Central banks in focus this week

After a volatile week, markets have reopened to fairly orderly conditions in Monday trading. S&P 500 futures are down 0.4% at the time of writing, giving up early session gains as investors digested banking sector headlines. The Hang Seng led Asia declines, falling 2.7% with some pressure on banks. In Europe, bank stocks also led the Stoxx Europe 600 index 0.5% lower in early trading. After early-session declines, the safe-haven Japanese yen and gold both reclaimed levels above their Friday close.

Over the weekend, UBS announced it would acquire Credit Suisse. In its statement, Swiss regulator FINMA said it “welcomes the takeover solution and the measures taken by the Swiss Confederation and the Swiss National Bank SNB. The transaction and the measures taken will ensure stability for the bank’s customers and for the financial centre.”

Alongside the deal, major central banks late Sunday voiced reassurances on financial system stability, with the Federal Reserve, European Central Bank, and other peers announcing a move to daily joint liquidity operations via existing US dollar swap lines. Market attention will now turn to the interest rate decisions by the Fed, Swiss National Bank, and the Bank of England this week.

What's next in markets?

Stress in the banking sector in recent weeks has raised three interrelated, but different, issues: bank solvency, bank liquidity, and bank profitability.

Overall, we think bank solvency fears are overdone, and most banks retain strong liquidity positions. Policymakers have also been swift to act both in the US and in Switzerland. Depositors in the vast majority of institutions globally remain well-protected, even if bank profitability could face headwinds in the months ahead.

As we consider the broader economic implications, while policymaker steps announced in recent weeks should help alleviate financial stability risks, financial conditions could tighten, increasing the risk of a hard landing. Banks are a key conduit for transmitting central bank interest rate policy into the broader economy, and higher bank funding costs, attempts to boost liquidity, and a more cautious risk appetite could lower economic growth in the coming quarters.

Central bank tightening is also continuing. The ECB’s hike on Thursday and its commitment to fighting inflation point to a high likelihood of another, albeit smaller, increase in interest rates of 25bps at the May meeting. If, as we expect, core inflation does not abate by the middle of the year, we see a further 25bps hike in June, lifting the deposit rate to what we believe will be a peak of 3.5%.

Attention will now turn to the Fed’s interest rate decision this week. The backward-looking data is pointing to further hikes, with the Atlanta Fed’s GDPNow estimate for 1Q23 standing at 3.2%, payrolls up 815,000 over the last two months, and inflation still well above target. That said, the Fed has already raised rates a long way, lending standards have been tightening rapidly, and recession risks were seen as very high even before this new banking shock.

How do we invest?

As the effects of interest rate hikes conducted so far become more apparent, we believe markets will increasingly start to price in interest rate cuts over the next one to two years. That would make attractive fixed-rate returns on cash and fixed income assets harder to come by in the future. So, we recommend investors lock in current high yields and manage timing risk by doing so progressively.

With all-in yields still high, we see high-quality fixed income as an attractive asset class in the current environment. We think fixed income allows investors holding cash the possibility of diversifying their credit risk, as well as the opportunity to lock in yields at a time of uncertainty about the future path for interest rates. We like high grade and investment grade bonds, and the defensive fixed income themes that we favor have gained strongly in response to the recent fall in rates. In our view, they should continue to gain if markets price a greater possibility of recession or deeper future interest rate cuts.

In equities, we have US stocks as least preferred. The Fed faces an increasing challenge balancing its battle with inflation and risks to growth and financial stability, reducing the probability that it will be able to achieve a “soft landing.” We prefer emerging market stocks, where valuations are lower than in the US and China’s reopening offers support. At a sector level, we like global consumer staples, where relative earnings momentum is positive and strengthening. We also favor strategies that switch direct equity exposure into capital preservation strategies, to help hedge equity market risks.