Rarely has there been so much uncertainty about the direction of the business cycle. Economists who have been predicting a recession for 12 months and debating whether the U.S. economy would suffer a soft or hard landing began kicking around the idea of “no landing” in February.

Then, after three banks with questionable business models went bust in mid-March, the conversation transitioned to the prospect of a crash landing. Contractions in the credit markets have revealed fragility in the system. But is this 2008 all over again? To many, those comparisons fall flat.

Still, for pandemic-exhausted investors longing for a return to normalcy and an end of this bear market, March provided another melancholy jolt.

The Treasury Department’s quick decision to backstop all bank deposits temporarily quashed bank runs at two recently collapsed institutions, Silicon Valley Bank and Signature Bank. The third collapse was Silvergate Bank. SVB specialized in providing financial services to the venture capital and technology industries, while Signature and Silvergate had huge exposures to crypto. The rescue has raised a series of larger questions about consumer confidence and the possible restructuring of the regional banking industry.

Some of the smartest minds were quick to remind folks that the rocky part of the cycle wasn’t anywhere near over. Liz Ann Sonders, Charles Schwab’s managing director and chief investment strategist, told advisors that the rolling recession was likely to continue along with ongoing market volatility. Sonders, who was correctly bullish on equities from 2009 to 2018, had said earlier that the current bear market probably hasn’t touched bottom.

In his annual letter, BlackRock CEO Laurence Fink urged the Federal Reserve not to let the bank failures cause it to back down from raising interest rates. Fink said what others are starting to realize—that inflation may fall to the 3.5% or 4.0% area and then remain there for longer than markets anticipate.

Others were slightly more optimistic. “Inflationary pressures ahead most assuredly will decline now, and the Fed, in our view, is most assuredly now on hold with further rate hikes,” observed Stephen Auth, chief investment officer for equities at Federated Hermes. “A significant tightening of credit conditions across the economy seems likely. While the initial regulatory response was probably sufficient to stave off a panic, it certainly will have a sobering effect on lending activities at all banks in the near future.”

Whether the economy can dodge a recession remains an open question. As of mid-March, the Atlanta Fed’s widely respected GDP Now estimator forecast 3.2% growth for the first quarter, though its model includes little post-March 10 data.

A Rolling Recession
Advisors seeking historical parallels might want to revisit the rolling recessions of the mid-1980s. That era was characterized by a strong labor market and by inflation that was subdued but refused to die. There were also persistent problems in the banking and savings and loan world. But at the same time, tax cuts and robust government spending left consumers flush. In 1985, corporate profits decelerated, but GDP stayed positive, and eventually the business cycle resumed its expansion.

Richard Fisher, the former president of the Federal Reserve Bank of Dallas, told CNBC that the Silicon Valley Bank failure reminded him of the collapse of Penn Square Bank in July 1982. That Oklahoma City bank was the nation’s sixth largest after it grew rapidly during the 1970s energy boom, only to fail when the oil industry headed south. Whether it was SVB this year or Texas banks in the 1980s, regional lending institutions are inevitably more reliant on a small handful of local industries, some of them highly cyclical.

During the pandemic, excesses in the economy were concentrated in Silicon Valley, Wall Street and crypto. It shouldn’t be surprising that the recent bank failures, at least so far, have also been located in these regions. Could troubled commercial offices loans be next?

Another similarity with the 1980s is the rapid rise in interest rates and the ensuing duration mismatch crisis at financial institutions. SVB and Signature are just two of many banks sitting on huge losses caused by rising rates in their bond portfolios (though initial reports indicate their asset-liability management was particularly egregious).

It’s worth noting that Paul Volcker, the chairman of the Fed in the ’80s, didn’t raise rates at the same speed the current chair Jerome Powell has over the past 12 months. Many among his growing legion of critics believe Powell has been overcompensating for a decade of reckless near-zero interest rates, a policy he continued even in the face of resurgent inflation. The Fed is also getting hammered for lax oversight. Now some fear if it keeps raising rates the banking system could turn into a china shop.

It’s too early to discern exactly what all these recent events mean for regional banks or the financial system. But the lending availability at many traditional banks since the financial crisis has been slowly declining. Just witness the rise of private credit and a shadow banking system. Last year, Wells Fargo announced it was exiting the mortgage business, and the trio of bank failures in March are likely to push borrowers into the arms of non-banking entities. Demand for mortgages and other loans no doubt has fallen as interest rates have climbed in the last year. But if the banking industry grows even more cautious and lending activity continues to move to opaque, fragmented private credit markets, the cost of debt for companies and consumers alike is likely to rise. Entities offering private financing also probably won’t be paying for increasingly expensive deposit insurance, which could be spread across fewer banks if there is a wave of regional consolidation via shotgun marriages.

Redefining Bank Runs
America’s ever-increasing reliance on industry bailouts in the two decades since September 11 has also renewed questions about moral hazard. Customers withdrew $42 billion in deposits from SVB in a single day, when it took them two weeks to remove just $16 billion from Washington Mutual in 2008. That shows how bank runs have become increasingly dangerous in an instant-information world.

Bankers and politicians can be expected to reopen a debate on whether $250,000 in deposit insurance is sufficient. What if an 85-year-old wants to park $750,000 in life savings? It’s a lot to ask that they comprehend the fine print on a bank deposit agreement.

When it came time to rescue SVB, Signature and Silvergate, a consortium of large Wall Street banks said no. However, they did agree to invest in another imperiled institution, First Republic Bank, for reasons we may soon learn.

After the three banks collapsed, bitcoin and technology stocks rallied, prompting old-school fundamentalists to decry what they see as rewards for bad behavior. Miraculously, bitcoin has managed to rally for most of the last six months even as one pillar of the crypto ecosystem after another has vaporized, sometimes in a disgraceful fashion that exposed the “fake it until you make it” motto of many crypto players.

That should justify ongoing vigilant skepticism.