By Jan Faure
Global equity markets were mostly positive in April, largely driven by better than expected first quarter company earnings in the US, which was supported by surprisingly resilient global economic growth, despite continued higher interest rates and further banking sector stress. The more growth focused S&P 500 gained 1.5% while the tech-heavy NASDAQ Composite ended the month flat, both underperforming more value natured global peers. In Europe, the Euro Stoxx 50 gained 1.0% while the UK’s FTSE 100 increased 3.1%. In Asia, Japan’s Nikkei 225 gained 2.9% while Hong Kong’s Hang Seng declined by 2.5%, despite economic data confirming China’s reopening-driven rebound.
US headline inflation declined more than expected to 5.0% YoY in March (from 6.0% in February). This is the 9th consecutive monthly decline and the lowest level since May 2021. Core Personal Consumption Expenditure (PCE) inflation, the Fed’s preferred measure of inflation, also declined to 4.6% YoY in March (from 4.7% in February). US inflation is now largely in line with Fed interest rates while in Europe and the UK there is still a sizeable gap between policy rates and inflation (implying large negative real rates). Three-month US Treasuries currently offer yields of approximately 5.20% against yields of 0.80% 12-months ago.
The minutes of the Federal Reserve’s March policy meeting (FOMC Minutes) pointed to a ‘mild recession’ in the US later this year. This is largely due to “recent banking-sector developments” which has led to a notable decline in bank deposits. Lower deposits imply lower lending and consequently lower economic activity. Additionally, banks may wish to retain more capital on their balance sheets for fear of deposit flight, while corporate customers may be reluctant to borrow in an environment of higher interest rates.
A soft landing (shallow recession) is supported by a strong labour market and consumer resilience. The US unemployment rate fell to 3.5% (from 3.6% in February). There are roughly 1.7 job openings for every unemployed person, pointing to continued tightness in the labour market. The labour market should however begin to ease as companies feel the impact of higher borrowing costs and tighter credit conditions.
A hard landing scenario is supported by the continued inverted yield curve, weakness in manufacturing and the aggressive nature of the tightening cycle. The magnitude and speed of the tightening cycle has also resulted in a mini banking crisis, which claimed another victim in the final week of April.
The US regulator (Federal Deposit Insurance Corporation or FDIC) took receivership of the troubled US regional lender First Republic Bank (14th-largest US bank) and agreed to sell the bulk of its assets and operations to JPMorgan. This came as First Republic’s share price collapsed after customers withdrew $100bn of deposits in the first quarter. The move represents the latest effort by US regulators to restore consumer confidence in the US banking system after suffering three major bank failures in the last two months. Both Silicon Valley Bank (SVB) and Signature Bank (SB) were taken over by the FDIC following bank runs by their customers.
The JPMorgan takeover is a good outcome for both the bank’s customers and the US banking system. Like SVB and SB, the failure was not due to risky banking activity but rather the fallout from the rapid increase in lending rates over the last year. First Republic’s business model of providing inexpensive mortgages to wealthy clients left it severely exposed when interest rates climbed dramatically. It again highlights the need for regulators to more widely and rigorously stress test banks’ liquidity requirements. Large US banks have been resilient. A positive long-term outcome from this crisis would be the consolidation of mid-sized and regional US banks. There are close to five thousand commercial FDIC insured banks in America.
Turmoil in the US banking sector is a headache for Federal Reserve policy makers that must weigh up financial-stability concerns against stubbornly high inflation. The fight against inflation has left behind some casualties, notably three mid-sized banks in the US and one heavyweight in Europe, following an uncompromising monetary policy response. Thus, while the Fed still needs to tame inflation it also has to factor in an economy that is showing some deepening cracks.
US first quarter earnings season got underway mid-April. Analyst expectations going into the reporting season were weak with overall earnings expected to decline 6.7% for Q1 (FactSet). With just over half the S&P 500 companies having reported financial results by month end, the expected earnings decline for Q1 has improved to -3.7% after almost 80% of the companies reported positive earnings surprises. The S&P 500 is trading on a forward Price to Earnings (P/E) ratio of approximately 18.1x, which is neither cheap nor expensive in historical terms.
Table 1: Global Indicators – Local reporting currencies