For the past year, investors have navigated an environment characterized by one main driver – the Fed’s campaign to raise interest rates in order to combat high inflation. Month after month, investors looked at resilient economic data set against still-high inflation. Many were hopeful for an end to the Fed’s aggressive rate hiking cycle.
However, that narrative is now changing. We are seeing increasing signs of economic stress, and we have seen the first obvious casualties of the Fed’s aggressive policy stance for this cycle. Despite the stresses, markets moved higher in March.
Markets are now digesting a far more uncertain future. Fed policy is no longer a one-way bet, and investors are now being forced to weigh not only if and when the hiking cycle will end, but what will follow. Will the Fed move quickly into a cutting cycle, or will rates stay higher for longer? If the Fed does begin to cut rates, is this positive, or will it be in response to a much weaker economic backdrop or something else breaking? As the outlook for monetary policy changes, so do the potential paths forward.
So, what broke? Silicon Valley Bank (SVB) and Signature Bank collapsed, calling the health of small regional banks into question, prompting intervention from US regulators, and raising serious concerns on the overall state of lenders. SVB, a popular lender for technology startups, was the first to collapse after a plan to raise fresh capital contributed to a run on deposits after investors grew concerned about the state of the bank’s balance sheet. US regulators swiftly jumped in with emergency measures, but deposits left small banks at a record pace the following week.
Although regulators moved quick to minimize panic, as the news broke on SVB and Signature Bank, regional banks saw an upswing in withdraws as money moved to larger banks, emphasizing the lack of confidence customers now have in regional banks. The final impact remains to be seen, but these failures can have long-lasting effects for smaller banks and the entrepreneurs and businesses they serve.
Bond markets were not immune to the stress from the banking failures. The 10-year US Treasury yield had its biggest quarterly drop since 2021, finishing the month at 3.49%. Bond investors continue to navigate the challenging environment that inflation and the Fed are creating.
Throughout this economic cycle and Fed’s rate hiking, the natural question has been, “Is there going to be a recession?” Our base case continues to be that a recession will be difficult to avoid with the degree of tightening that’s occurred and the work that remains to be done on the inflation-front.
As this cycle continues to unfold, it’s important to have the right perspective. We cannot compare this cycle against the prior two recessions as circumstances are different. With that in mind, we believe we’re going to experience a more “traditional” cycle, which may be longer and more uncomfortable to navigate than what we’ve recently seen. However, we are viewing this period as an opportunity to be tactical. As the landscape ebbs and flows, we are analyzing all components of monetary policies, economic data, and the evolution of this cycle to prepare our shopping lists to put our time-tested processes to work.
What Could Go Right in 2023?
It’s easy to focus on what could go wrong in markets and the economy this year given the current landscape – but what if we flipped the script and highlighted what could go right in 2023?
We asked analysts from our Tech, Life Sciences, Capital Goods, and Fixed Income sectors for their thoughts. See their answers: What Could Go Right in 2023?
Checking In on Global Central Banks
The Federal Reserve is not the only central bank fighting inflation, in fact, many around the world have embarked on campaigns tightening monetary policy. We hear from one of our Fixed Income analysts on what is happening in Canada, Australia, Europe, Japan, and the US and if we’ve reached the turning point of global monetary policy in our latest article.
- Economic Cycle
- The economy is late cycle; the Fed is being forced by high and persistent inflation to tighten into an already weakening economy; a recession in the US is becoming increasingly likely
- Stock Market
- US stock market weakness has improved valuations, however, equities are not cheap by longer-term historical standards; valuations may be partly explained by robust corporate profitability, as EBIT margins have climbed to historical highs; rising input costs are posing a risk to the ability of corporations to maintain this elevated level of profitability; returns will be harder to come by and stock selection will be increasingly important
- Bond Market
- Interest rates have risen well off their lows reflecting shifting expectations on inflation, growth, and central bank policy; corporate and municipal bond credit spreads have widened, but not enough to make them materially more attractive at this time
- Important Issues on the Radar
- Inflation: a confluence of massive policy stimulus, tight labor markets, gummed-up supply chains, and rising energy costs have caused inflationary forces to broaden and become more entrenched than previously expected
- Ukraine-Russia War: an environment of elevated geopolitical risk entails a general risk-off environment, lending upward support to the dollar, gold, and commodity prices
- China’s Economy: China has pivoted on the two key economic issues that acted as severe headwinds to growth over the last two years; we will now have to see how strong and sustainable the rebound in growth will be
Sources: Wall Street Journal, Bloomberg
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