Tighter monetary policy induced the first near-systemic fallout in this cycle as runs on two regional US banks, SVB and Signature, as well as the forced sale of Credit Suisse to UBS, sparked a loss of confidence in the global financial system. As of this writing, authorities had staunched the bleeding of deposits by implementing a variety of measures aimed at ensuring liquidity and protecting depositors. But with fault lines emerging as a result of higher rates, a reassessment of the investment landscape is warranted. We think the economy and markets will face their biggest test in the coming months.
While the particulars of the bank failures may be idiosyncratic, recent events will still likely lead to tighter credit conditions and reduce business and consumer activity. At the same time, the transmission effect of the Fed’s unprecedented rate hikes has yet to fully work through the real economy. Uncertainty will predominate as policy decisions will require judgment calls based on economic dynamics not yet visible in the data. We believe a recession is now more likely and could happen sooner than we thought last quarter.
We expect volatility to remain elevated and risk assets to struggle. Thus, our broad asset class views remain somewhat defensive. We maintain our moderately underweight view on global equities, with current valuations reflecting an overly optimistic economic view. Given the risk of higher correlations across equity regions, we have adjusted our underweight view on Europe to moderately underweight and our overweight view on Japan to moderately overweight. We continue to favor China and Asian equity markets that are likely to benefit from China’s reopening as well as from lower-priced oil imports. Government bonds have rallied but we think there is further upside, especially in the US, given attractive yields and the likelihood that the Fed will pivot to cutting rates sometime in the second half of 2023 amid a US recession. Spreads have widened but not to levels that reflect recessionary risks. We maintain our underweight view on growth fixed income, especially in high yield and bank loans. We still have a slight overweight view on commodities but have shifted the focus from oil to gold.
The upside risk to our generally defensive view is a soft landing where the bank failures turn out to be isolated events thanks to central banks’ expanded balance sheets, credit tightens just enough to slow demand and inflation, the Fed avoids overtightening, and a recession is averted. This scenario is possible but unlikely, in our view. In fact, a seemingly benign outcome like this might just sow the seeds of a more entrenched inflation problem and a tougher challenge for central banks.
Equities: Valuations too high, but pockets of opportunity to be found
Our moderately underweight view on global equities is unchanged. So far, bank strains have largely had specific effects on bank equities and credit spreads rather than creating more generalized contagion across risk assets. As noted, however, we believe the probability of a recession has been pulled forward, with credit tightening likely to contribute to a contraction in lending as well as in corporate and consumer spending.
Valuations of about 15 times the 12-month forward P/E ratio1 for global equities and expected earnings growth in the mid-single digits over the next 12 months are still too high to suggest that a recession is the market’s base case. Moreover, valuations in equities are misaligned with those in the bond market — around 190 bps of rate cuts are reflected in the fed funds rate curve by the end of 2024, relative to where we are today.2
Valuation headwinds will be exacerbated if — as we expect — central banks are forced to choose between controlling inflation and combatting financial instability in an environment where inflation continues to run too hot for their comfort. Margins will be challenged by a still-tight labor market but now also by a slower economy. The recent jump in accruals (the difference between net income and operating cash-flow measures) also points to the risk of earnings downgrades and reduced buybacks. Recent guidance from companies has turned more cautious as shown in the S&P 500 negative-to-positive preannouncement ratios.
Within regions, we have the most favorable view on Chinese equities. We would expect consumer and private business spending to make up for the limited policy impulse. Business sentiment is improving, and consumer surveys show higher spending intentions across most income cohorts. Overall, we believe consensus expectations for growth in China this year are too low. Meanwhile, we think China’s low correlation to other regions makes it attractive from a portfolio construction viewpoint. The fact that the US dollar has not strengthened into recent banking turmoil is also helpful for China and EM ex-China relative performance.
In Japan, recent data shows a catch-up in services inflation, with wage negotiations resulting in the highest negotiated wage increase in 20 years. The global bond rally has given the Bank of Japan (BOJ) more breathing room when it comes to raising the 10-year yield cap.
In the US, we do not perceive direct risks from systemically important large-cap banks, but we are focused on possible cyclical impacts if companies face tighter lending conditions. Margin normalization and higher valuations relative to other markets (compared with what we have seen historically) also weigh on the US. Our reduced underweight view on Europe stems from recent improvements in macro conditions and the retreat in energy prices. Still, the region’s companies and economy are vulnerable to macro spillovers from tighter lending standards, which were signaled in the last European Central Bank (ECB) survey of credit conditions. In addition, core inflation continues to surprise on the upside, putting the ECB in more of a bind when it comes to the trade-off between inflation and financial stress.
Regarding sectors, we prefer defensive sectors such as utilities and staples, as well as natural resources equities. Technology has outperformed along with defensives on the back of falling interest rates. However, we expect more margin normalization after companies’ overinvestment during the pandemic. Banks are likely to face headwinds from an increase in funding costs, reduced profitability from balance sheet deterioration in particular sectors of the economy, and potential tightening of capital requirements for regional US banks (Figure 1). That said, amid market shifts and restructuring in the banking industry, there is room for winners and losers, creating potential opportunity for active managers.