Markets slump Friday as investors grapple with banking fallout, rate uncertainty

Financial markets have flip-flopped all week as a global crisis in confidence over the banking sector has led to a dramatic shift in expectations for central banks’ fight against inflation, and has made a recession more likely.

The S&P/TSX Composite was down by less than 1% at mid-afternoon on Friday, weighed down by weakness in energy, financial and industrial stocks. U.S. markets were similarly in the red to cap a messy week of trading.

After the closures of Silicon Valley Bank and Signature Bank in the United States last weekend, fears over the financial system spread, sending bank stocks tanking Monday before markets recovered somewhat the next day.

On Wednesday, the flames were further fanned by European lender Credit Suisse’s latest problems, and on Thursday and Friday another bank joined in on the widening crisis, with the biggest U.S. banks coming to the rescue of First Republic Bank in an effort to prevent it from joining the ranks of SVB and Signature.

“The biggest market story of the week was the liquidity crisis in the regional banking sector,” said Lesley Marks, chief investment officer of equity at Mackenzie Investments.

As the week progressed, more contagion across the banking sector has led to a wider crisis in confidence, Marks said, though she noted that many of the issues causing concern at regional banks — less diversified business and lower regulation, for example — are not necessarily prevalent in the larger banks, which may even benefit in the long run from this week’s events.

Credit Suisse shares plunged Wednesday after the firm reported that managers had identified “material weaknesses” in its internal controls on financial reporting added to the crisis, said Marks.

Despite moves by larger banks and the U.S. government to protect investors and financial companies, markets haven’t yet found their footing, said Marks.

However, though bank stocks led major market drops on Monday, Wednesday and Friday, technology stocks told a different story throughout the week, helping lead index gains on Tuesday and Thursday.

Markets, which just over a week ago were anticipating the U.S. Federal Reserve would hike interest rates by up to half a percentage point at its next meeting, are now betting on a quarter-point hike or a hold — and some are even looking to potential cuts in the near future, though many analysts say that’s not realistic.

“I think that really highlights the historical significance of this liquidity crisis,” said Marks.

Market expectations can change on a dime, said Greg Taylor, chief investment officer at Purpose Investments, and this week they shifted dramatically.

While Taylor does think this week’s events could result in a more dovish approach by the Federal Reserve next week than previously anticipated, he thinks market expectations are probably overshooting it when it comes to rate cuts.

Marks agreed: “We still think that equity markets are not fully pricing in the increased risk to economic growth, and therefore earnings growth, for companies that exist as a result of the rapid increase in interest rates.”

However, this week’s events could slow inflation, said Marks, though she’s not sure yet whether there’s a silver lining to be had.

“I think that the markets are still priced for perfection and they’re not fully reflecting the outlook for the economy,” she said.

She said while cuts are marginally more likely after this week, the central banks are in a difficult spot as they try to focus on the inflation fight.

“They may move more cautiously than they otherwise would,” she said.

As for the Bank of Canada, which markets have also been suddenly speculating could cut this year, Taylor said the central bank may not want to diverge too much from what its U.S. counterpart decides to do.

“If the Fed keeps hiking and the Bank of Canada starts cutting, then that will crush the Canadian dollar.”

Taylor thinks the Fed will want to stay at their terminal rate for around six months to wait for the lagging effects of rate hikes to make themselves known.

But experts say the events of this week have made a recession more likely, after weeks of strong economic data had sparked hope that the economy could avoid a downturn altogether.

And that could change the dynamic for the Fed’s interest-rate plans, said Taylor.

“If you’re really looking for cuts, it’s probably meaning you’re looking for a recession,” he said.

Oil prices have also taken a hit, dropping below US$70 Wednesday over fears of a global slowdown that would curb demand.

“That was an indication of a pretty significant breakdown in price,” said Marks, adding that this week, she thinks oil prices have been a more realistic economic prophet than markets.