By: Jose Torres, Interactive Brokers’ Senior Economist
Equities resumed their indecisiveness of the last few trading days this morning, reversing from gains to losses on the back of lofty valuations, better-than-feared earnings performances and a weaker dollar. While a low bar to hop over for corporate earnings is helping sentiment, investors are dialing up their Fed hike expectations with Chairman Powell set to take the mound in two short weeks. Economic data overall hasn’t been rosy either, with today’s New Residential Construction report depicting further weakness in the sector.
Residential construction declined last month, with permits and groundbreaking associated with multifamily projects declining sharply while single-family prospects increased modestly. The increase for single-family units, however, could potentially be short-lived as potential buyers continue to struggle with historically low affordability driven by an unfavorable rate-valuation mix, the initial signs of a cooling labor market among other headwinds. In another development, a handful of regional banks have reported encouraging first-quarter results this week, but in the coming months, they are likely to face adversarial pressures related to the competition for deposits, rising cap rates in commercial real estate, loan delinquencies and potential write downs in their held-to-maturity securities. In the meantime, however, first quarter results are alleviating fears that the collapses of Silicon Valley Bank and Signature Bank may not be isolated events.
The pace of building permits fell 8.8% in March to 1.41 million seasonally adjusted annualized units while housing starts declined a more modest 0.8% to 1.42 million. Permits missed the 1.45 million forecast while starts exceeded their 1.4 million expectation, both metrics declined from February readings of 1.55 and 1.432 million. From a regional perspective, the Northeast was the only region gaining on permits and starts, up 25% on the former and 72% on the latter. The only other regional gainer was the South, adding 6.8% to their pace of starts.
Among asset classes, multi-family apartments weighed heavily against the backdrop of landlord margin compression characterized by softening rent rolls amidst rising financing, maintenance and insurance costs.
Among asset classes, multi-family apartments weighed heavily against the backdrop of landlord margin compression characterized by softening rent rolls amidst rising financing, maintenance and insurance costs. Weakening profitability has weighed on multifamily activity last March with starts down 6.7% and permits down a startling 24%. Still, multifamily construction remains near the highest level in decades as the incentive to build single-family homes has dwindled. In March, however, single-family bounced from low levels with permit and start activity up 4.1% and 2.7% respectively.
Markets experienced strong gains in the morning on the back of better-than-expected earnings from Bank of America, Johnson & Johnson and the regional banking sector. The valuation ceiling, at around 19 times for earnings based on the S&P 500’s 4170 level, served as a constraint yet again, however, and just like that all three major U.S. indexes have reversed their gains and are in the red. Bond yields are relatively unchanged while the Dollar Index is down 0.3%, driven by stronger growth expectations from Europe’s pound sterling and the euro. Additionally, a stronger than expected 4.5% GDP growth rate from China weighed upon the dollar. WTI crude oil is roughly unchanged at around $81.00 per barrel as market players weigh supply constraints against the demand outlook.
Regional Bank Earnings Alleviate Contagion Fears
Broadly speaking, regional banks reported encouraging results, but challenges with rising deposit outflows surfaced for a least some institutions. For example, State Street Corp. and M&T Bank Corp. deposits fells 3% from the fourth quarter while Charles Schwab’s deposits dropped 11%. State Street’s earnings per share (EPS) of $1.52 missed the analyst consensus expectation of $1.64 but earnings for M&T Corp. and Unity Bancorp. exceeded expectations. Other regionals with EPS that exceeded expectations included MainStreet Bancshares and FB Financial Corp.
Banks may be enjoying only a temporary tailwind, however. For the most part, portfolios of held-to -maturity bonds don’t appear to have impacted earnings significantly with yields having declined after a steady rise earlier in the quarter. The 10-Year Treasury yield, for example, climbed from a mid-January low of 3.37% to a high of 4.06% in early March, but has since declined to approximately 3.56%, helping to reduce the extent to which banks have had to write down their portfolio values.
Guaranty Bancshares, for example, reported that its securities portfolio value declined only 12.8% during the first quarter. In its earning statement, it maintains its conservative portfolio helped limit losses. On a positive note, the bank reported no credit loss provision for the first quarter after reporting a $2.8 million provision in the fourth quarter. The bank’s net income was $8.3 million, or $0.69 per share, which matched analysts’ expectations and was driven by $42.0 million in revenue. The results exceeded the $8.0 million, or $0.67 EPS for the final quarter of 2022. The most recent quarter’s results fell short of the year-ago quarter when the bank generated $10.7 million in earnings, or $0.89 per share. Results for that quarter, however, increased by the bank reversing a $1.3 million provision, higher interest income and lower non-interest expenses.
A Rocky Road Ahead
In recent months, it’s become substantially easier for businesses to find an office with a view of the Golden Gate Bridge with San Francisco’s office vacancy rate recently hitting an all-time high of 29.4%. In New York city, office vacancy rates have also soared, hitting 16% as businesses scale back their operations and work from home policies reduce the demand for cubicle clusters and conference rooms. Things could worsen. Investors are now pricing in an 87% chance of a 25 basis point hike to the fed funds rate in May, which could create more pressure on businesses and potentially support an additional contraction for office space demand. Warehouse demand is also weakening as goods purchases have declined significantly. The office and warehouse industries spell potential challenges for regional banks that as a whole have served as strong financiers to the commercial real estate asset class. Challenges could also extend to residential real estate. Approximately 10% of homeowners who purchased homes in the past year with financing currently have mortgages that are underwater and historically low affordability has pushed many potential buyers out of the market. At the same time, potentially higher interest rates could cause banks to increase their mark downs of held-to-maturity securities while they face higher costs for attracting deposits, as illustrated by firms such as State Street and Charles Schwab, who are struggling to retain existing deposits.
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Originally Posted April 18th, 2023 IBKR Traders’ Insight
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