The S&P 500 is currently trading on 18.8 times 12-month forward earnings, a 16% premium to the average over the past decade. (UBS)

Shares in PacWest Bancorp fell 28%, and Western Alliance lost 15% of its value.

Fears over the economic impact of problems in the banking sector were voiced by top investors and policymakers gathered at the annual Milken Institute conference. David Hunt, chief executive of asset manager PGIM, warned that a ratcheting-up of regulation in the banking system was likely to constrain credit and economic growth.

Meanwhile, Kristalina Georgieva, head of the IMF, said there would be a “price to pay” for “unnecessary deregulation” of the banking sector.

Anxiety also mounted as the US comes closer to hitting its debt ceiling, with Treasury Secretary Janet Yellen saying that the government could run out of money within a month unless Congress agrees to lift the statutory borrowing limit.

Along with bank stocks, energy companies were among the biggest losers, as the price of Brent crude oil fell 5.1% to its lowest level since March. The decline partly reflected disappointment over survey data pointing to the contraction in Chinese manufacturing activity since December. China is the world’s top importer of crude.

Finally, investors are nervous ahead of rate decisions by both the Federal Reserve on Wednesday and European Central Bank on Thursday. While the Fed is expected to raise rates by just 25 basis points, this would be the tenth consecutive hike and would take the federal funds target rate to a near 16-year high of 5–5.25%. Job openings data on Tuesday suggested that while the labor market is cooling, it remains too hot for comfort, with around 1.6 job vacancies for every unemployed American in March.

Meanwhile, Eurozone inflation data presented a mixed message to the ECB. Excluding volatile food, fuel, alcohol, and tobacco prices, inflation slowed to 5.6% from 5.7% year-over-year, below forecasts for 5.7% for its first decline since last June. But headline inflation picked up pace to 7% in April from 6.9% a month earlier.

What do we expect?

Despite the failure of First Republic Bank, which now ranks as the second-largest bank collapse in US history, policymakers continue to act decisively to avert a systemic crisis in the sector. But headwinds for the industry look set to cause more vulnerable institutions to cut back lending in order to bolster their liquidity. Banks were already tightening lending conditions prior to the collapse of Silicon Valley Bank in early March, based on the Fed’s Senior Loan Officer Opinion Survey. The more recent Dallas Fed Banking Conditions Survey (conducted 21–27 March) shows that credit standards have continued to tighten and loan volumes are falling across all key lending segments. This will take a toll on growth. Meanwhile, the lagged effect of the most rapid Fed hiking cycle since the 1980s is continuing to feed through into the economy.

This is taking place at a time when US stock valuations remain elevated. The S&P 500 is currently trading on 18.8 times 12-month forward earnings, a 16% premium to the average over the past decade. In our view, the market is pricing in a high probability of a near-perfect landing for the US economy. While the VIX index of implied US stock volatility rose on Tuesday, it did so from a near 17-month low. That suggests the market had become too complacent, in our view.

How do we invest?

Against this uncertain economic backdrop, we advise investors to:

  • Buy quality bonds: We see attractive opportunities in high-quality fixed income given decent yields and the scope for capital gains in the event of an economic slowdown. We prefer bonds relative to equities, and we prefer taking quality exposure to high grade (government), investment grade, and sustainable bonds.

  • Diversify beyond the US and growth stocks: After a strong start to the year, US equities are pricing a high chance of a soft landing for the US economy. Yet, tighter credit conditions, declining corporate earnings, and relatively high valuations all present risks. By contrast, we like emerging market stocks, powered by a weaker dollar, rising commodity prices, strong earnings growth, and China’s stronger-than-expected recovery, alongside select opportunities in Europe. We also advocate reducing exposure to growth stocks after their exceptional year-to-date performance.

  • Manage liquidity as rates peak: Many investors have held more cash than usual in anticipation of higher interest rates. On the surface, this could seem an even more attractive strategy if, as expected, top central banks tighten policy further this week. But rates are now approaching a peak. Although the path to lower inflation may not be smooth, we think investors should stay (or plan to be) sufficiently invested and diversified, act soon to lock in attractive yields before markets start to price much lower interest rates, and avoid unnecessary deleveraging.

Main contributors - Mark Haefele, David Lefkowitz, Christopher Swann, Jon Gordon

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

Original report - Risk-off mood hits stocks, 3 May 2023.