There's a passage in Ernest Hemingway's The Sun Also Rises in which a character is asked how he went bankrupt. “Two ways,” he answers. “Gradually, then suddenly.” This is a good description of recent bank failures. Losses from long-duration Treasury holdings built up gradually over the past year, as did the risk from deposits that were highly concentrated in hard-hit tech companies and start-ups. When these issues suddenly accelerated, they led to the recent, and surprising, failures of Silicon Valley Bank and Signature Bank.
In mid-March, when the banking stress first surfaced, Morgan Stanley Research’s primary takeaway for U.S. equity markets was that these failures and close calls would likely lead to a credit crunch, supporting our existing below-consensus outlook for corporate earnings. Now, the data suggest a credit crunch has indeed started. More specifically, we’ve seen the biggest two-week decline on record in lending by banks, as they are being forced to simultaneously sell mortgages and Treasuries at a record pace to offset deposit flight.
In fact, since the Fed began raising rates a year ago, almost $1 trillion in deposits have left the banking system. Throw in the already tight lending standards and it’s no surprise that credit growth is shrinking. If that isn’t enough, last week the latest small business survey showed that credit availability had its biggest monthly drop in 20 years, while interest costs are at a 15-year high.
In hindsight, the bank failures seemed predictable, given the speed and magnitude of the Fed’s rate hikes; concentrated deposits from corporates; and poor controls around duration risk, which means the banks failed to hedge the risk of losses they might incur in the event of interest-rate hikes. Nevertheless, most investors did not see the failures coming.
This leads to the question of what other surprises may be coming from the most abrupt monetary policy adjustment in history?
In contrast to what we expected, the S&P 500 and Nasdaq have traded well since Silicon Valley Bank first announced it was insolvent, although small caps, banks and other highly leveraged stocks have traded poorly. However, that should not necessarily be viewed as a signal that all is well. On the contrary, the gradual deterioration in the growth outlook for U.S. stocks is likely to continue. And even large-cap indices are at risk of a sudden fall, like those we have witnessed in the regional banking index and small caps.
Earnings May Be Poised for a Rapid Slide
Hemingway’s poetic passage can also extend to the earnings growth deterioration we’ve observed over the past year. Until now, the decline in earnings estimates for the S&P 500 has been steady and gradual.
Since peaking in June last year, the forward 12-month bottom-up consensus earnings per share (EPS) forecast for the S&P 500 has fallen at a rate of approximately 9% per year. This has not been severe enough for equity investors to demand higher returns for the additional risk they are taking, but we think they should.
Investors are further comforted by the consensus earnings forecast, which implies that the first quarter of this year will be the trough for the S&P 500 EPS. This is a key buy signal that we would normally embrace — if we believed it.
Instead, if we are right on our well below-consensus forecast, the pace of decline in earnings estimates should increase materially over the next few months as revenue growth begins to disappoint. To date, most of the disappointment on earnings has been a result of lower profitability, particularly in the technology, consumer goods and communications services sectors.
However, there are other risks to earnings — notably falling demand. To those investors cheering the softer-than-expected inflation data last week, we would say: Be careful what you wish for. Falling inflation last week, especially for goods, is a sign of waning demand, and inflation is the one thing holding up revenue growth for many businesses. If revenues begin to disappoint, earnings could see a gradual, then sudden, slide.
