Investment Strategy Insights: Banking on a Recession, Not a Crisis

Stance: Recent turmoil in the banking sector serves as a stark reminder of financial tightening’s possible consequences. While financial instability creates a potential path toward recession, regulators have taken action to mitigate the likelihood of contagion. The medium term, however, may see a further tightening of lending standards, either through self-imposed measures or regulation, which already is quite stringent. Meanwhile, the economy has slowed somewhat since January but remains robust. In February, the Consumer Price Index increased at a rate of 6.0% year over year (y/y), as expected, but the Producer Price Index showed signs of disinflation and supply chain normalization, rising only 4.6% y/y, down from 6.0%. Despite a somewhat softer US labor market in January, data on initial jobless claims, JOLTS job openings, and nonfarm payrolls surpassed expectations and suggest continued strength. In China, recovery remains a standout story, with reopening efforts on track and few concerns about a wobble in first-quarter data.

Outlook: Despite firmer domestic economic data and China’s solid reopening, financial stability concerns are growing. While contagion is unlikely, signs point to a recession in the second half.

Risks: 1) Inflation falling faster than expected or the Fed looking through services inflation and pivoting earlier; 2) systemic problems in Europe or the US; 3) more resilient economic fundamentals across Europe and the US.

The banking system is in survival mode, and we anticipate liquidity pullbacks in every area of banking. Meanwhile, volatility is unprecedented and won’t let up anytime soon. The two-year began February at 4.04%, shot up to 5.08% before the month ended, then rocketed down to 3.64% on March 20. That’s a 13-Sigma event, or a move of 13 standard deviations! Meanwhile, the Fed is in the ultimate pickle, as attempts to stop inflation rattle the banking system. The highest-yielding point on the Treasury curve is the fed funds rate. If banks borrow from the Federal Home Loan Banks, there is no Treasury security or agency mortgage-backed security (MBS) that yields more than fed funds. So, banks borrowing money means banks lose money. The Fed’s repo solution poses the same problem. On the other hand, inflation is still 6%. Printing money and making it cheaper through rate cuts will not stem the tide of inflation.

The blow to confidence in the banking system due to regional bank failures and the takeover of Credit Suisse has not completely abated, but the many “bailout” actions have substantially reduced contagion risks. Furthermore, the market’s expectation of future Fed rate hikes has fallen. In the wake of these developments, however, credit spreads have widened to levels that warrant an improvement in our CS despite the emergence of additional macro risks. While valuations are far from cheap relative to recession/systemic risks, they are sufficient to reduce the substantial underweight in risk levels across many portfolios. With yield curves also declining substantially, particularly on the short end, fixed-rate credit prices have been reasonably stable despite the spread widening. High yield (HY) spreads briefly breached +500 levels, and investment grade (IG) spreads have widened to the +150 area. At these valuations, our prior preference for IG versus HY has diminished. While floating-rate credit spreads also have widened, the differential compared with fixed spreads has compressed, resulting in a more neutral stance.

The tug of war between “higher for longer” and “monetary policy acting with a lag” likely will generate higher volatility in the short term. Volatility should subside, however, once US growth and inflation slow, dampening Fed hawkishness. Continuing concerns about the banking system may increase short-term volatility, sending global risk markets into a higher volatility regime, which typically is painful for equities and risk assets while benefiting the US dollar. Since the US was the epicenter of the recent financial sector instability, and the US dollar’s status as an equity volatility hedge has been eroded, the euro may wind up the winner in the banking turmoil. Rate differentials remain key for currencies. The European Central Bank (ECB) is likely to remain more aggressive than the Fed in tightening monetary policy through June and may be slower in reversing/easing than the Fed, as the monetary policy lag in the eurozone tends to be longer than in the UK and the US. We favor using short-term US dollar strength to reposition for a weaker dollar in the second half of 2023, as we expect US economic activity will fade, and the Fed will pause. Our 12-month euro/US dollar forecast of 1.1000-1.0500 makes us neutral to mildly bearish on the dollar over that investment period. The dollar tends to have a negative relationship to global growth and underperforms emerging market (EM) currencies during periods of a US-only recession. China’s reopening helps bolster EM activity and supports a widening of the growth differential between EM and developed markets (DM).

