OUTLOOK CLOUDED BY HEIGHTENED MACRO UNCERTAINTY
Global markets were off to the races in January with broad-based gains across equities, sovereign bonds, and credit. Investor risk appetite was boosted by a decline in energy prices, particularly in Europe, and the surprisingly fast reopening in China. Growing expectations that central banks might be nearing the end of their current rate hike cycle boosted risk assets, especially growth stocks. However, the rally reversed course as inflation readings remained high, leading investors to ramp up rate hike expectation and contributing to the whiplash of losses across asset classes. Uncertainty around inflation and Fed policy has led to a tug-of-war between risk-on and risk-off, even before serious vulnerabilities in the regional banking sector occurred in mid-March. Subsequently, long-term yields fell precipitously as rising risk aversion gripped markets.
Despite the sharp increase in market volatility, equities posted solid gains in the first quarter. Meanwhile, the U.S. 10-year bond yield, which was north of 4% in early March, fell. Gold benefited from elevated risk aversion and lower real yields, while credit posted modest gains. Commodities lagged other asset classes amid heightened recession worries, while emerging market equities fell slightly for the quarter as increased risk aversion offset the bump from optimism about reopening in China.
Slower credit growth, tightening financial conditions, and rising prospects of recession will likely have a material impact on equity sectors and styles with higher sensitivity to cyclical factors. These would include sectors like financials and consumer discretionary, as well as small-cap stocks. Likewise, value equities are traditionally aligned with the business cycle and would also be disproportionately affected by increasing risk aversion. While this seemingly makes the case for higher-quality areas of the equity market, valuations in that space have risen to levels that make them potentially unattractive.
LENDING STANDARDS MAY CONTINUE TO TIGHTEN
The failure of Silicon Valley Bank and two other U.S. regional banks, along with the shotgun wedding of UBS and Credit Suisse arranged by the Swiss National Bank, illustrate the old adage that “when the Fed taps the brakes, someone always flies through the windshield.” Global central banks and regulators have responded forcefully to the burgeoning crisis with the Fed opening the discount window and guaranteeing deposits at the affected banks in an effort to control contagion and stem sprouting systemic risks. Still, the risk of a full-fledged banking crisis remains, and additional flare-ups depend on whether the Fed will be successful in cutting off potential tail risks lurking in the banking sector and potentially the shadow banking segment.
Banks are likely to see the ongoing impact of higher rates on highly leveraged firms and on companies in interest-sensitive sectors such as real estate and consumer. Exposure to Commercial Real Estate (CRE) is a key risk, particularly for smaller banks that have a larger share of their loan books in CRE. While CRE has been under pressure since the pandemic due to climbing vacancies, high valuations, and rising interest rates, efforts by smaller banks to restructure their balance sheets in the current environment could result in slower credit growth and constitute an additional headwind to avoiding a recession in coming quarters.
The recent U.S. bank failures appear to be the result of a concentrated deposit base as well as classic mismanagement of assets and liabilities, rather than traditional banking loans going sour. While the efforts implemented by authorities were necessary to prevent an escalation of the crises, they are insufficient to permanently eliminate the vulnerabilities of small- and mid-sized banks if still-spooked depositors move their deposits to larger banks presumed to be “too big to fail,” and the credit quality of loan books deteriorates given the elevated risk of recession.
Historically, bank crises impact economies through disruption to payments, negative wealth effects, and sharply tighter credit conditions, resulting in significant contraction in economic activity. A Congressional Budget Office study estimated that the U.S. savings and loans crisis cut GDP by up to 0.6%. Lending standards to businesses and consumers have already tightened over the past few quarters, and any further measures by banks to shore up balance sheets could result in additional lending restrictions, which would adversely impact the economy.
The team is defensively positioned across multi-asset portfolios: overweight in cash and bonds and underweight on risk assets. U.S. equity market valuations still do not fully price in possible downside scenarios, and with an increased possibility of a tail-risk situation, the team expects equity risk premium to adjust as historically high earnings and profit margins likely deteriorate in an environment of increased economic risk. The team thinks non-U.S. equities have a relatively better risk-reward tradeoff, with China a possible bright spot given attractive market valuations and expectations of a pick-up in economic activity following post-COVID reopening and easing monetary policy.
Real estate remains a concern, especially within the commercial sector, which has to contend with expensive valuations and low occupancy rates. Banking sector stress could further tighten credit given the significant commercial real estate exposure in banks’ loan books. As a cyclical asset, commodities will likely struggle in the face of a broad economic slowdown. While China’s reopening is a positive, rising recession worries are contributing to near-term volatility. However, the team remains positive on this space in the medium to long term.
Should the risk-off market environment of the past several months endure, the U.S. dollar may temporarily resume its mantle as a safe-haven currency despite the recent large drop in yields and expectations of monetary easing on the horizon. The relative strength, however, will likely be against more fragile regions, such as Europe and commodity-centric currencies. Given the comparably safer banking environment in Japan, and the arguably even-safer haven currency of the Swiss Franc, the outperformance of the dollar will be mixed, and we remain secular dollar bears.
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