Ferguson Wellman’s Mid-Year Outlook: Stalemate

by | May 31, 2023 | Uncategorized

By Ralph Cole, CFA, Director Equity Strategy and Portfolio Management

A manifestation of interest rate risk and deposit flight amid the Fed’s ongoing battle to tame inflation precipitated the nation’s first significant bank failure since the global financial crisis (GFC). Despite concerns about U.S. banking, blue-chip equity indices finished the first quarter in the black, led by mega-cap technology stocks.

While dramatically higher interest rates over the past year create the potential for adverse banking outcomes, poor management of its balance sheet is what doomed Silicon Valley Bank. In an industry as large as U.S. banking, exceptions like this exist, but should not be viewed as a harbinger of systemic risk. In contrast to the profligate mortgage lending that metastasized in the U.S. financial system in the GFC, banks today employ more prudent loan underwriting and have notably stronger balance sheets amid heightened regulatory oversight.

Meanwhile, the Federal Reserve is steadfast in its quest to slay the dragon of inflation, which has been slower to recede of late. Recognizing that historically it takes at least a year to feel the full economic impact of a rate hike, the economy has only now absorbed the weight of the first two hikes that totaled three quarters-point in March and May of 2022. Recognizing there is more economic slowing in the pipeline, with the Federal Funds rate now exceeding the yield on the two-year U.S. Treasury, the bond market is signaling to the Federal Reserve that they have done enough … to which we agree. As the chart depicts, the nature of inflation has changed from the more volatile components of energy and goods to services such as rent, which tend to be slower to retreat. An unseen benefit to bank clouds lingering is that in their quest for additional balance sheet liquidity, banks are likely to make fewer loans, and this headwind to economic activity should help end the stalemate of slower inflation reduction.

Amid generationally low unemployment and an ongoing surfeit of job demand, we observe a U.S. consumer who is gainfully employed with the ability to spend. Consumers also have benefitted from pandemic stimulus, which gives consumers additional spending power. While inflation has eaten into consumers savings this past year, the chart below highlights the still $1 trillion in excess savings on consumer balance sheets. Given that consumption is over 70% of economic activity, we believe that if a recession occurs, it should be short and shallow.

Many of the national trends are playing out in Central Oregon as well as the rest of the state. While job growth continues to be strong, wages are struggling to keep pace with the cost of living, especially housing. The chart above is a good example of households having to dip into their savings to help make ends meet. While recessions do not occur when employment is full, something has to give. Home prices are already falling at a faster rate in Bend than the rest of Oregon. Our expectation is that housing costs will continue to slide until a more reasonable equilibrium is achieved.

Ralph Cole, CFA, serves on the board of directors for Ferguson Wellman Capital Management, an investment advisory firm managing $7.4 billion for 950 clients, including $156 million for individual and institutional clients in Central Oregon.