). Over the last few weeks, money market funds have seen their largest inflows since early in the pandemic, bringing their total assets to over $5 trillion (the most on record).

If this trend accelerates, and all depositors demand their money back at the same time, that can put banks in a tough spot. When it happened with Silicon Valley Bank, it had to sell some of its assets at a big loss to pay back its flighty depositors (who were largely concentrated in an interconnected web of tech start-ups). And it still wasn’t enough. The fear then follows — when confidence in the banking system is shaken, will it ricochet to the point of contagion?

There are promising signs that some of the worry is abating. For one, policymakers have made a big effort to not only backstop failed banks (like SVB and Signature Bank) but to also provide liquidity to all banks (for instance, through the Fed’s discount window and new Bank Term Funding Program). This helps ensure banks have the cash on hand to meet the demands of their depositors.

How much these facilities are used can give us a sense for the degree of panic depositors may be feeling and, in turn, the pressure banks may be facing. While banks have tapped the Fed’s and other sources of liquidity, this borrowing now seems to be decelerating (albeit remains elevated). That suggests that liquidity strains at least aren’t getting worse.

This bar chart describes the Fed’s discount window and how much the Fed lends out through its bank term funding program (BTFP) in March 2023 as well as the peak usage during the global finance crisis and COVID-19.

That said, things can change quickly, and banking system stress is still high. If things take a turn for the worse, that begs the question of what more policymakers can do. A number of industry leaders have called for enhancing the FDIC’s deposit insurance, which currently guarantees that deposits are safe if a bank fails – but just up to a limit of $250,000. This means almost half of U.S. bank deposits today are uninsured. But while upping the limit and extending insurance to all banks could reduce the risk of further bank runs, such action is politically contentious and would require action from Congress. It’s possible, but it would be a tall feat.

2) What other pressures are lurking?
To keep deposits in the door, banks may be forced to offer higher rates that compete with other banks and money market funds. They also may be more reticent to lend in an uncertain environment. All of this cuts into banks’ profitability – and the upcoming earnings season should provide an initial sense for these challenges.

What’s more, the bank shock has highlighted gaps in existing regulations. Moving forward, regulators will likely take a stricter approach to current rules, as well as introduce new ones in time. Yesterday already brought an example of this, with the White House calling for regulators to tighten their grip on mid-sized banks.

Finally, the impact of the shock isn’t limited to the banking system, prompting many to question what the next shoe to drop may be. Here, it matters who smaller banks have been lending to, and concerns have been growing around commercial real estate (CRE). The sector has already come under pressure as interest rates have risen, but this dynamic is now in acute focus given CRE makes up almost half of small banks’ loans.

This chart shows the breakdown of loan exposure for small banks and large banks for C&I, Residential RE, Commercial RE, Consumer, and Other.

The most vulnerable area looks like offices. Disrupted by the rise of remote work (which is still 7x of what it was before the pandemic), office CRE is likely to go through a real reckoning – perhaps as serious as the Global Financial Crisis. Yet, it’s worth noting that the office subsector represents just ~14% of all CRE (and office construction is just 0.4% of overall GDP). Further, not all CRE is created equal: segments like data centers, hospitals, apartments, retail, and the like don’t seem to be facing the same pressures. Markets seem to be acknowledging at least some of this difference in risk:

The chart shows the price level performance for REITs (represented by the S&P 1500 REITs index) vs Office REITs (represented by the S&P 1500 Office REITs index).

INVESTMENT IMPLICATIONS: Defensive, not fearful

Even if market volatility subsides, banks will probably lend less – but just how much is still an open question. We tend to be less optimistic given that small banks have driven the majority of lending over the last six months and also tend to make loans to small businesses, which employ 80% of the workforce. In all, less credit flowing into the economy tends to mean lower growth, and this could accelerate the path to recession.

The charts shows the 3-month annualized contributions to loan growth from small banks, large banks, and the total of all banks.

Tighter credit conditions from the banking sector can do the same job as rate hikes, which means that the Fed probably doesn’t have to raise interest rates as much as it otherwise would have. That said, sticky inflation is still a going concern.

We are focused on investments that are more defensive and can offer protection in a downturn. The quick collapse in yields over the last month demonstrates why bonds are essential. Strategies like structured notes can help stay invested in both the good days and the bad, through protecting gains and building in a buffer from adverse moves lower. Sectors like reasonably-priced technology, healthcare and industrials could be bellwethers as other cyclical parts of the market struggle. And as growth grows more scarce in the U.S., prospects in Europe and China look a bit better.

Above all, stick with your investment plan. History suggests that this too shall pass, and investors are less likely to suffer losses over longer periods – especially in a diversified portfolio.

Your J.P. Morgan team is here to discuss what it all means for you.


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