Two Ways to Monitor Economic Reality (October 22, 2023)

Fed SLOOS data and bank loan-loss reserves tell a different story than oft-cited loan growth. Market breadth is worth heeding.

By Lisa Beilfuss
October 22, 2023

The Wall Street consensus has swung back to predicting a soft economic landing. Investors should remain skeptical.

A recent survey by The Wall Street Journal showed that economists cut recession odds below 50%. This week, Praxis looked at two indicators that, together, suggest neither the economy nor the stock market is poised to land gracefully. First, the signal from bank-lending growth may be a false positive. Second, stock-market gains are masking deterioration under the service, as reflected in market breadth.   

On bank lending. Continued loan growth in the face of over 500 basis points in Federal Reserve interest-rate increases is one reason many strategists say a soft landing is likely.  

The latest weekly bank-lending data from the Fed show that bank loans and leases are still growing. But the pace of acceleration has cooled, with net loan growth lower than the pre-Covid average, notes Parker Ross, chief economist at Arch Capital Group. And while small banks are still lending, lending by large banks has stalled over recent months, says Cornerstone Macro’s chief economist Nancy Lazar.

What is more, fuzzy accounting may be flattering the data. 

First, consider the lead up to the Great Financial Crisis. Commercial and industrial, or C&I, loans reported on the aggregate balance sheet of the U.S. banking sector rose by about $100 billion from September to mid-October 2008. But the increase wasn’t driven by a rise in new loans, Harvard Business School professors Victoria Ivashina and David Scharfstein found. Instead, the increase was a result of businesses drawing down on existing credit lines. Based on news reports alone, the pair recorded credit-line drawdowns that accounted for roughly a quarter of the increase in C&I loans reported on bank balance sheets between September and mid-October 2008.

Second, as banks increasingly work with borrowers to renegotiate the terms of troubled loans, they may be “extending and pretending,” as Lazar puts it. It is unclear how many amended loans wind up classified as new loans. Lenders have significant latitude in amending loans to help borrowers avoid default, and in some cases banks would label the modified agreement as a new loan instead of a troubled debt restructuring, or TDR, says one former bank regulator. Banks may also defer foreclosure proceedings in hopes that the value of the collateral will rise prospectively in the face of interest-rate cuts. 

All that said, bank loans are a lagging macroeconomic indicator, says Lazar, making the measure more useful in confirming what we know to have happened than predicting what will happen. Better indicators are the quarterly Senior Loan Officer Opinion Surveys on Bank Lending (SLOOS) and banks’ provisions for loan losses.  

The Fed will report third-quarter SLOOS data in early November. The survey covers up to 80 large domestic banks and 24 U.S. branches and agencies of foreign banks. The second-quarter report issued in July showed that banks reported tighter credit standards and weaker loan demand from both businesses and consumers, and it showed that banks expect to further tighten standards over the rest of the year. 

While overall U.S. bank loans rose 4% in September from a year earlier, Lazar flags one specific SLOOS data point that she says leads loans by roughly six quarters. The net percentage of domestic banks reporting an increased willingness to make consumer loans was most recently negative 21.8 after a reading of negative 22.8 a quarter earlier–already a level that always signals recessions, according to Lazar.   

Banks’ allocations for loan losses are meanwhile rising. Data from the Fed Bank of St. Louis show that loan-loss provisions have risen 9.3% since the start of 2023, and they are 67% higher than pre-Covid levels. Bank lending doesn’t cool until well after lenders raise loan-loss provisions, Lazar says, adding that the pattern unfolding now resembles the runup to the 2001 and 2008 recessions.   

The stock market isn’t the economy, but the wealth effect is one reason many strategists point to market resilience as indication that a soft landing is likely. The S&P 500 is up 11% so far this year, but it is worth considering what is happening beneath the surface.

The percentage of S&P 500 stocks that are trading above their 200 day moving average is now just 33%, a year-to-date low, notes Warren Pies, founder of 3F Research. A market held up by a handful of stocks is inherently less stable than one with broad participation, he says, adding that outside of mega-cap tech the rest of the market is breaking down. “Entering earnings season, the market is more unstable than it was one month ago,” Pies says.

Rising interest rates have hollowed out market breadth, says Pies, adding that there will be no fourth-quarter rally without improving breadth and that there will be no improvement in breadth without rates “chilling out.” 

Put another way, when you remove the so-called magnificent seven–Apple (ticker: AAPL), Microsoft (MSFT), Alphabet (GOOG), Amazon (AMZN), Nvidia (NVDA), Tesla (TSLA) and Meta (META)--from the Russell 3000, the remaining 2993 stocks are down on the year, notes Jim Bianco of Bianco Research. 

The belief is that last year’s bear market ended on Oct 12, 2022, but “this looks more like a big bear market correction than the second year of a bull market,” Bianco says.

Soft-landing calls are based on various data points that are incomplete, misinterpreted or otherwise faulty indicators. Bank-lending growth and gains in major stock indexes are just two of them. Investors should continue to question Wall Street’s confidence in the Fed’s ability to sufficiently cool inflation without reversing growth–and in the stock market’s ability to fit that narrative.