Key Private Bank Investment Brief

March 2023

Key Private Bank Investment Brief

Our leading experts bring you their timely research and insights on topics that matter most to you. From navigating turbulent global financial markets to interest rates, inflation and wealth management, KeyBank Investment Center insights delve into today’s trends and tomorrow’s opportunities.

Key Private Bank Investment Briefing Notes

Key Takeaways:

1) The Federal Reserve (Fed) has one foot planted on the dock and one unevenly perched on the boat.

a) On the dock: The Fed is still very concerned with inflation, which continues to be driven by a tight labor market.

  • Last week, the Federal Reserve increased the Fed Funds rate another 25 basis points, to a range of 4.75% to 5.0%.

  • In their statement, the Fed stated that “some additional policy firming may be appropriate.”

  • In the past, the Fed had signaled the need for “ongoing increases” in the policy rate, so this recent change is dovish.

b) On the boat: The Fed must now address financial stability in the banking system.

  •  In their latest projections, the Fed marked down expectations for economic growth. Recent stress in the banking system likely drove the change in their outlook.

  • During his March 22 press conference, Fed Chairman Powell acknowledged the possibility of slowing growth by stating: “It is possible that stress in the banking sector would further tighten financial conditions …”

  • Powell also noted that if credit conditions tighten more than expected, “monetary policy will have less to do.”

  • Even prior to the recent banking stress, both large and small banks have been tightening standards on loans, which tends to slow economic growth.

2) Someone will get wet.

  • Recession odds are rising. Markets will likely remain volatile throughout 2023.

Bottom Line: Remain neutral to risk. Emphasize quality investments. Continue to build resilient portfolios through increased diversification and the incorporation of new tools, such as alternatives and real assets.

Equity Takeaways

Stocks rose in early Monday trading. The S&P 500 rose about 0.3%, with small caps up about 0.5%. International shares were mixed.

Despite a variety of negative headlines, stock markets held up well last week. The S&P 500 pulled back slightly to its 200-day moving average before stabilizing – the index was trading around 3995 early on Monday. 3765 remains a key support level.

Typically, if a market holds up well in the face of negative news, it will likely eventually move higher. 

Mega-cap technology shares have been the biggest beneficiary of the recent market turmoil. The ratio of the market-cap weighted Nasdaq 100 to the equal-weighted Nasdaq 100 has turned higher, as investors have sought the defensive growth characteristics of the largest technology companies.

In other words, the breadth of the recent market rally has been poor while sector dispersion has been significant. For example, two stocks now represent 13% of the entire market, and technology shares have rallied about 18% year-to-date (YTD), while cyclicals such as energy and financials have fallen about 10% and 9% YTD respectively. A healthy rally includes broad participation.

One possible bright spot going forward – housing. With the recent decline in 10-year Treasury yields and mortgage rates, both new home sales and builder sentiment have been showing signs of strength.

One concerning trend – signs of stress in commercial real estate. BBB-rated commercial mortgage-backed security spreads have moved materially wider over the past few weeks.

Fixed Income Takeaways:

After dropping sharply the past few weeks, Treasury yields rose in early Monday trading. 2-year yields rose about 20 basis points, to 3.98%, while 10-year yields rose 12 basis points, to 3.50%.

On March 7, market participants expected the Fed Funds rate to end 2023 at about 5.6%. Currently, the Fed Funds rate is expected to end the year at about 4.25%.  As noted above, after last week’s 25 basis point hike, the current range for the Fed Funds rate is 4.75% to 5.0%. 

Bond market participants to the Federal Reserve: “You’re done hiking rates.” 2-year Treasury yields have plummeted recently and now trade over 100 basis points below the Fed Funds target rate. This type of price action presents a major conundrum for policy makers.

Since 2016, changes in inflation expectations have led to inflection points in the 10-year Treasury yield. 3-year inflation expectations peaked in late 2021 and have moved significantly lower over the past year. 10-year yields peaked in late 2022 and have dropped over 50 basis points in the last month.

Private credit can offer significant benefits to investors when compared to owning public debt alone. These benefits include improved diversification, total return enhancement, higher yield, and better covenant protections.

The Fed Followed Through with a Quarter-Point Rate Increase, Insinuated One More Hike. . . Maybe

Key Takeaways:

  • The Federal Open Market Committee (“FOMC” or “the Fed”) increased the target range for the Federal Funds rate by 0.25%, bringing the new target range to a level of 4.75% to 5.00%. This was a unanimous decision.

