Financial crisis not imminent, Fed should keep raising interest rates
Why are stocks still expensive and the Fed will raise rates despite the problems in the banking sector? That and much more will be revealed today by Tomas Pfeiler of Cyrrus.
My guest for today's interview is Tomáš Pfeiler, Portfolio Manager at Cyrrus Investment Company, who also previously worked at Penzijní společnost České pojišt'ovna, studied finance at Masaryk University in Brno and holds a CFA certificate.
I recently saw a post on Linkedin where you wrote that stocks are still quite expensive. Is that still true?
Specifically, you state:
US stocks are expensive in the context of bond yields. If one were to compare the earnings yield on the SPX to the 10Y UST yield and apply a historical premium, the major stock index should be trading about 20% below current levels. Stock and bond prices have pulled apart. While bond investors are taking the expected repricing of terminal rates into account, equity hawks are not yet reflecting the Fed's rhetoric. Thus, some correction in the stock markets is strongly likely.
This is still the case in my view. Respectively, we now have Silicon Valley Bank, whose collapse has specific implications for the market. The other thing is interest rate hikes, where I think at this point the Fed is going to reassure us that nothing is actually happening and that they need to continue to tame inflation.
"Stocks are still not reflecting higher interest rates, and they are not reflecting bond yields."
When might we get to that point, the point where stocks are cheap?
I would say it could be as much as 10% lower, then I would consider the stock a good buy. Of course, it's good to build up a position for the long term and overbought regularly rather than timing the market like that. Here, the levels where the S&P 500 was at 4000 points are high for me, as that doesn't adequately reflect the complicated economic environment.
So if stocks are still expensive, what strategy do you choose? Do you hoard cash or do you see opportunities elsewhere?
At the moment it might not be a bad idea to opt for shorter term bonds and as for equities, I would focus there on those that can benefit from higher rates - for example banks, obviously I mean big banks like JPMorgan $JPM, Bank of America $BAC, they are still safe and there is no negative news like - deposit outflows or anything like that. On the other hand, the big financial houses have been experiencing record deposit inflows in recent days.
To what do you attribute the stock rally at the beginning of the year? After all, we are witnessing layoffs, poor results and a poor outlook for the future.
There are several factors, one being slowing inflation, which has raised hopes that the Fed might stop raising rates sooner than expected. The second factor is liquidity, for example the Bank of Japan had to buy government bonds, but here it was just a bit of a change in policy settings. Well, China was trying to jump-start the economy, so you could say that China and Japan overcame the Fed's restrictive policy. Well, last but not least, retail investors are also a factor, and in the heat of optimism they started buying and filling their portfolios.
Now I would like to move on to the current topic, which is the SVB that has shaken the markets. What is your take on this situation, do you think it is a larger problem or is it just one black sheep?
I see it as more of a black sheep, the bank hasn't been able to handle the deposit inflows for the last two years plus it was really dependent on unstable corporate deposits.
Because of the financial problems, the bank proceeded to sell securities and realized a loss of almost two billion dollars on them. The company's management also decided to issue its shares for $1.75 billion, but investors reacted negatively to the move and the effort to fill the hole led to a plunge in the company's stock price.
Signature bank had a similar profile and also failed, but I don't see this and similar risks across the board. As I mentioned, the larger banks like Bank of America and the like are pretty stable and something like this is not a risk there.
The banking system as a whole is generally resilient and has evolved quite a bit since the last crises. But banks with a similar business and liquidity profile to SVB's can run into trouble.
"In my view, the situation is unlikely to trigger a financial crisis."
Many people are comparing the current situation to Lehman Brothers, do you think there are any similarities?
There may be some similarities with Lehman Brothers, what both cases have in common is that everything broke out because of the Fed raising rates, so there was a revaluation of some of the assets that those banks had on their balance sheets. But that's where the similarities end. Lehman Brothers was clearly worse, because it shook the whole financial system, the financial system was more interconnected then, everyone had different exposures to each other, and also the banks were generally less well capitalised, which means that a small mistake could wipe out capital. In many ways, the whole situation has improved, the financial system was not prepared for Lehman then, but now it is prepared for such events and the authorities are able to react promptly if they occur. This was also confirmed in the case of SVB.
Do you think that the Fed can or even will continue to raise interest rates at this point in time in conjunction with high inflation and current events in the banking sector?
This will become clear in the next week, the market is already pricing in the Fed cutting rates towards the end of the year at this point. However, a week ago the market was pricing in a 5.5-5.75% range and is now pricing in at most two more hikes.
However, the current projections for the end of the year seem to me to be built as if a financial crisis is being factored in, where the entire financial system is in danger of destabilizing and the central bank would have no choice but to save the system from collapsing.
However, we now have a different situation where it appears that the banking system can resolve situations and problems quickly, the current collapse is not affecting the entire financial system, and therefore I do not think the Fed would do anything to save financial stability, on the contrary, it has to deal with inflation, which is at 6%, so it has little choice but to continue to raise rates. I expect there will still be some officials to reassure investors that contagion of the financial system is not imminent and the main focus will continue to be fighting high inflation.
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Please note that this is not financial advice.