Three Key Thoughts

Fed Hikes Bank Failures
US Economy Hangs On
Understanding China is Hard

Fed Hikes Bank Failures

From zero a little over a year ago, the Federal Reserve has raised short-term interest rates to 4.75%, an unusually steep rise by historical standards. Certainly, the Fed’s action was needed to fight stronger-than-expected inflation. But imposing that much forceful restraint in such a short time was bound to have unintended consequences. We began to see them in the first quarter.

Early in the year, investors expected the Fed to continue raising rates as we saw strong employment and inflation reports. Rates on one-year Treasury bonds rose to more than 5% and money market fund yields exceeded 4%. The spread between these yields and those paid by banks on deposit accounts was conspicuously large, setting the stage for major moves of deposits out of the banks.

But two other factors provided the necessary fuel for a problem: (1) some banks had invested their deposits into longer term bonds which fell in value over the past year as interest rates rose, leaving big unrealized losses; and (2) some had also courted high balance business accounts, with deposits well in excess of the FDIC insurance limit. Silicon Valley Bank had both of these problems and, once they were publicly disclosed, depositors fled and the bank failed. Concerns immediately spread to other, similarly situated banks, most of which were sizable regional banks. The Fed and the FDIC have put in place emergency measures to stop the bleeding but the impact of these events will continue to be felt as banks become more conservative in their lending approach, reducing the supply of credit to the economy.

For now, interest rates on short and longer term bonds have come down, making bank disintermediation a little less of a risk. However, if inflation stays strong, the Fed will likely have no choice but to continue to raise rates, putting more banks at risk of a deposit run and increasing the risk of a harsher recession.

US Economy Hangs On

Because the mini-crisis in the banking sector just happened in March, we haven’t yet seen the impact on the economy. For now, employment remains strong, if a bit weaker than earlier in the year, and demand for services is still expanding. Manufacturing has shown signs of weakness and some lower quality parts of the credit markets have seen more delinquencies. Probably the biggest area of concern is commercial real estate, particularly the office segment. So many employers have implemented reduced in-office schedules that the demand for office space is down significantly. As that lower demand translates into lower values, it will be more difficult for landlords to refinance their loans as they come due. The mini-crisis only adds fuel to this potential slow burning fire.

On the positive side, the consumer continues to be in very good shape. Incomes are up, even though they haven’t kept up with headline inflation. And leverage remains at pretty low levels, a legacy of financing done at the low rates that prevailed before 2022. We are still seeing strong travel and entertainment spending, as the COVID-deferred spending still has some distance to run. With consumer spending the key driver of the US economy, we expect to see positive growth for another couple of quarters.

China is Hard to Understand

Speaking of COVID, the most mysterious handling of the COVID pandemic must belong to China. After nearly three years of harsh lockdowns that destroyed consumer confidence, upset global supply chains and sidelined the real estate market, the Xi regime abruptly abandoned those policies late last year. While the country withstood the initial wave of COVID infections reasonably well (although official statistics seemed laughably low), the impact of the lockdown policy will be felt for years to come.

President Xi appears to understand the importance of re-igniting growth in the domestic economy but so far the playbook for doing so isn’t inspiring a lot of confidence. They have said that they wish to support private enterprise’s role in stimulating the economy but, at the same time, it must be done in ways the government wants. The old “build infrastructure” plan gets hung up on the amount of debt already outstanding from prior programs and the lack of actual demand for more infrastructure building. Meanwhile, international companies with manufacturing facilities in China are moving rapidly to diversify to other locations. This is a long process but it will hold back China’s growth for years to come.

For consumers, there has naturally been some bounce back from the very low spending during the lockdowns. However, for that to be sustained, we believe people need to be optimistic about their future. A prominent indicator for this lack of optimism is the fact that China’s population shrunk in 2022, with more deaths than births. The government has provided modest incentives for child birth but they haven’t yet provided the key ingredient: expectations of a brighter future.

Those who are optimistic about China point out that Xi’s policies are quite consistent with long term party principles that brought China’s growth so far over the last several decades. And that the “common prosperity” he seeks is also consistent with the Chinese belief system, honed over thousands of years. Finally, they point out that the Chinese Communist Party is above all pragmatic, constantly testing and adjusting their policies to seek the greatest good. While they sometimes move slowly and make mistakes, they have ultimately made the adjustments needed to keep the economy moving and their people happy.

We see both sides of these arguments and would welcome a return to growth in China. But we remain skeptical that the heavier hand of the CCP under President Xi will be able to succeed.

Investment Implications

We continue to be cautious about the current environment, believing that there may be more downside to the economy and markets in the near term than there is upside. That said, we can now earn solid returns on fixed income investments so we are minimizing cash holdings. We are focusing on investing in stocks of companies that will thrive through and beyond a period of economic weakness that likely still lies ahead.