Investors' top concerns in March were related to the state of the financial sector. The turmoil that erupted in the wake of the failures of SVB and Signature Bank undermined market sentiment and forced policymakers to take urgent action to restore confidence. Days later this was followed by news that UBS would take over its ailing rival Credit Suisse in an emergency rescue deal. The concerns led to one of the sharpest corrections in short-term government bond yields since the 80s, with investors expecting that the banking sector problems would lead to an early end of the interest rate hiking cycle. The yield on the 2-year US Treasury note ended the month at 4.03%, more than 1% lower compared to the high before to the banking turmoil. US Treasuries gained 2.9% in March, while the Bloomberg Pan European Aggregate Bond Index rose 1.9%. Similarly, gold benefited from a flight to safety, falling real interest rates, and a weaker US dollar and ended the month just below $2000/oz. WTI crude was down more than 16% to a 15-month low before it started a significant recovery rally on the back of the surprise announcement of production cuts by the OPEC+ (-1.8% for the month).
The confidence that regulators' prompt response was sufficient to avert a full-blown banking crisis was evident in the advance of equity markets in March. The MSCI All Country World Index delivered a total return of 3.1% for the month. Information Technology performed particularly strongly during the recent bout of bank stress as investors have started to anticipate lower yields. However, the tailwind from falling Treasury yields for these long-duration stocks could easily morph into a headwind over the coming months if markets start pricing in Fed rate cuts in the second half of the year. From a regional perspective, China was the best-performing market in March, returning 4.3% amid a surge of optimism on future growth. The Swiss (defensive) and the UK stock market (value), on the other hand, both lagged in performance.
The threat of inflation persisted even as the banking sector crisis got underway. US monthly core CPI inflation rose 5.5% on a 12-month basis. In the Eurozone, annualized core inflation increased to 5.7% in March. Both, the FOMC and the ECB decided to proceed with interest rate hikes of 25 and 50 basis points respectively in March. However, during his press conference, Fed Chair Powell acknowledged that the latest developments “are likely to result in tighter conditions for households and businesses and to weigh on economic activity, hiring, and inflation.” When pressed to quantify the impact of tighter credit standards, Powell said “I don’t know”. For the first time in decades, central banks must not only walk a tightrope between containing inflation risks on the one hand and accepting recession risks on the other - but increasingly also strike a balance between ensuring inflation credibility and financial stability. Tighter credit conditions will ultimately harm economic growth, but how soon and how much are the tricky questions.
Central banks continue to fight overheated labor markets and above-target inflation, and as such, financial markets have been pricing a higher probability of a hard landing for the economy. The steep decline in government bond yields over the past few weeks along with nearly 100 bps of implied Fed rate cuts by year-end indicates the bond market is pricing for a US recession in the second half of 2023. While wider credit spreads and a lower oil price embed a fair amount of recession risk too, an S&P 500 at 4.100 is more consistent with a “soft landing” scenario.
While the global economy may continue to perform better than expected in the short term, we anticipate that the lagged effects of tighter monetary policy and stricter bank lending standards will ultimately be working their way through the economy. The Atlanta Fed GDPnow model estimate for first quarter US growth is 2.5%-3%. Since the Fed growth projection for the full year is +0.4%, this means that the FED is assuming negative growth for the next few quarters. While timing is difficult, the safe conclusion for investors is, that the risk of a moderate US recession has gone up for the second half of 2023.
Markets may get a reprieve if the banking stress subsides. Until inflation does as well, the Fed and the ECB will not pivot unless growth is worse than their forecast. Amid this backdrop, we expect global stocks to offer modest returns over the remainder of the year. We remain underweight equities, particularly in the US, where the adverse consequences for growth are likely to be greater than in other regions. Within fixed income, we have a preference for high grade debt and shorter maturities.
Please find attached our last Asset Allocation Update for April.