Strong start anticipates a profitable year for equities

In stock markets, the first quarter of 2023 saw a bouncy rise for investors, with the world's main equity index, the S&P 500, up more than 7%. This despite the drama that started with an overheated economy and ended with a budding banking crisis. A crisis hitting small banks in particular will in a way take care of the monetary tightening on behalf of the Fed, as long as the hit is precise and limited, like a controlled swipe with a telescopic bat on the thigh by a mall security guard.

The silver lining of the banking crisis, at least in the short term, has been the way in which interest rate expectations have fallen. This graph shows the market's current expectations for the Fed policy rate and where expectations were hovering before the banking crisis.



No wonder the tech-heavy Nasdaq is up more than 15% since the start of the year. This is the environment I'm more familiar with, where the stock market rises when there is bad news. The Helsinki Stock Exchange did not get in on the action and the general index is a little in the red since the start of the year.

This is a funny mix of statistical observation and anecdote due to the paucity of data, but over the last 70 years the S&P 500 has risen by an average of 23% in a year when it has risen by more than 7% in the first quarter. A strong start to the year has also meant a strong finish to the year on a total of 15 occasions. The only exception is the infamous 1987, which also ended up 2% up despite an epic 23% collapse in one day. If this statistic is any guide to the rest of the year, more greening is on the way.



In this post, we take a quick look at developments in the banking crisis and inflation. Let’s also look at how accounting fraud, which is costly for investors, tends to proliferate ahead of recessions. 

Brief news on the banking crisis
 
The banking crisis takes a back seat for now, as once again no banks failed over the weekend. In the US, the deposit leakage from small banks appears to have stalled, although this data ends on March 22.
 

On the other hand, the Fed's net liquidity growth has also stalled, suggesting that banks haven’t needed to raise much more emergency funding.

 
It seems money flowed from banks' low-interest deposit accounts into higher-yielding fixed-income funds, such as cash ETFs. This Bloomberg graph shows how cash ETFs have recently seen a record inflow of money in search of higher interest rates.

 
Small banks are swaying more in the headwinds. This graph shows the share of loans relative to deposits held by small and large banks in the United States. The higher the ratio, the more fragile the bank in a bad situation. Even a small bank run will make the bank run out of money if the funds are tied up in illiquid loans. Following the tightening of regulation after the financial crisis, smaller banks took on a greater role in financing riskier real estate, such as office space. After all, that sector melts the most when interest rates rise. At the same time, large banks have proportionally more low-risk mortgage loans. The big banks also have huge amounts of liquidity.



No wonder then why many small banks have collapsed in a matter of weeks as there is also more risk there. If you use this measure as a risk indicator, you can still see that both small and especially large banks are much better off than they were during the financial crisis, when the loan-to-deposit ratio was well over one.

Scams grow ahead of recessions

One of the features of the boom years is that some companies succumb to aggressive accounting or even outright fraud. One of the most famous scammers is Enron, once one of the largest and most valuable companies in the world until it quickly fell into bankruptcy in 2001 after accounting fraud came to light. Earlier this year, the Adani Group, owned by the world's third richest person, Gautam Adani, crashed on the stock market after the short selling firm Hindenburg published a report suggesting a massive accounting fraud. The final verdict on the matter is still pending, but despite tighter regulation, the books are still being cooked somewhere, so to speak, and investors should remain vigilant.

Accounting experts have developed various measures to detect fraud, one of which is called the M-Score. This model flagged, among others, the German scam company Wirecard, before it collapsed after being caught manipulating in 2020. It pays attention to factors such as the development of trade receivables in relation to turnover. If a company books a lot of sales but customers don't pay, it raises questions. Another example is an exceptional growth rate. The third is depreciation, by changing which the company can affect its accounting result. High use of debt leverage can also encourage a company to meddle with its numbers. The measure is not perfect, as for example a company that is growing at rocket speed and is tying up a lot of working capital looks dubious on this measure.

Here’s a link to one of the M-Score calculators, if you want to try for yourself how it treats the companies in your portfolio.

At present, this measure suggests that the number of companies likely to manipulate their results is close to record levels. This graph from the WSJ shows the total scam probability of 2000 American companies. Not always, but scams are often most prevalent before a recession, when companies go a bit too far to look good on the outside. I wouldn't predict a recession on the basis of this, because a high reading doesn't always mean a recession, but it's a fun curiosity all the same.



Inflation is cooling down, slowly...

Inflation data from both the eurozone and the US were released last week and let's go through them again quickly.

According to preliminary data, inflation in the eurozone eased further to a 6.9% year-on-year in March, which is good news. The bad news is that this was largely driven by falling energy prices. After all, oil prices have been falling for a year, but other price pressures continue. Food, alcohol and tobacco prices are rising at an annual rate of more than 15%. Core inflation, which excludes volatile food and energy prices, accelerated further to 5.7% on an annual basis. However, declining energy prices should ease price pressures at some point. Within euro countries, the differences are huge. In Spain, inflation is already falling like a stone, already close to the ECB's 2% target, while annual inflation in Germany and Italy is still hovering around 8%.

In the United States, personal consumption expenditure (PCE) inflation continued its very slow easing. PCE excluding food and energy rose 4.6% year-on-year in February. Note that this data updates a bit slower. The advantage of the PCE is that it puts a very moderate weight on shelter costs, and I understand that the Fed puts more weight on this indicator.

The Dallas Fed has a trimmed version of this, which removes the most volatile items to give a clearer picture of the direction of price pressures. Trimmed median inflation hovers at the same 4.6% level and is tapering off very slowly as can be seen in this graph. The good news is that the Fed policy rate is already at 5% above that inflation rate. It also remains to be seen in the spring how the small banking crisis will affect economic conditions and price pressures.

 
For now, I want to remind that the labor market is tight and wages are growing at a quick pace, so the inflation problem is still there, although it seems to be slowly slipping into the background in the minds of forward-looking investors.

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