(March 23rd, 2023)
By (Signorelli Marco, Equity Analyst)
Edited by (Ascanio Cicogna, Head of Research)
Is The Current Situation Really That Bad?
The recent collapse of Silicon Valley Bank ($SVB), together with the turmoil surrounding many other regional banks in the US and the uncertainty regarding the future of Credit Suisse ($CSGN), has brought back painful memories of the recent past, in primis: the infamous banking crisis of 2008/09.
Many investors have been affected by the fear, uncertainty, and doubt that has spread through the market in the past few weeks. While we acknowledge that some of the panic is warranted, we believe that this crisis could have a paradoxical effect on the stock market. In fact, the second largest banking collapse in American history may serve as a catalyst for an unexpected bull market, particularly for stocks that have been undervalued due to higher interest rates and increased uncertainty, such as growth stocks.
We have identified three key reasons why we believe that there may be an opportunity to find hidden value in the current market conditions. These reasons all share a common denominator: the Federal Reserve (FED).
QE Might Be Back (at least temporarily)
On June 1, 2022 the Federal Reserve officially started its crusade against the scorching inflation that has been affecting the United States since the beginning of last year. In the war against inflation the FED used an unconventional weapon, quantitative tightening (QT).
Quantitative tightening is a monetary policy strategy employed by the United States Federal Reserve to reduce the size of its balance sheet by selling debt securities from its portfolio. This approach creates downward pressure on bond prices already in circulation, resulting in a decline in their value.
Ultimately, QT leads to an increase in interest rates, which the Federal Reserve Board of Governors views as a necessary measure for successfully fighting inflation.
QT has profound and meaningful consequences on stocks and the broader equity market: in fact, the higher yield that has now been provided by government debt securities makes stocks in general less attractive for investors, since it increases the opportunity cost of capital of the latter. In other words, the rate of return required by investors to bear the additional risk that comes with holding stocks is now higher and this reduces the present value of future cash flows. That is the reason why many growth stocks have seen their market capitalization collapse in the last few months.
In the past five months and a half the Fed’s balance sheet has come down from a high of roughly $9T to about $8.3T; in other words, the Federal Reserve has sold $700bn worth of Treasuries and MBS (Mortgage-Backed Securities), while significantly increasing interest rates.
One week ago, the Federal Reserve unexpectedly changed course and expanded its balance sheet by approximately $300 billion, reversing nearly half of the progress made in the last 10 months.
Last week's quantitative easing (QE) may be viewed as an anomaly that will soon be corrected, or it could mark the beginning of a new path that the Board of the Federal Reserve intends to pursue in the coming months.
Figure 1: Total Assets of the Federal Reserve
Source: The Federal Reserve
Interest Rate hikes slow down and Inflation Cools off
While Quantitative Easing is undoubtedly a popular measure in the eyes of the market, it is not the only factor that can provide a boost to stocks. Another factor is expectations, when expectations of future interest rates decrease, this can serve as a significant positive catalyst for stocks, particularly those that are supported by highly anticipated future earnings.
A big part of the problem with the balance sheets of many banks, together with poor risk management, has been the unprecedented rate at which the Federal Reserve has raised interest rates, causing the collapse in value of all the debt securities acquired by the banks in the preceding months. This is why many managers, political figures, and investors are pressing the Fed to temporarily stop, or at least slowdown, future interest rates hikes.
Yesterday, on March 22nd 2023, at 2:00 PM EST, the Federal Reserve validated the prevailing market outlook and opted to implement a 0.25% hike in interest rates, contrary to the previously anticipated 0.50% upsurge that had been widely expected up until the previous week.
Additionally, although the battle against inflation is not yet won, the Federal Reserve can boast that it has successfully brought inflation down a fair amount. In fact, inflation has declined for eight consecutive months, falling from a peak of 9.1% in June 2022, to 6% in February of this year.
Furthermore, there is little reason to be pessimistic about future inflation trends, as evidenced by the recent decrease in the Producer Price Index (PPI), which declined by 0.1% month-over-month, in contrast to the market's anticipated increase of 0.3%. It is therefore plausible to expect that the Consumer Price Index (CPI), which is regarded as a core measure of inflation, will follow the same pattern indicated by the PPI.
The optimistic prospects for future inflation data may provide some relief to the Federal Reserve, which could prompt the institution to consider easing its program of interest rate hikes.
Figure 2: U.S. Inflation Rate
Source: Trading Economics
The Lender of last resort
From the outset of the current crisis, both the US Government and the Federal Reserve have conveyed a consistent message: they will take all necessary measures to ensure that depositors do not lose their money and that no other banks fail in a similar manner to SVB.
In order to demonstrate their commitment to the American public and to aid banks experiencing potential liquidity issues, the Federal Reserve announced a new Banking Term Funding Program (BTFP) on March 12th. The program offers loans of up to one year to eligible depository institutions, including banks, savings associations, and credit unions, with collateral in the form of U.S. Treasuries, agency debt, mortgage-backed securities, and other qualifying assets, all of which will be valued at par.
While I acknowledge that the initial concerns expressed by depositors and investors regarding the condition of the American banking system were to some extent warranted, I now believe that there is little cause for concern.
Conclusion
The recent pivot by the Federal Reserve, coupled with a reduction in projected interest rates, a favorable outlook for inflation, and a secure banking system has prompted us to reassess our stance on the market, at least for the short term.
In our view, there are attractive investment opportunities in purchasing growth stocks with robust fundamentals and high betas, which have been unduly penalized by the market in recent months.
I suggest seeking out stocks of companies whose market capitalization has declined by 50% or more, yet exhibit no indications of liquidity or solvency issues, and hold strong growth prospects for the foreseeable future.
Citations:
Trading Economics. United States Inflation Rate. Retrieved March 21st , 2023, from https://tradingeconomics.com/united-states/inflation-cpi
Federal Reserve. (2023, March 14). The Balance Sheet. Retrieved March 21st, 2023, from https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm
Federal Reserve (2023, March 12). Bank Term Funding Program Press Release. Retrieved March 21st, 2023, from https://www.federalreserve.gov/newsevents/pressreleases/monetary20230312a.htm
Legal disclosure:
The projections or other information generated by BSTA regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. As such, BSTA does not assume any legal responsibility for actions that may have been taken by readers associated with any investment projections made by the members of BSTA. There are risks associated with investing in securities. Investing in stocks, bonds, exchange traded funds, mutual funds, and money market funds involve risk of loss. Loss of principal is possible.
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