  • Balance sheet reduction remains on pace.

  • “Ongoing increases remain appropriate” shifted to “some additional policy firming may be appropriate.”

  • Modest changes were made to the Summary of Economic Projections (SEP).

  • The Committee does not anticipate any rate cuts in 2023. “Rate cuts are not in our base case.”

  • “The US Banks are sound and resilient.”

The Federal Reserve Open Market Committee raised the benchmark Federal Funds rate today by 0.25%, setting the new target range at 4.75% to 5.00%. This marks the highest Federal Funds rate range since late 2007 and the ninth consecutive rate increase by the Fed in the past 12 months – with the specific intent to reduce inflation and bring it closer to its 2.0% objective.

The Committee noted that the “banking system is sound and resilient,” adding that the recent developments “are likely to result in tighter credit conditions for households and businesses,” which could weigh on economic activity, hiring, and inflation levels.

“The extent of these effects is uncertain. The Committee remains highly attentive to inflation risks,” the Committee included in today’s statement.

Although the Fed’s balance sheet has experienced expansion over the past week due to the banking sector disruption, Chair Powell commented in his press conference that they will remain on pace with the balance sheet reduction plan than began in 2022.

As part of their meeting, the Committee released modest changes to the Summary of Economic Projections (SEP). The Federal Funds rate is now expected to be 4.30% in 2024, up from the previous December estimate of 4.10%. Participants continue to forecast the policy rate at 3.10% and the longer run rate at 2.50%; both remain unchanged from December.

The Fed revised its real GDP projections downward, lowering the growth rate from 0.50% to 0.40% in 2023 and adjusted their forecast for 2024 from 1.60% to 1.20%. However, their 2025 growth rate was revised upward from 1.80% to 1.90%. The unemployment rate was revised upward to 4.60% in 2025 from 4.50% in the December SEP. 

On the inflation front, the Personal Consumption Expenditures (PCE) price index forecast was increased to 3.30% from 3.10% in the December SEP. PCE inflation is expected to ease to 2.50% in 2024 and 2.10% in 2025. Core PCE inflation (excluding Food & Energy components) was also revised slightly higher in 2023 to 3.60% and 2.60% in 2024, but expected to slow in 2025 to 2.10%.

During his press conference, Chair Powell commented that “the Committee anticipates that some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2.00% over time.” He also added, “In determining the extent of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.” Chair Powell fielded questions regarding the current financial stresses in the banking system very concisely. He commented that “it’s still too early to tell how stress in the banking sector will affect credit conditions,” and that if stress in the banking sector has a larger impact, then “monetary policy will have less to do.”

It appears the macro narrative has quickly shifted, and the market now seems to think a Fed pivot is in hand. During his prepared remarks, the Chair highlighted that the forward language moderates the tone for future tightening from "will be appropriate” to “may be appropriate.” Moreover, the observation was made early on during the press conference that a pause in March was considered by the Committee, which is a clear dovish skew and a potential precursor for one at the May meeting. If the Fed were forced to decide on May’s move today, it would be a pause. Fortunately for the FOMC, the next six weeks will offer greater clarity on the severity of the banking sector crisis.

As for the markets, Fed days are always quirky. The rates market saw today’s FOMC announcement as a dovish hike with the front end of the US rates curve rallying as 2-year Treasury rates declined as far as 3.91%. The 10-year Treasury rallied as well, although to a much lesser extent. Assuming the Fed is, in fact, preparing to pivot, it will also mark the commencement of the yield curve steepening. At the same time, however, Powell was consistently resolute in bringing inflation back to its stated goal. How this is accomplished is unclear, and thus, investors should expect continued volatility in the days and weeks ahead.

For more information, please contact your advisor.

Key Takeaways:

  1. About 2 weeks ago, the Federal Reserve (Fed) was signaling faster and more sustained interest rate increases. An increase in the Federal Funds Rate of 50 basis points was seen as likely, and projections of the terminal rate increased as a result. As of today, that dynamic has completely shifted.

    • The next Fed decision will be released this upcoming Wednesday, March 22. Expectations are for a 25 basis-point rate hike on the Fed Funds rate, to a range of 4.75% to 5.00%.

    • Forward expectations for the Fed Funds rate have dropped significantly. Market participants now expect rate cuts to begin over the summer and are expecting over 100 basis points of cuts by the end of 2023.

