Summary

1.Banking stress does the Fed’s job for it: it is too early to declare that the US regional banking stress is over. But US and Swiss central banks have acted decisively to address liquidity issues in the banking system. Tighter credit conditions will achieve slower demand and thus slower inflation, the latter being the Federal Reserve’s ultimate goal.

2.Key indicators to follow: we watch the MOVE index of US bond volatility, the XLF US financial sector ETF and the US CMBS commercial mortgage-backed securities index for signs of further stress or stabilisation. Lower bond volatility and a stable financial sector would be potentially a positive sign for stocks and credit.

3.Liquidity remains the key motor of financial markets: in recent months, China and Japan have boosted global aggregate liquidity. Now, the US Federal Reserve has begun to expand its balance sheet to support the banking sector. Post the fall in global liquidity over 2022, today’s improving liquidity supports financial markets.

4.Conservative investors – investment grade credit still offers attractive yields. We favour short-duration euro and US IG credit given that today they offer the highest yields (4.2%, 5.1%) since 2012 and 2009 respectively.

5.Dynamic investors – European insurance sector. Insurance companies have seen profits grow on higher inflation rates via higher insurance premia, and also from high demand for long-term savings products from cash-rich households. Favour European insurers, offering high dividend yields and strong balance sheets.

Key Calls: No big changes - still prefer stocks, IG Credit, Commodities

Asset class views: Positive on equities, Neutral on government bonds and Positive on investment-grade credit, Positive on alternative assets including commodities, Neutral on real estate.

Changes in view: we downgrade short-term government bonds to Neutral post the substantial rally over the last two weeks (US 2Y Treasury yield at 3.9%, German 2Y yield at 2.5%).

Flight to safety has boosted the gold price to around USD2000/oz. We remain Positive on gold for the medium to long term, but for now we would take partial profits after a 9% rally since 8 March.

Quality in equities: we retain our preference for Europe, UK and Emerging Market geographies.

In terms of investment style, we now prefer Quality, given the fall in long-term interest rates and the greater near-term economic uncertainty.

Lower stock  indices, high volatility and elevated dividend yields increase the attractions of equity-linked capital guaranteed structured products.

Short duration in investment grade credit: at this point we like short-maturity euro and US IG credit, given the risk that longer-term rates move back higher. 

What has the current banking stress really changed?

Slowing economy to slow more

The US regional banking stress is clearly not over, following the failure of Silicon Valley Bank (SVB) and Signature Bank. Client deposits at regional banks continue to fall as households and businesses put their cash on deposit at larger nationwide banks, or into money market funds that yield 4.7% gross on average.

While up to now, US authorities have acted quickly to support the US banking system via increased liquidity (the Federal Reserve’s balance sheet has increased by USD300bn over the last week or so) and by guaranteeing deposits at SVB, more action may be needed to prevent more stress at regional banks.

Credit conditions to tighten even more

Even before these latest regional banking failures, US credit conditions had been tightening on the back of higher interest rates and greater caution in lending by US banks, according to the Federal Reserve’s Senior Loan Officer survey. It is inevitable that credit conditions will tighten even more over the next few months, as regional banks, in particular, will have to maintain high levels of liquidity, implying lower lending. Lower credit availability leads to lower growth.

In essence, these tighter credit conditions will do the Fed’s work for them in slowing economic growth and thus also slowing inflationary forces. Ultimately, this combination of the lagged effects of interest rate hikes and tighter credit conditions should cool demand, and thus inflation. This, in turn, should allow for lower short- and long-term interest rates in the near future. 

Financial stress is contained for now

The Office of Financial Research’s financial stress index remains far from the peak levels of stress observed in 2020 at the time of COVID lockdowns, or in 2008 during the Global Financial Crisis. We should try to keep a longer-term perspective here: while the banking ghost of 2008 still looms large in investors’ memories, the reality is somewhat different.

The 1980s US savings & loans crisis saw over 200 banks shuttered per year over the decade, with over 90 banks shuttered per year in the 1990s. In 2008 and 2009, US bank failures averaged 150 per year. In contrast, since 2021 we have seen a total of 6 US bank closures thus far, averaging just 4 per year.

Watch bond volatility, real estate, financial sectors

The issue of deposit outflows from regional banks will continue to be an issue for the US bank sector in the near term. We watch the commercial mortgage-backed securities (CMBS) market for signs of emerging stress in refinancing of US commercial real estate – where US regional banks have heavy lending exposure. For now, the CMBS market is relatively stable, suggesting that regional bank stress has not spread to commercial real estate thus far.

We also watch closely for signs of easing bond market volatility (monitoring the MOVE index of US Treasury bond volatility). Now that the Federal Reserve has arguably reached the end of its interest rate hiking cycle at 4.75-5%, we can hope to see easing volatility in Treasury bonds, which should then calm volatility in the stock and currency markets. 

