February 12, 2024Scroll down
The CIO’s Take:
After a busy week of earnings and Fed action at the turn of the month, last week’s excitement was primarily around the S&P 500’s struggle to cross the 5,000 mark for the first time ever: a feat achieved on Friday, putting the broad US market up over 5.5% year-to-date. That rally in risky stocks suggests investors are already over Fed chair Jerome Powell’s confirmation at January’s post-FOMC press conference—and again on 60 Minutes days later—that rate cuts aren’t happening in March, with timing likely to be driven by hard data rather than investors’ sheer desire to see that happen in Q1. The data continue to be a double-edged sword, on the one hand driving home how strong the US economy appears to be, playing into the “soft landing” story, but on the other creating no urgency to ease quickly. Turmoil at New York Community Bank over the last couple weeks highlights to us a risk that the lagged impact of tight conditions could bring about a sudden downturn, leaving us cautious—though we do not believe the situation at NYCB, itself, is likely to spark a broader crisis.
Powell 60 Minutes Recap
It isn’t often that the chair of America’s central bank shows up for an interview on the evening news, but that’s precisely what the Fed’s Jerome Powell did two Sundays ago, appearing on 60 Minutes for an interview with CBS’ Scott Pelley to discuss his outlook for monetary policy in 2024. We didn’t take away from the segment anything that might qualify as “breaking” news. Powell essentially reiterated everything we’ve been hearing from him and other Fed officials since the late-January FOMC. He made it clear the question of rate cuts at this point is a matter of “when” not “if.” He also stressed that market participants shouldn’t expect easing as early as March, nor is there a current plan to cut more than three times this year. According to Powell, the bank is still inclined to take a cautious approach, waiting for hard data showing inflation is well in hand before making its next move. Throughout the conversation, Powell spoke to how things like inflation and high interest rates are affecting average Americans: a framing that makes sense if one considers the audience, but also suggests the Fed is conscious of the central bank’s role in an election year, with an incumbent hoping to take credit for an economic success and a challenger who has already announced he will fire Powell if victorious.
ISM shows US economy stronger
In looking for hard data to justify sooner-than-later cuts, recent macro releases have surely muddied the waters. Although Powell’s 60 Minutes spot aired on Sunday, it was actually recorded prior to Friday’s release of January jobs data, discussed at length in last week’s Perspectives, which showed almost twice as many jobs created than economists had expected. Likewise, last Monday’s release by the Institute for Supply Management (ISM) showed the manufacturing sector snapping back unexpectedly, with a significant increase in new orders and prices, suggesting inflationary pressures remain and countering the notion that a broader economy in decline might prompt the Fed to cut rates earlier than the bank has signaled. With respect to potentially persistent inflation—something Powell explicitly referenced in his interview as “the kind of things that would make us want to move later”—the ISM’s services report was even more concerning, showing the biggest one-month increase in its “prices-paid” component in a decade (see below).
Despite the last year ending with super-strong GDP growth and an historically tight labor market, we’ve previously suggested how this apparent economic boom might be more fragile than some of the most frequently touted data indicate. While manufacturing activity recovered meaningfully in January, for example, the headline purchasing managers index (PMI) still came in at 49.1, its fifteenth straight month below the baseline of 50 that separates contraction from expansion. Of course, the market knows this, and that’s why any improvement—e.g., the PMI’s rise from to 49.1 from 47.1 a month earlier—still offers encouragement to traders that the “soft landing” scenario remains intact.
Bank loan officers see improvement
One of the reasons we have been so focused on monetary policy in our Perspectives musings is that high interest rates remain perhaps the most important constraint to improvements in data like those depicted above. Whether businesses expedite expansion plans or put them on hold, whether consumers keep borrowing, whether new houses are built: all of this hinges on how tight financial conditions are and expectations for when they might loosen. Intelligent investors recognize how important risk of a Fed overshoot is, with 24% of respondents in Bank of America’s January global fund manager survey nominating “hard landing” as the biggest tail risk keeping them up at night—second only to “geopolitics,” which garnered 25% of the votes. But remember: even the prospect of future rate cuts and reduced fear over an economic contraction can be enough to loosen financial conditions in the present. As such, it’s not a big surprise to see that although recent Fed data show banks on net still tightening lending standards as of the beginning of 2024, the proportion is shrinking, while more banks are seeing an increase in loan demand (see below).