Despite turmoil elsewhere, current EM risk factors are relatively benign. According to our vulnerability indicators, the sovereign EMBI investable universe is now less vulnerable than it was three years ago, and the EM IG universe is particularly robust. Market access is key, but large parts of the HY universe can survive this year on support from the International Monetary Fund, the World Bank, and wealthy friends, even if some countries are near distressed-debt levels and should be considered uninvestable. Geopolitical tensions remain high between the US and China, yet unlikely to increase despite the harsher diplomatic tone. Likewise, the China/Europe relationship has probably already bottomed. The outcome of Taiwan’s election in January 2024 will be critical to the long-term view. EM resilience and strong fundamentals make us optimistic on the asset class. EM corporate IG offers attractive entry points on a risk-adjusted basis amid lower leverage, higher average credit ratings, and considerably shorter duration than US IG and EM sovereign IG. Local currency debt offers an attractive alternative to sovereign IG. We are currently being selective and believe Mexico, Colombia, Indonesia, and South Africa show favorable attractiveness.

We see four main forces driving the global economy and markets: a slowdown in disinflation, with goods prices no longer an issue as secular service inflation gains strength; Europe’s avoidance of an energy crisis, providing consumer confidence and purchasing power; China’s ability to reopen without monetary pullback; and the negative consequences of central bank tightening. Despite recent economic data showing signs of strength, we believe this strength is the result of earlier central bank easing. That is now being reversed with the notable exceptions of the Bank of Japan (BOJ), which continues to use its balance sheet to defend its yield curve control (YCC) efforts, and the People’s Bank of China, which has allowed its balance sheet to surge to prevent China’s economy from falling apart. We believe the new BOJ governor will likely end YCC in the next three to nine months and that the Chinese government is now looking to hold back after the strong economic reopening. The global central bank balance sheet may go back to contracting mode soon. Furthermore, a strong US economy and a tight labor market only boost the odds of more Fed tightening, and thus the odds of a harder landing. Discussions with private credit market specialists have provided us with insightful bottom-up views, particularly for small and medium-sized enterprises. These companies typically borrow in floating-rate form, which means their borrowing costs have already risen from 5% to 9%, driving meaningful margin contraction. Together with banks tightening lending standards, we believe we will see the full impact of tighter and more costly credit in the second half of the year. Overall, we maintain a cautious risk posture and see pricing of risk in our Capital Market Line as overconfident, reflected in our below-neutral Risk Dial Score of 3.5.

Macro conditions remain dynamic, with new signals of stress. While contagion is possible in the banking sector, the Fed and US Treasury reacted quickly to restore liquidity and confidence, despite the Fed’s commitment to breaking inflation through higher rates. Companies continue to exhibit optimism in their business outlooks. Many are signaling slow but gradual improvement in supply chain and staffing issues. Price/cost relationships are still favorable, but surveys indicate pricing power is trending lower. Earnings estimates also continue to drift lower on macro impacts. We continue to find market volatility around Fed policy normalization presenting opportunities to invest in advantaged companies at valuations below typical highs. As always, portfolio style balance remains a key component of our risk management.

Our score remains unchanged on little tangible movement in EM despite considerable geopolitical noise and the DM banking woes. Based on our analysis, there is little risk of Silicon Valley Bank-style contagion in global EMs, but we are watching developments intently. In China, home appliance and furniture companies are being driven by the recovering housing market. Travel-related demand expectations and investment into artificial intelligence and electric vehicles remains strong. Smartphone sales have been muted recently. In India, banks continue to witness strong credit growth, while heavy industries including electricity, coal, cement, steel, and energy also continue to show good growth. With global energy prices coming down, margins of Indian companies should rise, and inflation should remain under control. In Latin America, there is increasing divergence of performance between Mexico and other markets. The former has emerged as an area of relative political and economic stability in a region that faces multiple challenges. In Central and Eastern Europe, companies have adapted to the Ukraine war’s impact and benefit from the low base set in 2022. We continue to engage with portfolio companies with the goal of improving their ESG attributes and enhancing their long-term prospects.

Our US Conviction Score deteriorated to 4.25, with contributions mainly from a flatter curve and wider credit spreads. Our global credit forecasts remain positive on EM and negative on DM. In DM, our industries model favors banking, finance companies, insurance, capital goods, and basic industry. It dislikes electrics, natural gas, utilities, consumer non-cyclicals, and energy. In EM countries, the model likes Argentina and Taiwan. Among EM industries it likes metals, real estate, and financials and dislikes utilities, infrastructure, and transportation. Our global rates model forecasts lower yields globally and flatter curves in Europe, the UK, and Oceania; a slightly flatter curve in Japan; and slightly steeper curves in North America. The rates view expressed in our G10 model portfolio is overweight global duration. It is overweight North America and Japan and underweight Europe. Along the curve, it still positions for flattening with over-weights in six-month, 10-year, and 20-year durations versus underweights in two-year, five-year, and 30-year durations.