Stocks rally on improved bank sentiment, favorable inflation data

The courage to press on regardless of whether we face calm seas or rough seas, and especially when the market storms howl around us, is the quintessential attribute of the successful investor. – John Bogle 

After a slow start to the week, stocks found their footing and never looked back as the major stock averages all gained at least 3% and ended the first quarter on a high note.  The stock market has been volatile after the collapse of Silicon Valley Bank and Signature Bank, but concerns have eased about the health of the banking sector and market sentiment has improved greatly. Bank stocks were up nearly 5% this past week, helped partly by measures taken by the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) to provide additional liquidity and protect depositors. Confidence in the banking system was also improved when Michael Barr, the Fed’s vice chairman for supervision, told Congress last week that the Fed may have to adopt tougher rules for banks in its role as a financial regulator. The steps taken by the Fed and the FDIC should be enough to avert a financial contagion and prevent any more bank runs and a credit crunch. Deposit outflows from small banks also slowed considerably last week. Nevertheless, there are already indications that bank lending standards will tighten and that this could lead to less credit expansion and slower economic growth. Investors also received good news on the inflation front last week as the core personal consumption expenditures (PCE) index, the Fed’s preferred measure of inflation, rose only 0.3% in February, slightly less than expected and lower than the increase in January. On an annual basis, the core PCE increased 4.6%, slightly less than in January, causing some economists to predict that inflation will be less than 4% by year-end. This favorable outlook lifted investor hopes that the Federal Reserve may only hike interest rates one more time in May by 25 basis points (a basis point is one hundredth of one percent) and pause at a terminal federal rate at between 5.0% and 5.25%. While the Fed has been steadfast in its goal of bringing down the inflation to its targeted rate of 2%, the market believes the Fed will begin cutting rates before the end of the year to deal with a slowing economy and possibly a recession. The bond market seems to agree as the 2-year Treasury yield of 4.05% is about 100 basis points less than the federal funds rate and the 10-year Treasury yield has dropped to 3.5%.

Last Week

The final reading for gross domestic product (GDP) showed that the economy grew at a 2.6% annualized rate in the fourth quarter, slightly below the previous estimate of 2.7%. The Atlanta Federal Reserve expects first quarter GDP to be 3.2%. The Case-Shiller Home Price Index showed that home prices continued to slide in January, falling for the seventh straight month. Weekly jobless claims rose to 198,000, up 7,000 from the previous week and higher than the estimate of 195,000, as companies are still slow to lay off workers. The University of Michigan consumer sentiment index in March fell as consumers increasingly expect the economy to fall into a recession.

For the week, the Dow Jones Industrial Average rose 3.2% to close at 33,274 while the S&P 500 Index surged 3.5% to close at 4,109. The Nasdaq Composite Index jumped 3.4% to close at 12,221.

This Week

The most important piece of economic data this week is the March employment report, which is expected to show that about 235,000 new jobs were created and that the unemployment rate remained unchanged at 3.6%. The ADP National Employment Report of private sector jobs is forecast to show an increase of 210,000 new jobs. The ISM manufacturing index for March is expected to be less than 50 and show contraction while the ISM services sector index is expected to be above 50 and show expansion.

The stock and bond markets will be closed on Friday April 7^th in observance of Good Friday.

Among the most notable companies scheduled to report quarterly earnings this week are Constellation Brands, Conagra Brands, Acuity Brands, Levi Strauss, CarMax and RPM International.

Portfolio Strategy

What a difference a month makes. At the beginning of March, expectations swung from a 25-basis point increase in the fed funds rate to a 50-basis point increase as inflation remained stubbornly high due in part to a strong labor market. Fast forward to March 10^th with the failure of Silicon Valley Bank and the subsequent collapse of Signature Bank and fears of a contagion spread with thoughts of a financial crisis and increased odds of a recession. Investors sought a safe haven by purchasing Treasury securities, driving their prices up and the yields down as expectations grew that the Federal Reserve would end its interest rate increases by May and begin lowering rates in the second half of the year. Not only did the 2-year Treasury yield plunge from 5.05% to 4.05% at month’s end, but the stock market reacted positively to the prospect of Fed easing with the technology sector particularly strong. Technology stocks gained nearly 7% in March and now trade at nearly 30 times forward earnings estimates. On the other hand, bank stocks have been the worst-performing sector in the S&P 500 Index and have been a drag on the performance of so-called value funds or high dividend-paying funds since they comprise a disproportionate amount of the funds’ assets. While the yield curve (the difference between the 2-year Treasury yield and the 10-year Treasury yield) is still inverted with the 2-year at 4.05% and the 10-year at 3.5%, the difference is about half (55 basis points now compared to 105 then) what it was when the 2-year Treasury yield was at 5.05% in early March. An inverted yield curve is still recessionary, though, and right now whether the Fed pauses or raises rates another 25 basis points in May is a toss-up. For stocks to continue their rally, inflation needs to remain on its downward trend, first quarter earnings and guidance need to be favorable and assurances have to be made that the banking crisis has been solved.