Investors appeared encouraged by the lack of any further banking collapses, raising hopes that the threat to the US financial system may be receding. The VIX, a gauge of expected volatility, fell from around 27 to 24, down from a peak of over 30 on Monday, which was consistent with daily moves in the S&P 500 index of close to 2%.
The market moves reflect initial confidence in federal efforts to prevent the need for banks to sell bonds at a loss to meet depositor outflows. Measures announced over the weekend include a new Bank Term Funding Program (BTFP) from the Fed, offering banks the possibility to take loans of up to one year against Treasuries and other collateral. The collateral would be valued at face value rather than market prices.
The yield on the 2-year US Treasury rose 27 basis points to 4.25%, as investors calculated that financial strains were less likely to prevent the Fed from raising rates at the policy meeting next week.
US economic data released on Tuesday underlined that the inflation threat has not gone away. Month-over-month, core CPI inflation, excluding food and energy, rose at the fastest pace in five months, accelerating to 0.5% in February from 0.4% in January. Year-over-year, headline inflation moderated to 6% from 6.4%—and down from a June peak of 9.1%—but the core measure only eased to 5.5% from 5.6%. The data suggest that the Fed will hike rates further unless restrained by worries over financial stability.
What do we expect next?
Despite Tuesday’s rally, concerns over further problems for regional banks look set to remain a headwind for market sentiment for some time to come. Investors should also remain on alert for signs of financial strain in other regions. More broadly, the Silicon Valley Bank situation is a reminder that Fed hikes are having an effect, even if the economy has held up so far. While investors may be relieved that SVB should be a contained risk, we think the fundamental outlook for the next six to 12 months has not really changed. Both soft and hard landings are still very plausible scenarios, in our view.
The federal funds futures market suggests that the Fed may be able to return its focus to combating inflation. The implied peak in interest rates has risen to 4.85% from a low of 4.7% over recent days—still well below the 5.69% markets were pricing in as recently as last Wednesday.
Strong inflation prints over the past two months and revisions to the seasonally adjusted consumer price index have made the short-term trend look less favorable. Over the same period, nonfarm payrolls have also increased by 815,000. This data suggests that the Fed needs to raise rates further to bring inflation down toward its 2% target. However, the recent bank failures could be a reason for policymakers to pause at next week's FOMC meeting. If the Fed does pause, they are likely to signal that they still expect to raise rates at future meetings.
How do we invest?
A positive session does not yet mean that the period of strain is over, and investors should brace for further volatility.
We remain least preferred on financials in our US strategy and recommend investors who have above-benchmark weights in global financials (15%of the MSCI All Country World Index) to revisit their exposure. Instead, we favor switching the excess exposure into more defensive areas, given risks to the US economy. We prefer the global consumer staples sector, where relative earnings momentum is positive and strengthening.
In addition, we recommend investors diversify beyond the US and growth stocks. We like value sectors, including energy, which should be more resilient if inflation proves sticky. Earlier inflection points in China and Europe favor outperformance in select European names, emerging market equities, and some early-cycle markets relative to the US.
Bond yields only partially retraced their decline from late last week. But all-in yields are still attractive, in our view, particularly relative to opportunities in other asset classes. At around 4.25%, the yield on the 2-year US Treasury is still more than double the level of 12 months ago, albeit down from a recent peak late last week above 5%. High grade and investment grade bonds still provide some protection against recession risks, despite the recent moderation in yields. We are also most preferred on emerging market bonds, which we see benefiting from an expected rebound in Chinese growth following the lifting of pandemic restrictions.
Main contributors - Mark Haefele, Christopher Swann, Brian Rose, Daisy Tseng
Content is a product of the Chief Investment Office (CIO).
Original report - Relief rally in US equities, 15 March 2023.