    • On March 7, market participants expected a Fed Funds rate of 5.50% in December 2023. As of March 20, forward expectations had shifted to a December 2023 Fed Funds rate of 3.78%.

  2. Policymakers are revisiting their 2008 playbooks while navigating new challenges. In particular, high inflation is currently complicating matters, forcing policymakers, who are revising their 2008 strategies.

    • On March 19, six global central banks announced actions to provide greater liquidity via US dollar swap lines.

    • Last week, the Fed’s balance sheet expanded significantly as member banks accessed the Fed’s discount window for liquidity.

    • Inflation today remains high and the speed of data and money has greatly accelerated; during the 2008-2009 financial crisis, digital banking via smartphone was still in its infancy.

    • Unlike 2008, credit quality is not the issue driving these actions. Credit spreads have widened over the past few weeks, but not in dramatic fashion.

  3. Confidence is the grease that keeps the economic machine running, and it is again being tested.

    • Money-market mutual fund assets under management have increased to record highs as investors seek safety and yield.

  4. Markets have not panicked in general (apart from the obvious places).

    • In general, markets showed good resilience last week amidst an onslaught of bad news.

    • Weakness was concentrated in Financials. Small caps and international shares also fared poorly.

  5. What is next for the banking industry?

    • Some banks may face profit pressures as their cost of deposits is likely to increase in the coming months.

    • Credit standards on loans are likely to tighten as credit trends fluctuate.

    • Increased regulation is likely.

Bottom Line:

  • We see the odds of a recession rising in the second half of 2023 amidst a new market paradigm.

  • Compared to the pre-COVID period, this new paradigm may include higher inflation, higher interest rates, less liquidity, increased volatility, and deglobalization/decoupling of the global economy.

  • In such an environment, active management is likely to become more important. Stay diversified and stick with quality investments.

Equity Takeaways

Stocks rose in early Monday trading, with many of the laggards from last week bouncing higher. The S&P 500 rose about 0.5%, while small caps rose about 2%.

Last week, the S&P 500 rose about 1.5%, but underneath the surface, there were divergences everywhere. In general, international equities are much weaker than US equities. US market weakness was concentrated in cyclical sectors (Financials, Energy, Materials, and Industrials), as well as small caps.

Despite the sell-off in Cyclicals, the S&P 500 showed strong resilience last week, led by Technology shares. The Nasdaq 100 finished over 5% higher last week. We continue to watch the S&P 500’s 65-day low (currently about 3765) as an important level of support. The S&P 500 was trading around 3935 early on Monday.

The opening of global central bank swap lines is a very important step toward increased liquidity. Typically, central bank moves to increase liquidity (such as this one) are precursors to interest rate cuts.

Fixed Income Takeaways:

As noted above, the Fed meets this week and Fed Chairman Powell’s next press conference is scheduled for Wednesday, March 22.

The Fed statement this week will probably address recent financial instability, and the Fed’s ability to provide liquidity where needed. Chairman Powell is likely to continue highlighting inflation as the Fed’s primary concern; however, the forward outlook will give the Fed plenty of wiggle room to react to upcoming events.

2-year Treasury yields dipped significantly lower again last week. Market volatility has been extreme. On March 8, 2-year Treasuries were yielding 5.07%. This morning, they were yielding approximately 3.9%.

The 2-year yield’s recent drop is a market signal telling the Fed that their tightening cycle should end. Market participants may also be speculating that the Fed will hold rates steady at this week’s upcoming meeting.

10-year Treasury yields also dropped last week. 10-year Treasury yields have dropped from near 4% to near 3.45% since early March. With 2-year yields falling much further, the 2-year/10-year Treasury curve has steepened.

The Treasury will auction 20-year bonds on Wednesday March 22, as well as 10-year Treasury Inflation Protected Securities (TIPS) on Thursday. Both auctions will give us a read on the demand for longer-dated paper.

Last week saw zero new investment-grade (IG) or high yield corporate bond issuance. The last week of zero IG issuance was back in June 2022. Credit spreads have widened but are still below levels seen in mid- to late 2022.

A 25 basis-point hike is priced in for this week’s Fed meeting on March 22. If the banking system stabilizes between now and March 22, we believe the Fed is likely to continue forward with a 25 basis-point rate hike.

