Thought of the day

Markets continue to show signs of stabilization as investors appear to have looked past last month’s banking turmoil. On Monday, the VIX index of implied stock volatility closed below 17, the lowest level since January last year, while at the end of last week, the MOVE index of Treasury volatility had fallen to levels seen before Silicon Valley Bank's (SVB) collapse. The S&P 500 20-day realized volatility was even more subdued at just 12.6%, a level last reached in late November 2021.

The drop in market volatility suggests that investors only envisage a narrow range of outcomes for the economy. In early March, the resilience of the US economy, tight labor market, and sticky inflation prompted concerns of further rate hikes, and market pricing for the terminal federal funds rate hit 5.69%.

But while market expectations for the terminal fed funds rate have dropped by 70 basis points since SVB’s collapse, we think it is hard to believe that a banking crisis and tighter credit conditions have narrowed the range of possible outcomes, especially to the downside. We expect credit conditions to continue tightening with a negative impact on growth.

As a result, we continue to prefer high-quality bonds over equities and are selective within our equity positioning:

  • We prefer high-quality bonds over equities. Bonds are most preferred in our global strategy as current risk-adjusted returns are appealing to us, relative to other asset classes. In addition to offering attractive yields, high-quality bonds tend to be resilient in the event of a recession, as credit spread widening tends to be offset to a good degree by falling interest rates.
  • Defensive equity sectors should be relatively resilient as economic growth slows. We maintain a preference for consumer staples and utilities in our global equity sector strategy. Consumer staples continue to see positive and strengthening relative earnings momentum. Meanwhile, the utilities sector should be supported by a relatively stable revenue base, which we think is likely to help keep earnings resilient in the event of a recession.
  • We think the outlook for US equities is challenged amid tighter financial conditions, declining corporate earnings, and relatively high valuations. The S&P 500 forward P/E of 18x is near its highest in about a year and is higher than pre-pandemic levels. Historically, when the S&P 500 has traded above 18x, consensus earnings growth expectations were robust (14% on average) or the 10-year Treasury yield was less than 2%. Today, we expect S&P 500 EPS to contract 5% in 2023 and the 10-year Treasury yield is 3.59%. In contrast, we see low-teens total returns from emerging market stocks over the remainder of the year, powered by strong earnings growth, China’s recovery, and relatively cheap valuations.