Macro and FX Outlook

Slower growth but signs of resilience

Central banks have taken strong and coordinated actions to contain the current banking crisis and avoid a domino effect. Consequently, the risks of a systemic impact on consumer and business sentiment have fallen. Consumer confidence has been mainly driven by inflation uncertainty and the strength of the employment market.

We keep our assumption of a sustained fall in inflation over the coming months. Economic activity and the job market should cool down as a consequence of the central bank interest rate hikes. Unemployment should, however, remain low compared with long-term averages.

However, it is likely that banks will become more risk averse and tighten their credit conditions owing to the recent turbulence. A temporary recession in the US in the second half of this year is our base-case scenario. In the eurozone, economic activity is expected to slow further but a recession could be avoided. 

Temporary dollar strength

The EURUSD (value of one euro) temporarily broke through 1.09 on 23 March. The banking turbulence led to an important change in market expectations for the path of US interest rates versus the eurozone. The main central banks have taken strong and coordinated actions to contain the crisis and avoid a domino effect. As a consequence, the risk of a systemic impact is much lower.

Once the uncertainty fades, bond yields should rebound as the fight against inflation will entail more rate hikes. The Fed should reach its terminal rate in May (at 5.25%) while the ECB will probably make another hike of 50bp at its next meetings. We expect the ECB to wait until early 2024 before cutting rates, following on from the Fed. The combination of lower inflation and a recession in the second half of the year could lead the Fed to cut as much as 200bp in 2024. The ECB would follow in its footsteps but cut by a small amount.

We keep our 3-month and 12-month targets unchanged at 1.06 and 1.08 respectively. Medium term, we see more downside for the US dollar.

Investment Conclusion

We keep our assumption of a sustained fall in inflation over the coming months. It is likely that banks will become more risk averse and tighten their credit conditions following the recent turbulence. A temporary recession in the US in the second half of this year is now our base-case scenario. In the eurozone, economic activity is expected to slow further but a recession could be avoided. We keep our EURUSD 3-month and 12-month targets unchanged at 1.06 and 1.08 respectively. Over a longer time horizon, we could see more downside for the US dollar. 

Central Banks: nearing end of cycle

Central Banks: nearing end of cycle

Global hiking mode: central banks around the world are still in a hiking mode so far this year given persistent inflation concerns. Only a handful of frontier market central banks have cut rates. But the tone of central bankers in developed countries has softened amid the banking crisis, suggesting policy rates are approaching their end-of-cycle rates.

Banking instability: the bankruptcy of three US regional banks in early March, followed by the collapse of Credit Suisse in Europe, has raised concerns about financial stability. Central banks in the US, the eurozone, Switzerland, the UK, Japan and Canada addressed this issue with a strong and coordinated action to contain the banking crisis, avoid another bank run or a domino effect.

Different tools: central banks have different instruments at their disposal to tackle different issues. Central banks can keep rising rates to curb persistent inflation, while using macro prudential tools to ensure financial stability.

Global hiking mode: central banks around the world are still in a hiking mode so far this year given persistent inflation concerns. Only a handful of frontier market central banks have cut rates. But the tone of central bankers in developed countries has softened amid the banking crisis, suggesting policy rates are approaching their end-of-cycle rates.

Banking instability: the bankruptcy of three US regional banks in early March, followed by the collapse of Credit Suisse in Europe, has raised concerns about financial stability. Central banks in the US, the eurozone, Switzerland, the UK, Japan and Canada addressed this issue with a strong and coordinated action to contain the banking crisis, avoid another bank run or a domino effect.

Different tools: central banks have different instruments at their disposal to tackle different issues. Central banks can keep rising rates to curb persistent inflation, while using macro prudential tools to ensure financial stability.

The Fed raised rates in March as expected, to 5%. The statement suggested the need to raise rates less than initially expected, since the recent banking crisis will likely lead to a tightening of credit conditions, that will have the same effects than rate hikes. We expect the Fed to stop its hiking cycle at the next meeting in May, with a policy rate of 5.25% and to maintain that rate throughout the year.

The ECB lifted rates in March, as expected, to 3% for the deposit rate. The next moves will depend on multiple factors, notably inflation, the effectiveness of the transmission of monetary policy and the stability of the financial system. We still expect a 25bp rate hike at each of the next two meetings (May and June), and an end-of-cycle rate of 3.5% in June.

The Bank of England hiked rates to 4.25% and has reached the end of its tightening cycle, in our view.

Other central banks also raised rates this week, notably in Switzerland, to 1.5%.

Investment Conclusion

The major central banks have kept hiking rates in response to the persistent inflation. That said, the tone of central bankers has softened amid the banking crisis, suggesting that policy rates are approaching their end-of-cycle rates. We expect the Fed to end its tightening cycle in May with a rate of 5.25%, and the ECB in June with a deposit rate of 3.5%. The Bank of England has reached the end of its tightening cycle, in our view.

