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As of 14 March 2023
In a matter of days, the cumulative effect of US Federal Reserve (Fed) policy tightening has hit the US banking sector hard, beginning with the collapse of Silicon Valley Bank (SVB) on March 10.
Panicked depositors in several banks have since rushed to the exits, setting off a liquidity crisis and leaving some banks’ capital positions in precarious shape. The Fed and the US Treasury have taken swift steps to help stabilize the banking system by providing liquidity and assuring impacted depositors that they will be “made whole.” This past weekend, they unveiled several new facilities designed to ease the "liquidity crunch" and to prevent further bank runs.
However, growing investor concerns are sweeping the financial markets: Safe-haven assets have benefited, Fed rate-hike expectations have been all but extinguished, government bond yields are lower and credit spreads wider, and the US dollar (USD) has risen. Meanwhile, global equities are down, with small-cap stocks the big laggards so far.
The situation is evolving rapidly as we speak, as are the potential economic and market implications. At Wellington, we don’t always agree with each other, but we vigorously debate the issues and ramifications. Here are some key points from our latest internal discussions, highlighted by a common theme that there is now a greater probability of a US recession in the near term. Many of us also think investors should consider pivoting to a “risk-management mode” that favors higher-quality assets.
In the near term, I expect risk-off dynamics to dominate and less risky assets to outperform. Financials and other sectors tied to the economic cycle will likely struggle the most. I also expect large-cap stocks to outperform smaller-cap stocks and growth-style equities to outperform value in the short term. China and other Asian markets tied to China’s recovery are apt to outperform the US and Europe, in my view.
Longer term, I see investment opportunities. Notably, I think quality assets may still be rewarded over time — for example, large money-center banks that have ample capital and have been subject to stricter regulation than smaller banks. Also, some high-quality US fixed income assets may offer relatively attractive yields and total-return potential if the economy softens. A risk is that the Fed’s additional liquidity succeeds in averting a full-blown financial crisis but fans the flames of inflation, thus requiring more Fed rate hikes down the line. This is another reason I suggest favoring quality.
My bottom line: Until this all subsides, proceed cautiously, and be prepared to follow the “higher for longer” investment playbook for inflation and rates in your long game.
The speed and magnitude of the Fed’s “about-face” from easy to tight monetary policy was bound to expose firms caught on the wrong side of rising rates. That’s precisely what’s happening here, and with the broader financial system now caught up in the turmoil, systemic risks should not be taken lightly. However, the US banking system is generally strong, especially the large, well-capitalized banks, and US regulation is designed to deal with commercial bank failures. I believe the Fed and Treasury will respond decisively to avoid a worst-case outcome.
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