- A 25bps hike with a view of further hikes and no rate cuts in the cards was the Fed’s message.
- Also, no need for immediate further rescue packages for the U.S. banking sector. The Treasury agreed.
- Markets did not appreciate these statements, fearing further banking troubles and eventually a recession. We are more sanguine.
Two weeks into troubled markets
Completing the second week of market routs evoked by banks in trouble, a quick take would be: 1. While the U.S. Federal Reserve (Fed) almost exactly copied what the European Central Bank (ECB) did last week, the market responded much more friendly to the ECB than to the Fed. 2. European banking troubles seem to have peaked for now as UBS’s takeover of Credit Suisse is considered a success, at least from a market perspective[1]. In the U.S., however, problems of (regional) banks (shrinking deposits, the cheapest form of funding) seem anything but fixed. Half of the banks from the KBW Bank index are down by more than 25% for the month.
While the Fed’s 25 basis points (bps) rate hike came in as expected by most, we believe it was a toxic mix of other ingredients that unnerved markets yesterday: 1. Treasury Secretary Janet Yellen’s refusal to provide “blanket” deposit insurance to U.S. banks. 2. Fed chair Jerome Powell’s refusal to pre-commit to any measures that would help ease the pain for regional banks, stressing the need to prioritize inflation-fighting. 3. The realization that any Fed rate cut may be a long way off, while economic cooling might come faster and more violent than hoped for. That’s at least what U.S. markets said by the end of trading: the S&P 500 down by 1.65% and 10y U.S. Treasury yields down 18bps.
We stick to our 12-month forecasts as we know (and knew when we made these forecasts) from history that stark rate-hiking cycles could lead. However, there might be some downside risk to our U.S. 2023 gross-domestic-product (GDP) growth forecast of 0.7% given the structural problems facing U.S. regional banks and given their importance in providing financing to local business, real estate and households alike.
Fed to deliver another 25bps hike in May and maybe another one in June
Fed meeting: not giving in to markets’ wish list
As we expected, the Fed raised interest rates by another 25 basis points despite the lingering uncertainties surrounding financial stability. Nonetheless, it indicated that the rate-hike cycle might come to an end any time soon, stating “some additional policy firming” may be appropriate instead of “ongoing increases.” Fed members also did not increase their median expectations of the terminal rate in 2023 but indicated to keep rates higher for longer. Members still judge the inflation risk to be on the upside despite the expectations of somewhat lower growth in 2023. The labor market’s increased resilience might explain this. For 2025, however, central bankers seem to be confident to be able to tame inflation.
In the press conference, Powell explicitly pointed to the effectiveness of their recent actions to support troubled banks. Just like the ECB, he made the distinction between macroprudential measures and interest rates. He also clarified that “some additional policy firming” was referring to their monetary policy tools and not to external factors like an escalation of financial stress. Nonetheless he admitted that credit tightening “in a way substitutes for rate hikes.”
Overall, it seems that the Fed is happy that financial conditions are finally acting on their behalf. To what extent remains to be seen. Despite this uncertainty, we think it is safe to assume that inflation remains the most prominent factor in the Fed’s reaction function. As Powell stated that further rate hikes will be very data dependent, we expect market participants to closely watch inflation and credit standards when assessing the most likely path of monetary policy. Our expectation is for the Fed to deliver another 25bps hike in May and maybe another one in June. The markets, however, expect three rate cuts before the end of this year already. We therefore leave the final word to Powell: “Rate cuts are not in our base case.”
Markets no longer in panic, but not bullish either
While U.S. markets didn’t really like what they heard yesterday, they are not in panic mode. Most equities are still up for the year to date and equity volatility (Vix) has come down over the past two days. But while the has only lost 1.4% so far this month, there was a lot more going on below the surface. Financials are down 12% for the month, followed by real estate equities (-9%), while tech is up 6% on average[2]. With financials now only accounting for 10% of the market cap of the S&P 500, compared to 20% twenty years ago, tech stocks were able to save the month. In Europe, real estate is the loss leader of the month (-14%) followed by banks (-13%), while tech is only up 1%. Gold is off its month’s high, but only slightly, while Brent oil, trading at 76$/b (down 8$/b for the month), also doesn’t show much confidence in GDP growth.
Asset-class implications
We stick to the general economic picture of GDP growth slowing in Europe and reversing in the U.S. before starting a mild recovery sometime in the second half of the year. We also stick to our constructive view on most asset classes on a strategic 12-month’s view. We are aware of the threats to our core scenario as it is still not foreseeable what kind of negative dynamic the U.S. banking sector might still develop – and what other risks are looming on the horizon (Ukraine, Taiwan).
Fixed Income & Currencies:
After the ECB and the Fed delivered in line with our expectations, we stick to our view that sovereign-bond yields still have some room to rise this year. More on the longer end than on the shorter end, leading to a steepening of the yield curve. We have become more positive on European corporate investment-grade (IG) bonds after the UBS takeover of Credit Suisse took the heat out of the market. High-yield (HY) bonds, however, might remain volatile for a while as investors are reassessing their default expectations in case of growing recession fears. On a total-return basis, we still consider this to be an attractive asset class in the longer term.
The dollar has, to the surprise of some, not been a winner of the recent market turmoil, while the Japanese yen proved to be the go-to currency in risk-off times. We do not expect this pattern to change, while it might moderate somewhat.
Equities:
Increasing recession fears and increasing cost of capital for some are weighing on stocks, as are peak margins and the investment alternative in the form of fixed income. Our key equity calls from the last CIO Day[3] (early March) remain unchanged, however. Our index targets offer some 7% total return from here on average over the next 12 months while we expect volatility to stay with us. We stick to our preference for 1) Europe, especially small and mid-caps, 2) Emerging Markets and 3) the communication services sector.
From a shorter-term perspective we are avoiding undercapitalized companies. As for financials, we believe the outperformance of the European sector is set to continue. In the U.S., we think small banks will remain challenged with big profitability pressures. For any bank, the fair cost of debt and equity is very uncertain right now. Still, we are confident that the biggest of the U.S. banks will be able to strengthen their market share.
Alternatives:
Small banks are important players in real-estate financing and development. Should recent events lead to decreased lending activity in this space, it could lead to lower supply and therefore increased real-estate valuations. On the other hand, if startups were to go out of business this could create more supply of commercial real estate.
Given markets’ lower expectations on global GDP, we expect the oil complex to remain under pressure. There has been little production response to the lowered oil price thus far, so we think that markets will focus on the reaction of OPEC+R for further directional guidance in the near term.
Base metals were lower and precious metals, especially gold, were higher as macro investors focused on the negative impact from credit tightening due to the banking concerns. In our view, metals will likely remain volatile as they digest the possibility of a weaker growth outlook during significant uncertainty given the interaction of path-dependent fundamentals with government and central-bank reaction functions.
