Upcoming Market Inflection point

SUMMARY

The S&P is at an inflection point. Both a sharp relief rally following bank earnings on 4/14 or the start of the next major decline driven by greater than expected deposit outflows are possible. The Fed balance sheet expansion of $400B in 3 weeks is a major positive near-term. We have a bias towards a short-term rally. However, longer-term we see earnings cuts & Fed balance sheet shrinkage driving the market to new lows in the second half of 2023.

Details

A relief rally could start on 4/14 given $JPM $WFC $C should see deposit inflows in aggregate despite future EPS estimates having to get cut due to worse Net Interest Margins (NIM). We expect $JPM to have the least downside to EPS (<5%) and to see the largest deposit inflows by far. Both $WFC and $C have more risk to EPS (5-10%) and deposit levels do pose some downside tail risk for both .

However, the key to whether the next major market near-term move is up or down is likely to be $PNC results. $PNC also reports on 4/14 but does not have the benefit of being a systematically important bank. As a consequence, their results may be a better reference point for the health of the banking system. 

We continue to expect more bank failures this year despite the implicit guarantee by the FDIC on depositor funds like we saw at SVB and Signature Bank. During the Global Financial Crisis, bankruptcies increased in 2009 despite the Troubled Asset Relief Program (TARP) being passed in October of 2008 as can be seen in the chart. In fact, it increased even further in 2010. To be clear, we believe there is still further downside risk to regional bank stocks as a whole even if we see a short-term relief rally. 

Therefore, we plan to have minimal directional exposure & wait for results & stock reactions on 4/14 before committing more capital either long or short.

We are biased towards a short-term rally due to expansion of the Fed balance sheet from its near-term low of $8.340T on 3/1/23 to a high of $8.734T on 3/22/23. The balance sheet has dropped slightly since then to $8.632T on 4/5/23 but has still undone 5 months’ worth of declines in less than a month due to the banking crisis. For reference, $8.965T was the balance sheet peak on 4/13/22.

As a reminder, during the Global Financial Crisis, following the passage of the Troubled Asset Relief Program (TARP) in October 2008 and another temporary bottom in November 2008, the S&P rallied 24% in six weeks till January 6th of 2009. During this time, the Fed balance sheet expanded from $0.906T in early September 2008 prior to the Lehman failure to $2.24T by year-end.

Eventually earnings mattered as the S&P fell 28% in 2 months to its ultimate bottom in early March of 2009. We would also note, however, that the Fed balance sheet fell to $1.900T by early March before the Fed started to expand the balance sheet once again.

More recently, the S&P was up 16% in 2020 despite a global pandemic driven by the Fed expanding their balance sheet by $3.2T to $7.363T. The S&P was up 48% in total over 2020 and 2021 combined as the Fed expanded their balance by $4.6T to $8.757T. Either global pandemics are wonderful or easy money covers up a lot of problems over the short-term.

Longer-term, we still believe the lows are ahead for market in the second half of 2023 due to:

1. IT spending being worse than expected affecting megacap tech outlooks, especially for the hyperscalers.
2. tougher bank lending standards & higher rates impacting global growth in the 2nd half of 2023.
3. US consumers running out of $1.5T in excess savings by year-end.
4. commodity inflation remaining higher than expected due to China exiting zero Covid.
5. potentially no rate cuts by the Fed in 2023 vs market expectations of ~three.
6. looming problems in commercial real estate.
7. elevated S&P valuation given inflation levels.
8. the Fed continuing to contract its balance sheet due to high inflation.