Key Takeaways:

  1. On Sunday, March 12, the Federal Deposit Insurance Corporation (FDIC), Federal Reserve (Fed), and Treasury Department intervened to create a new “Bank Term Funding Program” to address recent financial market volatility.

    • Depositors will have full access to their deposits.

    • Additional liquidity programs will be provided to all banks that need it.

    • Securities may be exchanged for a 1-year loan at par value, effectively allowing financial institutions to temporarily revalue their securities portfolios.

    • Some banks are likely to restructure their balance sheets to improve flexibility and profitability.

    • These events were caused by a liquidity crisis, not a credit crisis.

  2. What’s happening with some banks?

    • Bank deposits soared in 2020-21 due to increased liquidity.

    • Banks invested these deposits primarily in fixed income securities (which are sensitive to interest rate hikes).

    • As the Fed raised rates beginning in 2022, the value of these securities declined. Unrealized losses rose at some banks.

    • At the same time, deposits at some banks declined. Many depositors either needed cash or sought to invest their cash in higher-yielding securities.

    • As deposits fell, some banks had to sell securities at a loss to fill funding gaps.

    • As securities were sold at a loss, other depositors grew nervous and withdrew their cash, forcing some banks to raise capital.

    • These capital raises prompted some bank stocks to decline on concerns over dilution, and a vicious cycle was underway.

    IMPORTANT: Not all banks manage their balance sheets, customer bases, and funding mixes the same way.

    For example, KeyBank’s deposit sweep is overcollateralized daily with US Treasuries, and the assets are segregated from the rest of the bank’s balance sheet.

  3. Financial market events could cause the Fed to pause their campaign of interest rate hikes.

    • Don’t expect a pivot toward rate cuts unless events significantly worsen from here.

    • Wall Street analyst opinions are divided on future Fed policy. Additional rate hikes could place additional pressure on asset prices, which would negatively affect bank balance sheets. The next Fed press conference is Wednesday, March 22.

  4. Recent financial events are mostly company-specific, though there will be aftershocks.

  5. Recent financial events are deflationary, thus some caution by the Fed is advised.

  6. All else equal, economic resilience augurs for continued hawkish Fed policy.

    • Some cooling in the labor market has begun, but the jobs market remains tight.

    • Consumer Price Index (CPI) data will be released on Tuesday, March 14. This series remains a highly anticipated data point regarding inflation.

Bottom Line: We don’t believe this is a replay of 2008; this is not a credit event. Still, investors should expect continued short-term volatility and continue to own high-quality assets.

Equity Takeaways

Overnight, S&P 500 futures were as much as 2% higher but opened about 1% lower in early Monday trading. Small caps opened over 2.5% lower. International shares were also lower.

3765 on the S&P 500 is a key resistance level. It will take severe damage to reverse the recent bullish trend. The market has not touched a new 65-day low during the recent selloff.

At the time of this writing, the S&P 500 was off intraday lows, trading around 3850. After falling about 4.5% last week, the S&P 500 has reached oversold levels that would typically result in a short-term bounce.

Regional bank stocks remain under pressure. With social media influencing consumer sentiment, recent events occurred in a very short amount of time. Digital banking has increased transaction speeds, and future regulatory policy will need to take this new environment into account.

Fixed Income Takeaways:

2-year Treasury yields have dropped over 100 basis points in about a week. The two previous moves of this magnitude occurred in 2001 and 2008 during periods of severe economic stress.

2-year Treasury yields are sensitive to Fed policy expectations. Early last week, market participants were expecting a 50 basis-point hike by the Fed at the upcoming March 22 meeting. Now, expectations are split between a 25 basis-point hike and no action.

10-year yields plunged almost 30 basis points in one day last week. The recent peak in 10-year Treasury yields was about 4.0% - they are now about 3.50%. The recent peak in 2-year Treasury yields was over 5.0%. 2-year Treasuries were yielding about 4.06% at the time of this writing.

Corporate bond spreads widened in both high-yield and investment-grade credit last week, but the move was generally orderly. For example, large money-center bank spreads widened last week, but have remained relatively stable throughout 2023.

Key Takeaways:

  1. Inflation appears to be cooling.

    • European natural gas prices have fallen about 85% since their mid-2022 peak, while the Evercore Global Food Price Index has fallen about 20% from recent highs.

    • Job openings, as measured across many surveys (including Indeed, LinkUp and ZipRecruiter), are down from their 2022 highs but remain elevated.

