The Fed clearly decided that inflation is still the main concern for the economy, estimating that the drag on growth from tighter lending conditions will not make a hard landing for the economy inevitable.
The Fed took a calculated risk in making this decision, rather than err on the side of caution by not hiking to avoid potentially exacerbating the systemic banking risk.
This calculating rather than cautious approach also characterizes the rationale for changes to our asset class preferences this month, in which we upgraded fixed income to most preferred and downgraded equities to least preferred. The downside risks to the US economy have increased over the past month.
But the equities downgrade was not driven by an expectation of significant downside to stocks from current levels—our base case S&P 500 price targets for June (3,900) and December (3,800) didn’t change. Instead, the justification is that fixed income, and high-quality bonds specifically, offer a more attractive risk-return trade-off than equities based on current market pricing and plausible macro scenarios.
Starting with the macro side, the likely tighter credit conditions resulting from the bank failures is incrementally negative for growth, but exactly how much is uncertain. The most recent Fed data on bank deposits and use of its liquidity facilities suggest that the stress hasn’t gotten fundamentally worse over the last week and still appears contained to a handful of banks ( the CIO letter has more on banking crisis risk). At the same time, the US economy is ending 1Q with resilient momentum—the Atlanta Fed GDPNow 1Q tracking estimate increased from 2% on 7 March to 3.2% on 24 March—and the labor market has yet to show much weakness.
Still, the Fed is significantly downgrading its 2023 growth forecast: 1Q GDP tracking near 3% implies that the Fed expects less than 0% growth the rest of the year in order for its 4Q23/4Q22 forecast of 0.4% to be correct. This suggests that either the banking stress is worse than investors currently know (the Fed gets bank data before the market) or the Fed is being conservative with its growth assumptions because the credit tightening impact is highly uncertain. For investors, the safest conclusion is that the risk of a recession has gone up, but it’s unlikely to start before the second half of the year.
The economic outlook may be ambiguous, but market pricing now reflects distinct and divergent views across equities, fixed income, and other asset classes. The steep decline in US Treasury yields over the past few weeks—the 10-year yield has retreated over 60bps and the 2-year yield has fallen 130bps—along with nearly 100bps of implied Fed rate cuts by year-end indicates the bond market is pricing for a recession to start as soon as the summer. In contrast, the S&P 500 has dropped less than 1% from its level right before the banking stress began, which is more consistent with a soft landing. Oil prices, at about 10% lower, embed a fair amount of recession risk, while wider credit spreads, especially for investment grade corporate bonds, also imply more recession risk priced in than for equities.
Based on the greater macro risks and this market pricing, the risk-reward trade-off over the next six to nine months favors high-quality bonds over stocks, in our view. We’re assuming a modestly negative total return for the S&P 500 through year-end, which is likely to come with more large market swings like those experienced over the past year. In effect, we think US equities offer return-less risk, whereas investment grade corporate bonds should provide relatively low-risk, mid-single-digit returns. Thus, we recommend increasing allocations to US investment grade bonds at the expense of US equities.
This is not, however, a call to greatly reduce equity allocations. Slightly negative total return expectations are certainly underwhelming. But investors tempted to sit on the sidelines during this market volatility should know that this often results in being under-invested when a new sustainable bull market begins. Plus, there’s a decent chance of a market bounce in the near term.
Positioning has lightened and sentiment is poor, with investors not yet convinced that the policy actions so far, while significant and rapid, are sufficient to stamp out the risk of more bank failures. If an overwhelming policy response materializes—e.g., a near-explicit guarantee of all uninsured bank deposits—then risk assets would likely rally, especially with the impact of tighter credit on growth unlikely to appear for a while. Even without a tactical rally, significant market downside will likely be met with resistance as investors sitting on huge amounts of cash start to deploy it when expected returns for equities turns favorable, especially if a Fed pivot appears imminent.
In addition to buying quality bonds, another key Message in Focus (MIF) for 2Q is for investors to manage liquidity as rates peak. With the Fed nearing the end of rate hikes, if not already done, it is likely that Treasury yields have already peaked. Based on that, investors should actively manage liquidity portfolios to be prepared for rate cuts that create reinvestment risk. While the banking stress is not limited to the US, the adverse consequences for growth are likely to be greater there. Thus, this reinforces the message to diversify beyond the US and growth. US growth stocks, especially mega-cap tech, have outperformed in the past few weeks, leaving them expensive again relative to value stocks and those in other regions. China’s reopening picking up momentum and better earnings prospects should support emerging market equity and hard-currency sovereign bond outperformance. Fewer Fed rate hikes and slower US growth also support our downgrade of the USD to least preferred, and our recommendation that investors position for dollar weakness.
Main contributors - Mark Haefele, Jason Draho, Jon Gordon
Content is a product of the Chief Investment Office (CIO).
Original report - Selectivity beats being overly cautious, 27 March 2023.