CIO advise investors to diversify beyond the US and growth, given the deteriorating outlook for earnings, high valuations, and risks arising from interest rate hikes. (ddp)

Financials were among the main gainers on the day in the index, with the sector up 3%, a sign that anxiety over the health of the banking sector is receding. Europe’s Stoxx Banks index rose 4.8% and the US KBW Bank index, which tracks regional as well as national banks, gained +5%.

Increased market confidence has also been reflected in rising government bond yields, including a 26-basis-point rise in the yield on the 2-year German bund, the largest daily gain since 2008. The market is also now pointing to a roughly 80% chance that the Federal Reserve will raise rates by 25 basis points today. In the immediate aftermath of SVB’s collapse, markets were implying a pause in rate hikes.

But this doesn't mean we can go back to expecting a soft landing for the US economy:

The Fed looks set to raise rates further. Policymakers face a tricky choice at today’s rate-setting meeting, with the need to balance worries over the banking system with continued high inflation. In our view, the Fed is likely to hike rates, putting more emphasis on the fight against inflation. In addition, the longer inflation stays elevated, the more likely it could become entrenched, forcing the Fed to take more dramatic action to reestablish price stability.

Banking sector stress suggests banks will tighten lending even further, in our view. While we think bank solvency fears are overdone, and most banks retain strong liquidity positions, headwinds to profitability in the sector are mounting. Some banks will be forced to further increase deposit rates to reduce the risk of deposit outflows, and wholesale lenders may also demand higher rates of return, increasing funding costs. Banks may opt to refrain from issuing new loans in order to boost their liquidity, and a weaker economic outlook may require banks to take more provisions against future loan losses. So, while financial conditions had been loosening even while the Fed was hiking, we now expect a tightening.

Strains on the banks represent an additional headwind to corporate earnings and business activity. Until now, our central concern for the economy had been that slowing consumer spending would prompt businesses to pull back on hiring. Households are running through the excess savings built up during the pandemic (which have halved to under USD 1tr), and delinquencies are rising. Now a more restricted access to capital for businesses is becoming a growing risk. 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. This survey, which is correlated with earnings growth, looks set to deteriorate further.

Against this backdrop, we prefer high grade and investment grade bonds, which should be more resilient in the event of a recession. We are more cautious on corporate high yield credit given deteriorating corporate fundamentals and the risk of spillover from banking sector stress. We also advise investors to diversify beyond the US and growth, given the deteriorating outlook for earnings, high valuations, and risks arising from interest rate hikes. By contrast, we expect positive performance from emerging market equities, including China and Asian semiconductor stocks, and select European themes, including German equities.

Main contributors - Mark Haefele, Vincent Heaney, Christopher Swann, Brian Rose, Jon Gordon

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

Original report - Risks remain despite stock rebound, 22 March 2023