  2. The economy appears to be strengthening.

    • Initial unemployment claims showed a 4-week average of just 193,000 through February 25 and remain near the lowest level in half a century. The US labor market remains very strong.

    • The Conference Board runs a survey that calculates “jobs plentiful minus jobs hard to get.” This survey re-accelerated over the past few months and implies another strong payroll report is in our future this coming Friday.

  3. Data unveiled in the next two weeks could unlock the mystery of cooling inflation amidst a strengthening economy.

    • On Wednesday, March 8, Federal Reserve (Fed) Chairman Jerome Powell will testify to the House Financial Services Committee. This Friday, March 10, monthly nonfarm payroll data will be released.

    • Next week, important Consumer Price Index (CPI) inflation data will be released on Tuesday, March 14. The week after, on March 22, the Fed is expected to raise the Fed Funds rate again by 0.25%, this time to a range of 4.75% to 5.00%.

    • The Fed is not likely to pivot toward lower interest rates until we see significant weakening in the labor market.

  4. The valuation of stocks versus bonds is nearly at parity.

    • The Earnings Yield of the S&P 500 is simply the inverse of the Price/Earnings Ratio.

    • The gap between the S&P 500 Earnings Yield and the yield on the 10-year US Treasury is known as the Equity Risk Premium.

    • The Equity Risk Premium has narrowed to levels last seen in the late 2000s. In other words, bonds are becoming more attractive relative to stocks.

    • We remain neutral between stocks and bonds within client portfolios. Stock and bond prices remain correlated, which argues for increased diversification.

Bottom Line:

  • De-emphasize mega-cap shares, stick with quality companies, and stay fully diversified. Our goal is to build resilient portfolios.

  • The average stock continues to outperform the market-cap weighted S&P 500, which indicates that we are in a stock picker’s market and can benefit from increased active management.

Residential Real Estate Update:

  • Global housing prices have fallen quite sharply in some countries over the past several months.

  • In the US, mortgage applications have fallen to a 28-year low as the 30-year fixed mortgage rate has increased to almost 7%.

  • Shelter prices comprise almost 33% of the overall Consumer Price Index. This data flows through with a lag, but a slowing housing market is likely to push inflation lower, all else equal, as we move through 2023.

Equity Takeaways

Stocks were mixed in early Monday trading. The S&P 500 rose about 0.5%, while small caps dipped a similar amount. International shares fell slightly.

The recent pullback in the S&P 500 conforms to a normal pattern within a cyclical uptrend. To flip the trend negative, bears would need to push the market to a new 65-day low (currently around 3765 on the S&P 500), from its current level of about 4070.

Cyclical sectors continue to outperform defensive sectors. The relative performance of Cyclicals versus Defensives is near a new breakout versus the 2021 highs. The market is telling us that we are in a classical early cycle market configuration, which is bullish.

For example, the defensive Consumer Staples sector has underperformed the S&P 500 by over 8% year-to-date (YTD). Conversely, the cyclical Consumer Discretionary sector has outperformed the S&P 500 by over 7% YTD.

YTD in 2023, small cap stocks have outperformed large caps by over 4%. During the first year of an economic recovery, small caps tend to outperform large caps by a significant margin. There has not been a meaningful difference between growth and value stocks YTD. International shares have outperformed the US YTD, led by European shares.

Long-term, we continue to have a neutral / balanced view on equities. Our base case remains a stronger-than-expected first half of 2023, followed by potential weakness as we move toward the end of the year.

Fixed Income Takeaways:

Market participants continue to increase estimates for the terminal Fed Funds rate. Last week, the 2-year Treasury yield moved back above the Fed Funds rate, which is a very unusual occurrence. In early Monday trading, 2-year Treasuries yielded 4.87%, while 10-year Treasuries yielded 3.94%.

In recent weeks, Federal Reserve governors have continued to stress a hawkish message. Controlling inflation remains the Fed’s primary focus. As noted above, Fed Chairman Powell will address the House Financial Services Committee on March 8.

Investment-grade (IG) credit yields hit 5.6% last week, the highest levels since November 2022. Spreads remain stable. Increasing IG corporate bond yields have been driven by rising Treasury yields.

High-yield spreads tightened over 20 basis points last week. The current high-yield bond Option-Adjusted Spread is in the low +400s over Treasuries. This level is relatively tight. Market participants are not pricing an impending recession.

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