Another crisis ahead? Five questions hanging over markets, answered

March was not kind to banks, and it raised plenty of questions for investors. Recent weeks have seen huge shifts in the banking landscape, bond prices, and market sentiment. So this month, we offer our take on some of the top questions asked by our clients, from financial stress and the Fed outlook to key indicators of risk, safe haven investments, and where the S&P 500 will end the year.

1. Is the banking crisis over, or just simmering in the background?

Banks have stayed out of the headlines in recent days, while investors welcomed the sale of a large chunk of failed Silicon Valley Bank’s assets to First Citizens bank on 27 March. We believe banks do not look like a source of systemic risk today. They have more capital – particularly the large banks, particularly in Europe – and less exposure to riskier segments of real estate than pre- financial crisis. Issues to date have largely centred on banks’ deposits and hence liquidity, which regulators in the US and Switzerland have swiftly provided, or promised if needed in the euro area. Issues with credit quality and hence solvency would be more concerning (see question 2 for areas we are monitoring). Of course, a crisis of investor or depositor confidence, amplified by social media, is always a risk, particularly in nervous markets. Major bank stocks are down between 9-25% on the month. Some credit default swap spreads – or the cost of insuring banks’ debt against default – have widened (see chart). Deposit flows from smaller US banks to larger competitors and money market funds will hurt the former’s profitability, as could future regulation to shore up their capital and liquidity buffers. Investors may now seek a higher premium to invest in banks, and we expect a continued tightening of credit conditions, with less lending to businesses and households translating into slower economic growth.

2. Which risk indicators are you watching?

We are keeping a close eye on measures of loan affordability and on US banks’ commercial real estate lending, especially that related to offices, where demand has fallen sharply for non-central locations post-Covid. Around two thirds of commercial real estate exposure is on small and mid-size banks’ balance sheets, and there are fears that tighter lending could lead to problems when borrowers come to refinance loans. We are also watching gauges of broader contagion, including the market for contingent convertible bonds (an important source of bank funding), credit default swaps, interbank lending, use of central banks’ liquidity facilities, money market stress and deposit flows. 

3. Where will equity markets go this year?Should we be buying now?

The outlook for growth, and hence corporate earnings, has deteriorated in light of financial stress. However, tighter lending conditions may lead inflation to fall faster, and markets are now pricing in US rate cuts as soon as the second half of 2023. Meanwhile, investor sentiment has turned sharply negative, and equity market valuations have fallen slightly. Amid high levels of uncertainty, we keep a neutral stance on equities. Our core scenario sees earnings for US large cap stocks falling -5% in 2023 and the S&P 500 staying around the 3,900 level in 12 months’ time (see question 3 for our Fed outlook). If earnings fell by more than -20%, we think it could fall to 3,200. If financial risk stabilises and inflation falls without a crisis-led recession, it could rise to 4,600. For now, we seek areas that are cushioned by lower valuations, including value stocks, or more exposed to growth opportunities, including Chinese, emerging markets and Japanese small and mid-cap stocks. We continue to favour the healthcare sector for its consistent returns, defensive characteristics, and long-term earnings drivers, including innovation, ageing populations and more sedentary lifestyles. On the latter point, more physical inactivity is increasing risks of obesity, diabetes and cardiovascular diseases, while more screen time (see chart) is leading to a rising prevalence of eye-related diseases. 

4. Where will the Fed take interest rates?

The Federal Reserve (Fed) remains bound by inflationary as well as financial risks. Services inflation, and notably wage growth, remains too strong. Commercial banks pulling back on lending could do part of its job of tightening financial conditions, but by no means all. For now, we still see it implementing a 25 basis point (bps) hike in May and another in June, to take rates to a peak of 5.5%. However, fed funds futures markets think banking stress will lead to rate cuts as soon as June. This goes against the Fed’s messaging, and our own view of persistence needed to combat high inflation. Absent an unpredictable ‘Black Swan’ event that requires rate cuts and quantitative easing, we see the Fed keeping rates on hold until the early months of 2024.

5. Where can we find investment havens?

In recent weeks, there has been a surge of investor capital into bonds, both as a flight out of banking deposits into other ‘quality’ assets and on expectations of slowing growth in developed economies. There has also been a move into mega-cap technology stocks, some of the world’s biggest and most liquid securities, which would also benefit from US rate cuts. We, too, suggest investors seek quality assets, a preference we express via overweight positions in US Treasuries, investment grade bonds and the Japanese yen. The latter tends to perform well in periods of liquidity and credit stress. It should also be supported by Japan’s improving growth and terms of trade, and by potential future moves by the Bank of Japan to tighten ultra-loose monetary policy. We also retain an overweight to cash, giving us the flexibility to seize investment opportunities quickly