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.” (ddp)

The S&P 500 closed 0.9% higher, while the KBW regional banking index gained 1.5% after losing almost 15% last week. Earlier, the Stoxx Europe 600 finished 1% higher, with the banking subindex climbing 1.3%. Financials rose along with cyclical industries such as energy and basic materials. Technology was the worst-performing sector in the S&P 500. Most Asian equity markets rebounded Tuesday, supported by gains in both financial equities and in some Additional Tier 1 bonds. S&P 500 futures were trading 0.5% higher on Tuesday.

US financial authorities, including the Federal Reserve, have also acted swiftly in recent weeks to prevent instability in the banking system from causing broader contagion. After the collapse of Silicon Valley Bank, the Fed established a Bank Term Funding Program, which offers banks the possibility to take loans of up to one year against Treasuries and other collateral. So far, this appears to have helped contain anxiety over the stability of US regional banks.

Meanwhile, the Wall Street Journal reported that JPMorgan Chase was advising First Republic Bank, whose shares have fallen close to 90% this month, on raising capital. That followed news last week that JPMorgan and 10 other banks were depositing a combined USD 30 billion in First Republic to help restore confidence in the lender. Separately, Bloomberg reported US officials are considering ways to temporarily expand FDIC insurance on all deposits without the consent of Congress.

What do we expect?

The focus for investors will likely now turn to the Federal Reserve’s policy meeting, which concludes on Wednesday. Investors have scaled back the likely pace of monetary tightening since the failure of SVB. Initially, the federal funds futures market priced a pause in rate hikes this month; but as confidence in the banking system has stabilized, investors have moved to imply a high probability of a 25-basis-point increase. Investors will also be hoping for Fed guidance on how banking stresses will factor into the policy outlook.

Even if the Fed pauses this week, tightening may not be finished.

The Fed faces a relatively difficult decision at the FOMC meeting this week: It has to worry about a rate hike adding to the stress in the financial system, while at the same time inflation is still well-above target and the labor market looks extremely tight. In our view, the Fed is likely to hike rates, putting more emphasis on the fight against inflation than risks in the financial system. The longer inflation stays elevated, the more likely it could become entrenched, forcing the Fed to take more dramatic action to reestablish price stability. Also, in case contagion in the financial system leads to a recession, the Fed has confidence in its tools to help avoid a severe downturn. One of the advantages of higher rates is the greater scope to support the economy with big cuts when needed. If the Fed does decide to pause, we would still expect it to signal additional rate hikes in the months ahead.

Tighter lending standards risk a business-led recession.

Until now, our main fear for the economy had been that consumers would slow down their spending, prompting businesses to pull back on hiring. Households are burning through the excess savings built up during the pandemic (which have halved to under USD 1tr), and delinquencies are rising. Lending standards have been tightening since the second half of 2021. The Fed's latest Senior Loan Officer Opinion Survey showed that a net 43.7% of banks are tightening standards for small firms and 44.8% for large firms. Banking sector stresses suggests banks will tighten lending even further, in our view. The risk is that businesses will struggle to fund their operations, cut costs, increase layoffs, and reduce capital expenditures, all helping push the US economy into recession.

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 rate cuts over the next one to two years. 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 like high grade and investment grade bonds, and defensive fixed income themes.

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 where 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.

In the near term, the US dollar’s status as a safe haven could help keep it relatively highly valued. But for the longer term, we continue to believe the currency will weaken against most G10 peers and that investors can use periods of dollar strength to reduce allocations to the currency. Investors worried about the risk of a financial crisis can consider diversifying into traditional safe havens like the Swiss franc and gold.

Main contributors - Mark Haefele, Kiran Ganesh, Vincent Heaney, Jon Gordon

Content is a product of the Chief Investment Office (CIO).

Original report - Stocks rebound as contagion fears recede, 21 March 2023