US economic growth has been relatively modest in the first quarter with GDP growth expectations ranging from 1.5% to 2%. Meanwhile equity markets have continued to march higher with another 7% gain following Q4’s rebound. Yet, there is an underlying lack of confidence on the part of both investors and consumers that’s been exacerbated by the Fed and the recent banking crisis.
During March, the headlines surrounding the rapid failures of three specific banks highlighted that it no longer makes sense to hold excess (and uninsured) cash deposits in banks; rather, it’s far more beneficial to earn 4%+ returns by shifting cash into highly liquid money market funds - which means the cash is now outside the banking system. Since banks require cash deposits as the capital to provide loans, it now appears there is a slowdown coming in future loan growth which will ultimately slow overall economic growth. The Fed averted a banking system meltdown over the past few weeks. However, deposits will continue to leave the banking system as long as the Fed keeps short-term rates high (or the banks continue to pay so little on deposits).
This development probably assures that US economic growth will slow enough to qualify as a recession at some point during 2023. Anticipated weakness from declining loan growth will help do the Fed’s inflation work. Since the mid-March onset of the banking crisis, yields across the Treasury maturity curve have declined by 50 bps indicating the market believes the Fed will begin lowering rates before year-end. By accelerating the onset of a potential slowdown, the banking crisis may ironically be helping equity markets by shortening the amount of time until the economy can begin to normalize again. Investors typically price equities based on earnings expectations 6-9 months in the future.
When the slowdown arrives, we have some confidence it will be relatively mild because of the economy’s resilience over the past nine months. Schwab’s investment strategist, Liz Ann Sonders, believes that uneven cycles of economic activity experienced across industries this cycle have served to create a ‘rolling recession” which supported modest yet resilient growth across the economy.
We are continuing to use market volatility as an opportunity to add dividend growth to client portfolios. As we have frequently mentioned, dividend growth reflects a strong management discipline towards free cash flow generation. While the current interest rate environment is uncertain, our view is that corporate debt financing will likely remain more expensive than it has been over the past decade. This will benefit firms that can efficiently raise investment capital as well as diligently deploy it in order to grow their businesses. When compared to a company that borrows capital investment funds, a dividend growth firm has already demonstrated its successful cash generating discipline. Using its own money rather than more expensive borrowed money is a far less risky proposition for an equity investor.
We believe the most prudent strategy to meet our clients’ long-term investment needs is to position portfolios with high quality, reasonably valued, cash generating businesses that pay dividends. This current environment supports our investment philosophy now more than ever.
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