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The most important charts and themes in markets and investing…
1) First Republic Freefall
First Republic Bank has been shut down by regulators, becoming the 2nd largest bank failure in history.
Over the past two months, we’ve now seen three banks fail with combined assets of $548 billion. That’s significantly higher than the combined assets of the 511 banks that failed from 2009 through 2022 ($339 billion). And it’s already a record for a calendar year, surpassing the prior high of $373 billion set back in 2008.
The downfall of First Republic would have been a complete shock a year ago but came as a surprise to no one today. The stock ($FRC) was already in freefall, down 97% on the year. Its market cap, which stood at over $20 billion just a few months ago, had dropped to $652 million.
After releasing earnings earlier in the week, the writing was on the wall. Deposit outflows following the SVB/Signature failures far exceeded expectations (over $100 billion left the bank in the first 3 months) and funding costs were rapidly rising. Meanwhile, First Republic’s loan book largely consisted of low-rate residential mortgages whose market value was down sharply given the spike in interest rates. The combination led to an untenable situation, despite massive efforts by the Fed and the largest U.S. banks to infuse liquidity.
What will happen to the uninsured depositors, which totaled $19.8 billion at the end of the quarter and $49.8 billion if you include the 11-bank infusion?
Once again, they will walk away completely unscathed. In a deal brokered by the FDIC, JPMorgan Chase ($JPM) agreed to pay the FDIC $10.6 billion for all of the deposits and branches and most of the assets of First Republic. And so the largest bank in the U.S. will become even larger, and the too-big-too-fail unwritten rule will become even stronger. Additionally, the FDIC will share losses with JPMorgan on First Republic’s loans and provide $50 billion in five-year, fixed-rate term financing.
Judging by the response ($JPM stock up 2% on the news), the market seems to think this is a pretty good deal for JPMorgan.
And for the FDIC?
Another big hit to the Deposit Insurance Fund is coming, an estimated $13 billion. Along with the SVB failure ($20 billion estimated cost), this will lead to increased costs to banks to replenish the fund, which in turn will likely lead to increased costs for consumers.
Interestingly, the broader market has taken the First Republic news in stride, up over 9% on the year as of the end of April.
And unlike the post-SVB reaction, volatility has plummeted. The $VIX is now below 16, its lowest level since November 2021. Have market participants become too complacent? We’ll soon find out.
2) One More Hike?
If the markets are correct, the First Republic failure will have no impact on the Fed’s upcoming decision (May 3 FOMC meeting). Fed Funds Futures are pricing in a 94% probability of a 25 bps rate hike this week. That would bring the central bank rate up to 5.00-5.25%, its highest level since September 2007.
After that, though, the market is projecting a Fed pause in June/July, followed by a rate cut at the September meeting. Why would the Fed cut rates so soon after hiking? Either due to a) sharp decline in inflation and/or b) a sharp downturn in the economy.
But no one should be surprised if the market is flat-out wrong, which has been the case time and again over the past decade when it comes to Fed policy. With each and ever data point and Fed utterance, expectations change, and as we’ve seen over the past year, these changes can be significant (the market did not anticipate a Fed Funds Rate anywhere near 5% a year ago).
3) Reversing the Excesses
The US Money Supply (M2) contracted again in March, a surprising fact given the Fed’s liquidity injections following the bank failures. The 4% year-over-year decline is now the largest on record, which is reversing some of the excesses from the 2020-21 (record 40% increase in M2).
A leading indicator of higher inflation on the way up, we are now seeing the opposite effect with:
a) The PCE Price Index moving down to 4.2%, its lowest level since June 2021. The peak was 7% in June 2022.
b) US Rents increasing 1.7% over the last year, the slowest growth rate since March 2021.
c) US home prices up 2% over the last year, the slowest growth rate since 2012.
d) 8 out of the 20 cities in the 20-city home price index down on a year-over-year basis, the most since 2012.
4) Lumber Liquidation
Lumber futures are at their lowest levels since June 2020, down 80% from the peak in May 2021.
Homebuilders are directly benefitting from this trend as sale prices remain near record highs while input costs are going down. The Home Construction ETF ($ITB) is up 33% over the past year versus a 1% gain for the S&P 500 ($SPY).
5) Housing Market Standstill
US Pending Home Sales remain very weak, down 23% over the last year. This tends to be a leading indicator of housing activity as it’s based on signed real estate contracts for existing homes.
One of the main reasons for the housing market standstill: a lack of supply due to the spike in mortgage rates. The vast majority of outstanding mortgages are below 4%, and with a current rate at 6.4%, these homeowners simply can’t afford to move.
This has created an interesting dynamic where the lack of affordability has crushed demand not only from new buyers but also sellers, thereby slowing the pace of declines in the housing market due to an inventory shortage.
6) #1 Reason for Renting
Speaking of affordability, the average new home remains very much unaffordable at current prices and mortgage rates. The change over the last three years has been devastating for new entrants to the market.
Affordability is the primary factor which is preventing renters from owning a home.
And a lack of affordability has been a major factor in the lower rates of millennial homeownership versus prior generations, as they entered the homebuying age during the twin housing bubbles of the last two decades.
Many have simply given up at this point.
But there’s a huge variation in Millennial homeownership rates across the country, with more affordable midwestern cities (ex: Grand Rapids, Minneapolis, Cincinnati, St. Louis) showing much higher rates of ownership than less affordability coastal cities (ex: LA, San Fran, San Diego, NY).
7) Selling at a Loss
In March, 31% of homes sold by investors in Phoenix were sold at a loss, the highest % of any metro area in the country.
Investors own 10% of homes for sale in the US, down from a peak of 12.4% in 2021 but still more than double the % from a decade ago.
8) I Left My Office in San Francisco
Close to 30% of San Francisco’s office space is now vacant, more than 7x higher than the vacancy rate from early 2020.
One office building on 350 California Street that was worth around $300 million in 2019 is now expected to sell for $60 million, an 80% decline (source: WSJ).
9) Beating Low Expectations
The story of earnings season thus far is one of beating lower expectations. Facebook ($META) is the perfect example, with its stock jumping after an earnings beat, now up 102% year-to-date (leading all stocks in the S&P 500).
What did it report?
2.7% year-over-year revenue growth, a 24% decline in net income, and operating margins moving down to 25% from 31% a year earlier. Hardly anything to get excited about, but all above the low expectations heading into the report.
Facebook has now lost an astounding $30 billion in its reality labs division since breaking out the numbers in Q4 2020. One has to wonder if this bet will pay off, and if they simply bet on the wrong horse (ex: Microsoft has invested $13 billion in OpenAI, the creator of ChatGPT).
10) Slower Growth, but Still Growing
US Q1 Real GDP came in below expectations but was still positive, up 1.6% year-over-year. The average growth rate over the last 20 years: 2.1%.
11) The Inverse of 2022
The first 4 months of 2023 have been the inverse of 2022. Every major asset class is higher with the exception of commodities.
And that’s it for this week. Have a great week!
-Charlie
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Disclaimer: All information provided is for educational purposes only and does not constitute investment, legal or tax advice, or an offer to buy or sell any security. Read our full disclosures here.
