Markets Hold Up Despite Turmoil

Despite losses in bank stocks, the S&P 500 and Nasdaq ended the week higher

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Investor optimism is reflected in a modest rise in stock indexes despite a surge in bond prices and a drop in bank shares, reflecting market turmoil that has sent bond prices tumbling. 

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Commentators have speculated whether Silicon Valley Bank's collapse could constitute a "Lehman moment" - a shock to the financial system that would cause significant economic damage.

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As investors piled into bets that the Federal Reserve will have to move from fighting inflation to slashing interest rates rapidly, oil prices declined 13%, regional bank shares tumbled, and short-term Treasurys posted their biggest weekly rally in decades.

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In the meantime, stock indexes have remained choppy but resilient. UBS Group AG UBS 4.29 %increase; green up pointing triangle gained slightly on Monday after Swiss authorities negotiated over the weekend for Credit Suisse to take over the longtime rival. It comes after the S&P 500 gained 1.4% last week despite falling on Friday. Since March 8, the day before Silicon Valley Bank's bank run, the broad index had declined 1.9%. As of March 8, the Dow Jones Industrial Average had declined 2.9% while the Nasdaq Composite had risen 0.5%.

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There will be a lot of interest on Wednesday in how the Federal Reserve is going to react to the situation regarding the banking sector and how they will change their policy in light of it. Investors will continue to monitor the health of banks as well as the Fed's latest interest rate decision. 

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As opposed to other moments of heightened financial anxiety, when stocks have been relatively stable, including just after the September 11 terrorist attacks in 2001 and when Lehman Brothers collapsed in 2008, stocks have been relatively stable in recent years. It was quite similar to the decline in short-term Treasury yields in those episodes, but stocks were much more volatile, with the S&P 500 experiencing a single-day decline of over 4.5% on an average basis.

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A stock market that is not on the verge of Armageddon is, according to Matt Peron, director of research at Janus Henderson Investors, "certainly not pricing in Armageddon right now.” Peron explained that the market is reading about this as a localized problem, rather than one that is systemic.

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Even so, investor confidence is nowhere near what it should be, and market conditions continue to be highly volatile.

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Among the signs of anxiety that have arisen lately is the fact that the performance of the S&P 500 overall has been masked by stark divergences between sectors. A drop of 3.5% was reported in the economic-sensitive materials sector of the S&P 500 last week, while a decline of 6% was reported in the financial sector and a fall of 7% in energy. Information technology, which increased by 5.7%, and utilities, which increased by 3.9%, were favored by investors, as sectors that are more insulated from economic downturns.

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According to investors and analysts, stocks are at risk at this point due to several factors.

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As a consequence of current banking stress, regional banks are forced to pull back their lending more than investors expect.

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Investors are also disappointed by the Fed's refusal to shift monetary policy from tight to loose.

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In recent sessions, fast-growing tech companies have buoyed the market, but if the Fed continues to raise rates after its meeting this week, Treasury yields could rise, hurting the stock price of fast-growing tech companies. As investors worry about higher rates causing a recession more rapidly, they could also hurt economically sensitive stocks.

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According to Wall Street economists, the economy is under uncertain circumstances. Goldman Sachs economists estimated last week that a pullback in bank lending could lead to a 0.3 percentage point drop in economic growth this year, equivalent to the Fed increasing interest rates by one or two 0.25 percent points.

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It was reported last week that Goldman economists estimated the central bank would refrain from raising interest rates at its March meeting to keep its attention focused on financial stability—but then raise rates by 0.25 percentage points at the three meetings to keep the bank stable. This was shortly after the Fed and other regulators announced measures to support the financial system early last week.

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As noted by other economists, it is unlikely or unnecessarily necessary for the Federal Reserve to pause its rate-raising activities.

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According to Andrew Hollenhorst, chief U.S. economist at Citigroup, there is a big difference between today and when Lehman Brothers failed in 2008. The banks now do not have to worry about the assets that they hold, which is much less worrying for banking regulators than it was in 2008. After having witnessed a highly publicized bank run in the region, depositors have picked up uninsured deposits from regional banks, creating a contagion of fear between them.

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As Mr. Hollenhorst explained, the Fed would be in a strong position to address the funding issue of that kind, since it has the capacity to lend to the banks through its existing and new facilities, as it does now.

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The likelihood of banks lending less is still higher when they are losing deposits, or are worried about losing them. Nevertheless, the drag on growth is manageable, and the Fed can't afford to stop worrying about inflation while consumer prices continue rising far faster than its target, Hollenhorst said.

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As a result of low inflation, "markets are very conditioned," he said. When inflation is low, the Fed has more freedom to address financial market problems and to address growth concerns.

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According to him, "the Fed is just more constrained here."

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Whether the Fed raises short-term interest rates this week or not, some investors believe that what it has already achieved is more important than what it does this week.

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A cautionary addition has been made to the portfolio of Crossmark Global Investments' chief investment officer Bob Doll, who feels that the market's initial reaction to the banking challenges may have been overdone when it had initially responded to the banking sector challenges.

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While he said that he believes the stock market will remain weak this year, owing in part to the lagged effects of the interest rate hikes, he said the market is still likely to drop further.