Lastly, it’s worth noting that from an international perspective, the notion of “American exceptionalism,” at least with respect to interest rates, is alive and well. At the same time America’s position within global finance and trade make its monetary policy critical for countries and companies around the world, US households have shown a gradual decrease in their sensitivity to rate hikes. That’s why in Powell’s 60 Minutes interview, even as he acknowledged the costs rate hikes have imposed on Americans, he was comfortable asking for their patience as the Fed picked its spot to lower rates. That in and of itself gives the Fed a bit more wiggle room in the face of so much positive macro data to delay a decision on cuts until inflation has closed further in on its 2% target—but also increases the risk, in our view, that the central bank misjudges the situation and overshoots.
Another regional bank in trouble
Looking at the last few ticks on the chart covering loan officer survey data above, it wouldn’t be obvious that on the very day of that final data point in January, commercial real estate loans would once again emerge as a potential “ticking time bomb” for the US financial system. But that’s exactly what happened on January 31st, when New York Community Bancorp (NYCB) reported an unexpected $550 million loan loss provision, more than 10x analysts’ estimates. That triggered a new wave of concern over regional bank exposure to CRE loans. Prior to its bombshell Q4 earnings report, many investors would have seen NYCB as a beneficiary of turmoil in the banking sector last March, which infamously brought down Silicon Valley Bank (SVB) and others with portfolios of underwater real estate loans. Indeed, NYCB had acquired the non-crypto assets of another failed rival, Signature Bank—but that turned out to be part of the problem, as the banks’ larger size put it under greater regulatory scrutiny, requiring it to maintain heftier cash reserves. Post earnings announcement and prior to last Friday’s open, NYCB stock had lost 60% of its value as traders discounted its odds of survival.
Implications for the Fed?
Observing parallels to last March’s regional banking crisis, some spectators wondered whether another act in the ongoing CRE loan drama might push the Fed to consider accelerated rate cuts. Our current read of the situation is that NYCB doesn’t come close to posing the systemic risk that SVB, Signature, First Republic, and others represented early last year. For one thing, while acknowledging office properties are in bad shape and not likely to improve anytime soon in our post-COVID “hybrid work” world, NYCB’s total loan portfolio actually has limited exposure to commercial real estate, at 12% of its portfolio (see below), and even less exposure to office, around 4% of its total book. The lion’s share of its loans, representing 44% of its overall portfolio, turn out to be in the apartment segment, concentrated in New York City and usually subject to some form of rent control.
Since landlords’ income stream is limited by their inability to significantly raise rents as funding costs rise—especially in the case of loans due for repricing—such debt has become substantially higher-risk. In part, NYCB’s horrendous stock price reaction to a skyrocketing loan loss provision was punishment for the bank’s conservative stance in setting that account, which assumed no rate cuts in 2024 (not an entirely unreasonable forecast) and baked in the impact on landlords facing the grim dynamic we’ve just described.
Greatest risk is to sentiment
Such difficulties are, of course, relatively specific to NYCB, a lender that has primarily focused on New York multi-family properties for decades. Zooming out to the broader banking industry, one finds total distressed assets in the US CRE market stand at approximately $80 billion, significantly lower than levels observed during the Global Financial Crisis. Those numbers could get worse, of course, but we see a sudden collapse as unlikely, and believe the odds are low that this episode forces the Fed’s hand in making cuts before they’re otherwise ready. The biggest risk from NYCB at this point seems to us more a matter of negative sentiment leading to an increase in funding costs, a hit to earnings, and depositors once again fleeing. NYCB leadership seemed eager to get ahead of that sort of crisis in confidence, disclosing personal insider purchases of the bank’s stock by its executive team, prompting shares to rally by almost 17% last Friday.
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