Mike Wilson: Not All Bank Reserves Are Created Equal

Recent increases in the Fed’s balance sheet may not have the same impact on money supply, growth and equities as in previous cycles.

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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, April 3rd at 11:30 a.m. in New York. So let's get after it.

Over the past month, market participants have been focused on how the government will deal with the stress in the banking system and whether the economy can withstand this latest shock. After a rough couple of weeks, especially for regional banks, the major indices appear to be shrugging off these risks. Many are interpreting the sharp increase in bank reserves as another form of quantitative easing and are exhibiting the Pavlovian response that such programs are always good for equity prices. As we discussed in prior podcasts, we do not think that's the right interpretation of this latest increase in the Fed's balance sheet.

In our view, all bank reserves are not created equal. True money supply as a function of reserves and the velocity of money which is difficult to measure in real time. As a comparison, inflation did not appear after the first wave of quantitative easing used during the great financial crisis because the velocity of money simultaneously collapsed. This was despite the fact that the percentage increase in the Fed's balance sheet dwarfed what we experienced during COVID. The primary difference was that the increase in reserves during the great financial crisis was simply filling holes left on bank balance sheets from the housing crisis. Therefore, the increase in reserves did not lead to a material increase in true money supply in the real economy. In contrast, during COVID, the increase in reserves are pushed directly into the economy via stimulus checks, PPP loans and other programs to keep the economy from shutting down. However, these fiscal programs were overdone and the result was money supply moved sharply higher because the velocity of money remained stable and even increased slightly.

During this latest increase in Fed balance sheet reserves, the total liabilities in the US banking system have continued to fall. This suggests to us that the velocity of money is falling quite rapidly, more than offsetting the increase in bank reserves. In fact, these bank liabilities are falling at a rate of 7% year-over-year, the biggest decline in more than 60 years. Even during the Great Financial Crisis, money supply growth never went into negative territory. The kind of contraction we are witnessing today suggests this is not anything like the QE programs experienced during COVID or the 2009 to 2013 period. Secondarily, it also means that both economic and earnings growth are likely to remain under pressure until money supply growth reverses.

This leads me to the second part of this podcast. Year to date, major U.S. stock indices have performed well, led by technology heavy NASDAQ. This is partially due to the snap back from such poor performance last year, led by the NASDAQ. But it's also the view that unlevered, high quality growth stocks are immune from the potential oncoming credit crunch. It's important to note that the rally to date in U.S. stocks has been very narrow, with just eight stocks accounting for 80% of the entire returns in the NASDAQ 100. Meanwhile, only ten stocks have accounted for 95% of the entire returns in the S&P 500, with all ten of those stocks being technology-related businesses. Such an erroneous performance is known as bad breadth, and it typically doesn't bode well for future prices.

The counterargument is that technology already went through its own recession last year and it's taken its medicine now with respect to cost reductions and layoffs. Therefore, these stocks can continue to recover and carry the overall market, given their size. We would caution on such conclusions, given the increased risk of a credit crunch that suggests the risk of a broader economic recession is far from extinguished. Recessions are bad for technology companies, which are generally pro cyclical businesses. Instead, we continue to prefer more defensive sectors like consumer staples and health care.

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