Liquidity💧vs. Cyclicality 🛞

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You Are Supposed to Buy Low, We Believe it's Coming

I am currently experiencing the fourth Bear Market of my career and I have some decent news; we are likely approaching the third and final leg of this Bear. I am linking a brief article from Mike Wilson, equity strategist at Morgan Stanley. There are some pressing issues that, in our opinion, will likely result in a lower broad market over the next one to four months.

Availability of credit. By now you have heard about the regional bank crisis with some high-profile bank failures. The problem here is multifold. Yes, many are sitting on large unrealized losses from treasury purchases that are now underwater, but in isolation, that is not a problem. The trouble arises when deposits go out the door. And now, of course, deposits are going out the door, not because people fear XYZ bank will go under but because the low-risk return available in money market funds is too compelling to pass up. Check out the graph below and it's easy to see why capital is headed to money market funds at the expense of savings accounts. This isn’t only happening at regional banks, it's happening at all US banks. Now, the thing about money market deposits, unlike normal deposits, is they are not available to the bank to purchase assets and/or lend out thus hampering the bank’s ability to generate revenue.

Additionally, regional banks are lenders to small businesses and commercial real estate. It probably goes without saying that lending standards will tighten at the regionals after the deposit flight that has taken place. Less lending means fewer projects get the green light, fewer small businesses get needed financing, and so on.

Further, banks are large spenders on technology. Flexera did a survey of 300 corporate CIOs in 2020 to figure out what sectors spend the most on IT as a percentage of their revenue. Financial Services came in above average, as seen below. Needless to say, at the margin I would imagine that spending will decline over the near to medium term, not great for IT companies that sell into financial services.

Now the stock market is taking all of this in relative stride as the common belief is that the Federal Reserve is either done hiking interest rates or maybe they have one more 0.25% hike in May and then they will be done. This does make sense as our observation has been that goods prices have dropped significantly and really it’s the services component of our economy that is still quite hot. As the Fed sees what’s likely to be an incremental weakness in the economy, perhaps they take solace in the notion of inflation following growth and cease rate hikes. In isolation, the Fed stopping rate hikes is bullish for risk assets. If history is any guide, typically once they stop it’s only a matter of time before they need to cut again because the US economy is weak.

The big concern as we outlined all the way back in September of last year is earnings for 2023. Our thought then was consensus earnings for 2023 were too high, and even now at $221.40 as of 3/23 according to Yardeni Research could likely prove too optimistic especially after the issues with the banks.

Now the timing for the last stool of the current Bear Market is tricky. It may very well take getting through the Q1 earnings season and really getting a gauge of how companies are faring heading into the summer. Over the very near term, we may see the market act well in light of the belief that the Fed is very close to being done with rate hikes. But, as we have said many times we look at the market as a “market of stocks vs a stock market”. We are finding compelling opportunities in energy, healthcare (therapeutics), and some areas of technology. We are slowly accumulating the companies that we think will be market leaders as we move forward.

One more near-term driver in favor of higher equity prices is rising liquidity. To be honest, I’m not sure if the rising liquidity is a function of banks accessing the Fed’s overnight lending window, the action of Janet Yellen and the Treasury Department, coordinated action by the world’s major central banks, or something else but the trend is undeniable. The graph below comes from our friends at Crossborder Capital in the UK, they monitor and measure global liquidity.

It has been our observation that much of this liquidity has found its way into many of the mega-cap tech stocks in our market as well as precious metals. The battle between liquidity and fundamentals is sure to take center stage in the coming months as we believe the US economy will continue to show signs of slowing.

Good luck out there. Please reach out to have a conversation and talk shop!

Sincerely,

Frank Grinnell

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