Mar 24, 2023
Stock Bulls Bet the Trifecta: No Crisis, No Hike, Safety in Size
(Bloomberg) -- It takes guts to bid up stocks when the Federal Reserve is raising rates in the middle of a banking crisis. But what’s passing for bravery in a wild stretch for markets and the economy strikes many as willful blindness.
Two weeks after stress started shaking the financial system, the S&P 500 is sitting just a bit below where it began, despite significant up-and-down volatility. The Nasdaq 100 has shaken it all off and rallied, adding almost 4% since March 8, which amounts to a bet — a peculiar one — that everything taking place since SVB Financial Group collapsed was somehow good for tech investors.
Getting to a place where the price action makes sense requires an awful lot to go right. Boiled down, the thesis seems to be a belief that everything about the banking crisis has been exaggerated — except its dovish impact on the Federal Reserve.
Add to that a belief that big companies in possession of low-rate financing — a good description of the Nasdaq 100, and a decent one of the S&P 500 — will deliver rising profits even as the economy slows, and you get an exacta bet where any one misstep upends the entire wager.
“All of those things combined likely are what the drivers are for the market,” said Art Hogan, chief market strategist at B. Riley Wealth Management. “They’re all equally important.”
Bryce Doty, senior portfolio manager at Sit Investment Associates, phrases it differently: “The stock market is working awfully hard to convince itself that everything will be OK.”
While owning stocks has delivered profits over the long run, buying them now requires something like superhuman conviction the market will overcome a litany of roadblocks such as elevated valuations, earnings downgrades and the threat of a looming recession. Goldman Sachs Group Inc. strategists including Dominic Wilson and Vickie Chang say being bullish on equities from here is risky.
“Under any of these explanations, it looks like equities are now most vulnerably priced, and are at risk either from intensifying growth pressures or from overly optimistic policy assumptions,” they wrote.
There’s another problem: no risk-on signal is flashing in government bonds, where plunging rates are nothing if not bets that the economy faces a reckoning traceable to bank anxiety. And while credit spreads aren’t overtly pricing in a lender-fomented recession, not all of their messages are happy ones.
While no completely satisfactory unifying theory for the divergences exists, it is true that not every economic input is weighted equally by different investor classes. Where Treasuries tend to be a binary call on inflation and rates, the more varied makeup of the equity landscape allows for a hodgepodge of reactions that sometimes defy easy categorization.
“The bull case is that the Fed blinks. They fold and capitulate, say that we’re so fearful of a banking or financial crisis that we’re going to pause and or cut right away, stop the balance sheet runoff and restart QE,” said Sameer Samana, Wells Fargo Investment Institute’s senior global market strategist. “We think the opposite happens: the Fed sticks to their guns, fights inflation and tries to deal with banking issues on the side, as they arise.”
Another theory on the stock-bond disagreement: there isn’t one, and what looks like divergent signals is actually the result of divergent time-lines. While equities have been buoyant lately, they remain closer to their lows than their highs of last year, when a 25% plunge in the S&P 500 put equity investors on the record as predicting a recession. Bond yields spent 2022 rising — betting on inflation. In this lens their recent plunge could be framed as acknowledging what stocks already had — that the Fed’s response to inflation will gut the economy, one way or the other.
“To some extent, equities had already priced in an eventual contraction,” said Que Nguyen, chief investment officer of equity strategies at Research Affiliates. For the Fed, “the problem with driving the economy into a recession is that it undermines financial stability. And so, if you already have a situation in which you’re financially unstable, how aggressive can you really be about taking the air out of the economy?”
Even as Fed Chair Jerome Powell insisted Wednesday that rate cuts are not his “base case,” bond traders are sticking to bets that the central bank will reverse course this year. Swap rates linked to policy meeting dates now show the Fed’s benchmark ending 2023 around three quarters of a point below where it is currently.
Over in the land of equities, positioning has shown persistent bearishness despite a rally that lifted the S&P 500 as much as 17% from its October trough. In the latest Bank of America Corp. survey of money managers this month, allocation to US stocks fell to an 18-year low. That kind of defensive positioning may have helped put a floor under the market, and at times forced investors to chase gains.
When everyone is prepared for the worst, even a little dose of good news is enough to spark fireworks, in other words. This time, wary traders appeared to take comfort in the quick response by regulators to ring-fence the stress in the financial industry.
While credit agencies rushed to downgrade ratings for regional lenders and risks among big European banks still linger, analysts at Goldman Sachs suggested that the danger of a capital or liquidity event among large American peers is remote given regulators have imposed tougher rules on their portfolios.
Broadly, a credit stress may mean less for larger companies, considering more of them locked in low borrowing costs during the cheap-money era. Tracking non-financial corporations in the US, Europe and Japan, JPMorgan Chase & Co. found that interest expense as a percentage of operating cash flows has fallen to the lowest level since at least 1990.
In fact, interest payments dropped so much relative to the size of the economy in the post-2008 financial crisis period that even if current yield levels represent a “new normal,” it may take till the end of the decade for the whole decline to be reversed, strategists including Nikolaos Panigirtzoglou estimated.
For now, all the rate hikes have yet to bite in any big way. S&P 500 firms excluding financials are set to see $366 billion of debt mature this year and a refinancing at current rates would shave just $1.50 a share, or 0.7% from their earnings, JPMorgan strategists including Dubravko Lakos-Bujas estimate.
With contagion fears subsiding, investors rotated out of banks and sought safety in tech giants, companies seen as better positioned to weather an economic slowdown. The tech sector, with cumulative cash and free cash flow above $1 trillion, along with abundant low-cost capital, among other factors, “likely has defensive protection from a persistent recession as well as contagion from the Silicon Valley Bank crash,” wrote Bloomberg Intelligence’s Robert Schiffman and Abigail Marshall in a March 16 note. Free cash flow remains a point of strength for the sector, giving companies “ample financial flexibility,” they wrote.
Hogan at B. Riley echoes that optimism.
“While all of that’s happening and we’re starting to slowly get a handle around the regional-bank turmoil, the flight to safety seems to be in the fortress balance sheets,” he said.
--With assistance from Isabelle Lee and Katie Greifeld.
©2023 Bloomberg L.P.