Investment opportunities amid volatility

Conservative investors: IG Credit

Investors who are concerned about a looming US and European recession are understandably unwilling to invest in risky assets, such as stocks.

Based on our macro scenario of a modest recession in the US in the second half of this year, plus the prospect of falling inflation rates, investment grade corporate bonds look an attractive solution.

Firstly, the yields in this asset class are at their  highest since 2009 for US credit and since 2012 for eurozone credit.

Secondly, the risk of rising defaults from this asset class seems limited, given our expectation of only a modest US recession and the potential for the eurozone to just escape recession. Recall that historically, investment-grade bonds have witnessed a low default rate compared with non-investment grade bonds. According to Moody’s, the average default rate for investment-grade issuers is under 0.1% and under 1% over a one and five-year period respectively.

Prefer short-duration corporate bonds

Given that the extra yield for investing in longer duration credit (5-10 years) over short duration (1-5 years) is so low today at under 0.2%, we prefer shorter duration IG credit exposure.

Conservative investors – investment grade credit still offers attractive yields. We favour short-duration euro and US IG credit given that today they offer the highest yields (4.2%, 5.1%) since 2012 and 2009 respectively. 

Dynamic investors: insurance stocks

The European and US insurance sectors have been steadily outperforming the broader European and US stock markets since mid- to late-2021. On a fundamental basis, this is thanks to the ability of property & casualty insurance companies to raise insurance premia as inflation rates have increased, and for life insurance companies to offer increasingly attractive long-term savings plans as bond yields have risen.

The result of this exposure to inflation and bond yields has been steady growth in sector earnings per share, with double-digit growth in earnings and book value forecasts both for this year and for 2024. Shareholder returns have also increased in a similar fashion, with the STOXX Europe Insurance sector offering a generous forecast dividend yield of 5.9% matched with high single-digit dividend growth forecasts.

Over the last couple of weeks, European and US insurance companies have seen their share prices suffer in concert with the heavy drop in US and European banks on the back of the US regional banking and Credit Suisse stress. We see this as a buying opportunity for  a sector that has outperformed the European stock market over the long term and also over the past year.

Dynamic investors should look at the European insurance sector for solid income potential, inflation hedging and as a way to benefit from the buying opportunity triggered by the current banking stress, which has seen insurers lose 8% in less than 2 weeks. 

Asset classes to avoid

Concerns about US office Real Estate debt

The US office real estate market has enjoyed strong performance since 2010, generating a 7.5% average annual return since 2010. However over the last few months, pressure has mounted on this segment of US real estate owing to the following reasons:

1. Office vacancy rates remain relatively high in key regional office markets such as New York, San Francisco and Chicago on the back of a slow return-to-office trend and rising layoffs in the technology and finance sectors.

2 .Cost of debt refinancing has tracked 10-year Treasury bond yields higher, rising from a low of 0.5% in mid-2020 to 3.3% currently.

3. US regional banks have provided a disproportionately high amount of debt financing to the US commercial real estate market, but are now likely to reduce risk in their loan books given the stress on their liquidity in the wake of the failure of Silicon Valley Bank.

The resulting revaluation of listed office REITs has been dramatic, with a 36% drop in office REIT share prices since early February. While unlisted real estate funds have also started to see a drop in valuations (the NCREIF office property index dropped 4.8% over Q4 2022), there is likely still much further for unlisted real estate fund net asset values to fall.

It is too early to look at unlisted US office real estate exposure; we prefer other geographies and other segments, such as hotels.

US high yield Credit: spreads too tight

Since 2008, US high yield (HY) credit spreads have averaged 5.4% over equivalent maturity US Treasury bonds. At present, this US high yield spread stands at only 5.1%, far from previous spread peaks reached in 2008, 2016 and 2020.

We expect the US economy to experience a modest recession in H2 (this year), suggesting that default rates in the high yield universe should rise from the trailing 12-month default rate of 1.5% as of February.

Fitch Ratings expect the US high yield default rate to rise to 3.0%-3.5% by the end of this year, close to the 2001-2022 average default rate of 3.6%. S&P Global are more cautious, forecasting a more expensive cost of refinancing plus weaker corporate earnings to take this default rate to 4% by end-2023.  A third credit rating agency, Moody’s, is more pessimistic still. They expect a 4.4% US HY default rate by end-2023.

But this is only part of the story. As well as default rates, we need to consider the average recovery rate in the event of a HY bond default. While historically this has averaged 40% of the principal bond amount, the risk is that the number  of structurally weak “zombie” companies has increased in the high yield universe over time, due to zero interest rate policies. Future recovery rates could thus be lower than 40%, suggesting that high yield spreads should then be higher to account for this additional risk.

We prefer the risk/return profile of short duration US investment grade credit to US high yield credit.