Powell splits the difference

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Good morning. We are generally admirers of Jay Powell’s press conferences. We think he is about as plain-spoken and direct as a person in his position can be. Yesterday, though, his subject matter got the better of him. At this point, the US economy is so weird that it defies plain speaking. But if you have a crisp account of what’s going on, send it to us: [email protected] and [email protected].

The Fed’s muddle

On Tuesday the former Fed economist Claudia Sahm told us this: “It’s almost like the Fed put bank failures in its toolkit, to cool off demand.” 

In yesterday’s post-meeting press conference, Jay Powell sounded Sahmian. He reiterated several times that bank failures and near failures will spur regional lenders to act conservatively, restricting credit in a way that “you can think of [as] being the equivalent of a rate hike, or perhaps more than that”. From Powell’s opening statement:

Since our previous meeting, economic indicators have generally come in stronger than expected, demonstrating greater momentum in economic activity and inflation. We believe, however, that events in the banking system over the past two weeks are likely to result in tighter credit conditions for households and businesses, which would in turn affect economic outcomes. It’s too soon to determine the extent of these effects and too soon to tell how monetary policy should respond.

As a result, we no longer state that we anticipate that “ongoing rate increases” will be appropriate to quell inflation. Instead, we now anticipate “some additional policy firming” may be appropriate.

That change in guidance is a big deal. “Ongoing rate increases” means “we’re in inflation-fighting mode”. But “some additional policy firming” sounds to us like “we’re almost done”.

Careful readers will spot a muddle. Powell is saying that, because of the bank stresses, the Fed anticipates a shorter, less aggressive path for rate increases, but is also saying that it’s too soon to tell how monetary policy should respond to the bank stresses. It can’t be both.

Powell’s attitude seems to be that it’s better to assume bank failures will bite and be wrong, than to assume they won’t bite and be wrong about that. Asked what the last two weeks mean for a soft landing, Powell said: “It’s hard for me to see how it would help the possibility.” Markets seemed to agree. Stocks fell to end the day while bonds rallied across the curve.

The muddle was also reflected in the Fed’s latest set of economic projections, released yesterday. There were few changes to speak of for 2023 — in defiance of the fact that consumption and consumer inflation have both picked up recently (For 2024, rate expectations were nudged up, and growth nudged down.) Nominally, the Fed is looking past the hotter data because of the bank failures, while at the same time acknowledging that the impact of the failures is an unknown.

Market pundits looked torn on what to make of it all. Some saw stubborn insistence on stamping out inflation; others saw the last gasps of a dovish Fed’s rate-raising campaign. Mostly, though, people were confused. Many spoke of threading needles. One said Fed decisions had become wrapped in a “particular aura of complexity.” That’s right: we have reached the point in the rates cycle where we talk about auras.

To us, this is a reminder that cycles don’t end smoothly or predictably. Jerky, non-linear events, like banks breaking, change the economic picture in an instant. Markets are now back to pricing in rate cuts later this year; they had finally come around to the Fed’s higher-for-longer view just a few weeks ago. Powell repeated his higher-for-longer mantra yesterday and, until now, we’ve been inclined to believe him. But it isn’t up to him anymore. (Ethan Wu)

Against bank stocks (and their dividends)

A few days ago we pointed out that bank stocks seem to be particularly risky: they are highly leveraged, vulnerable to runs, face systemic risks, and are beset by technological change. Given all those risks, and the share-price volatility that comes with them, one would expect bank stocks’ returns to be high across the economic cycles. One expects extra pay for taking extra risk. But, looking at the past two decades or so, the long-term bank returns are very poor. It looks like, for some unknown reason, markets fail to appropriately price in the riskiness of banks.

The piece generated a fair bit of mail. One note, from Charles Carignan, pointed out that I made a rookie mistake in my charts: looking at price return not total return, that is, return including dividends. Banks tend to pay dividends. So I reran the numbers yesterday.

Across what I would call the long bull market, from the end of 2002 to the end of 2021, including dividends makes no difference. Among the 24 major industry groups, banks came in dead last, with annualised total returns over that period of less than 6 per cent, less than half the return on the wider market (these are the S&P 500 indices for each industry):

You might object that we had a monstrous banking crisis in the middle of that span, so I have failed to pick a representative period. I’m not convinced by this, given both the frequency of banking crises and the fact that the chosen time span gives bank stocks a full 12 years to make back their crisis losses. But fine, let’s look at total return from the 2009 market trough to the year-end 2021 top:

Bar chart of Total shareholder return for S&P 500 sectors, 03/09-12/21, % annualised showing Meagre reward

Over this historically good span for stocks, banks outperformed the wider market by a percentage point a year. This is awful! The period began with most banks trading at all-time lows, and investors sought risk continuously over the ensuing years. And in the end investors who took bank equity risk get a lousy percentage point of extra annual return. After the whipping they took in 2008, and all the volatility they put up with along the way? Man, these things stink.

Another reader asked about banks’ relative performance in the pre-dotcom bull run — a good test to see if the past few decades have been anomalous. Well, they come up short again. From the autumn of 1989 (as far back as Bloomberg’s data on the S&P bank index goes) to the 2000 market peak, banks’ total return was 14 per cent annualised, to the market’s 18 per cent. The chart for the period looks exactly like you might expect: banks do well for a while, but as the cycle ages, they falter before the rest of the market does. You can almost smell the loans made during the early recovery defaulting as the cycle ages.

In the end, it’s the same story again: buy a bank, take a host of unique risks and receive average-at-best performance in return.

I submit there is a real puzzle here. It’s fine, and very likely true, to say that banks are hurt by punitive or unpredictable regulation, and that banker pay steals the returns, as my colleague Stuart Kirk has recently argued. But the risks themselves are not the main point here. The main point is that bank equity prices don’t seem to capture these risks and sources of volatility, providing extra return to those brave enough to invest. Why not? And what should investors do about it? Do we need index funds that own the whole market, except for banks? Do bank capital structures need a rethink, before investors figure out they should not touch the equity without big discounts to book value? Readers, if you have the answers, send them along.

One good read

Bank stress after a sharp rise in interest rates? We’ve seen that movie before.

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