Bank failures will lead to tighter credit conditions, a negative for growth, but the economy is showing resilience and the labor market hasn’t shown major cracks. So while tighter credit raises recession odds, it’s unlikely to start before the back half of the year.
The outlook is uncertain, but market pricing reflects divergent views across equities, fixed income, and other assets. The fall in US Treasury yields along with expected Fed rate cuts this year indicates the bond market is pricing for a recession to begin by the summer. In contrast, the S&P 500 is less than 2% off its 2023 high, more consistent with an economic soft-landing. Oil repriced about 10% lower after the bank failures, while credit spreads widened, indicating higher recession risk. Given these macro risks and market pricing we updated our asset allocation guidance this month by downgrading equities overall to least preferred and upgrading overall fixed income to most preferred. We keep US equities as least preferred versus other regions and within US corporate credit keep investment grade as most preferred and high yield least preferred.
The preference for fixed income over equities is predicated on a better risk-reward outlook for high quality bonds than stocks in 2023. The preference change does not stem from a bearish outlook for equities overall. Our year-end S&P 500 price target of 3,800 implies modest declines, but will likely come with large
market swings. The lower risk in high quality bonds with likely mid-single digit returns is more attractive in our view.
With the Fed likely near finished hiking rates, yields have likely peaked. As such, investors should actively manage liquidity portfolios and be prepared for potential rate cuts that could lead to reinvestment risk. Similarly, buying quality bonds in fixed income portfolios can hedge against further equity downside and credit risk in lower-quality fixed income and possible decline in Treasury yields.
While the bank stress isn’t limited to the US, the consequences for growth will likely be greatest here. The decline of the US dollar during this stress period indicates a negative spillover to the rest of the world should not be large. That fact, in conjunction with peak rates, leads us to recommend investors position for dollar weakness.
Within equities we recommend investors diversify beyond the US and growth. US large-cap growth stocks are expensive relative to value stocks and other regions, so we stay least preferred. Within US equity sectors we shift to a more defensive bias this month and are now most preferred on consumer staples, industrials and utilities, while least preferred on financials, information technology, and consumer discretionary. This month we also downgraded the energy and real estate sectors to neutral. Outside of the US the China reopening story is gaining steam. Relatively cheap valuations and better earnings prospects keep us most preferred on emerging market equities and hard-currency sovereign bonds.
Consistent with our recommendation to invest in real assets, commodities overall and oil specifically remain most preferred. We also upgrade gold to most preferred. In general, oil and commodities are already pricing in a high risk of recession, while supply constraints should become more binding as the year progresses, especially in light of China’s reopening.
Main contributors: Jason Draho, Michael Gourd
Content is a product of the Chief Investment Office (CIO).
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