Has the Fed Pushed it too Far?

March 13, 2023

Only a few months ago, the market was convinced that we would see a global recession in 2023, and the only question was how deep the recession would be. Going into 2023, the prevailing view was that Europe was already in recession, the US was on the cusp of one, and China would struggle to manage its reopening campaign. In the end, all three fears proved to be overblown.

Instead of falling into recession, the global economy has strengthened since the start of the year. This, in turn, has led to fears that, instead the global economy might be running a little hot. Why is that a bad thing? Because it could mean that inflation will not come down despite the much higher interest rates than a year ago. If inflation will not come down, central banks will keep raising rates, a realization that led to sharply rising US Treasury yields in February and caused a sell-off in interest rate sensitive sectors like real estate and growth stocks. It also led to a stronger US dollar, which put pressure on commodity prices. Unfortunately, it also led to the collapse of two U.S. banks.

We agree that inflation, rather than a recession, is the bigger risk for 2023. Nevertheless, even in the U.S., where inflationary pressures are most acute, there are still significant deflationary forces in the pipeline. We also still believe that headline inflation data will trend down in the coming months due to several disinflationary trends. The question will be how much it will come down and how aggressive the Fed will be in the coming months.

The risk of a recession in 2023 is being replaced by the risk of another inflation wave. We will probably turn more defensive on equities if it looks like inflation is returning. The upturn in the global economy is displacing fears that growth will be too weak, with fears that it will be too strong, which could force central banks to hike rates more than was previously thought necessary to tame inflation. This was confirmed by Fed Chair Jay Powell’s testimony before the Senate banking committee, which moved up the futures markets’ expectations of the peak fed funds rate, indicating that Powell’s commentary came as a hawkish surprise. In particular, Powell noted that the recent strong economic data releases and revisions suggest that inflationary pressures are stronger than they had anticipated at the February FOMC meeting. This enforces our view that we will not see a U.S. or global recession in 2023. 

Silicon Valley Bank Collapse

And then two days after Jay Powell’s comments, we saw the sudden collapse of Silicon Valley Bank (SVB), which is a sign that the fast-rising interest rates are threatening stability in the banking system. History tells us that the Federal Reserve will raise rates until something breaks. In this cycle, it seems that an overnight rate of 4.75%, with the threat of higher rates coming soon, was enough to topple Silicon Valley Bank after an old-fashioned run on the bank. The problem for Silicon Valley Bank is that when depositors started to withdraw funds, it had to sell long-dated U.S. Treasuries at a big loss. 

Bank stocks plunged 6.6%. The two-year Treasury note, dropped 48 basis points in two days. This is a plunge exceeded only by drops after the 1987 market crash, 9/11, and the immediate aftermath of the Great Financial Crisis. Suddenly, the Federal Reserve’s risk is not that it let inflation get away but that it had failed to protect the banking system’s stability.

Fortunately, regulators seem to have learned from mistakes made in 2008 and took swift action. Not only did they quickly seize control of SVB but also of the crypto-lender Signature bank, while at the same time guaranteeing that all depositors will be made whole.

The Fed and Treasury created an emergency program to backstop deposits at Signature Bank and Silicon Valley Bank using the Fed’s emergency lending authority to stem the damage and stave off a bigger crisis. The FDIC’s deposit insurance fund will be used to cover depositors, many of whom were uninsured due to the $250,000 limit on deposit guarantees.

This is an important step to maintain confidence in the financial system, as it would have hurt many start-up companies that held unsecured deposits at SVB. It could have led to a widespread contagion, which could push many more companies into bankruptcy.

While depositors will have access to their money, equity, and bondholders at both banks are being wiped out, a senior Treasury official said. While Jay Powell indicated two days before the SVB collapse that the Fed could raise rates even faster, we think that is now much less likely. The Fed will have to consider other risks now, not just inflation. Already, markets are starting to discount any further rate hikes. On top of that, we are still convinced that inflation will come down significantly in the coming months.

Europe

Not only did Europe apparently avoid a recession, but the latest data suggest that growth is accelerating, thanks in part to falling energy prices and €800 billion in fiscal support for the private sector. Consensus forecasts for European GDP growth this year continue to be revised upwards.

A Strong Rebound In Chinese Consumption 

China’s post-pandemic re-opening is creating a mean reversion in the country’s economy. Hence, the activity in many hard-hit sectors is reverting to their pre-pandemic trends. Household consumption, particularly in consumer services, will likely benefit the most this year.

Due to the recent full reopening of the country, consumption growth should pick up faster than income as spending fell more than income during Covid. If we assume that income will increase by 7% in nominal terms, then consumption growth should rebound to at least 10%.

China’s consumption of durable goods will improve from last year, but the recovery will be more muted and emerge later in the year. A modest upturn in new home sales and housing starts is likely, putting a floor beneath property prices. In addition, the recent government stimulus should help property developers finish constructing existing housing projects. Sales of furniture, decoration materials, and appliances could benefit from a rush in the supply of completed homes.

We are already seeing indications that spending on luxury goods and cars is accelerating. Beyond the next 12 to 18 months, however, structural forces may drive Chinese household consumption growth lower than in the pre-pandemic era. Global investors hoped that having consolidated power over the Communist Party in October, the Xi administration would shift its attention to focus more intently on stabilizing the economy, not only by removing pandemic social restrictions but also by easing monetary and fiscal policy. So far, however, the NPC session suggests that the Xi administration is continuing its relatively tight economic and hawkish national security policies. While some policy easing may occur, it will likely focus on domestic consumption and technology rather than the infrastructure and industrial growth that lifts global cyclical assets.

Equity Markets

The good news for equity markets is that corporate earnings estimates should stabilize if we do not see a global recession in 2023. We think this is the part that the market has overlooked. A stronger economy, with moderating price pressures, should bode well for corporate earnings in the coming quarters. There are also signs that wage growth is still lower than nominal inflation. While that is not good for workers, it tends to be good for profit margins. According to The Conference Board, earnings guidance has arguably been too cautious, which is not surprising given that 93% of CEOs expect a recession over the next 12-to-18 months.

It is too early to know what the fall-out of the Silicon Valley Bank and Signature bank collapse will mean for the stock market. We think these two banks failed because of the specific risks they took, combined with the fact that the US Government acted quickly and decisively to contain a wider fall-out. If it will lead the Fed to moderate further interest rate increases and inflation slows as we expect, that could actually be positive for equity markets.

Silicon Valley Bank’s collapse may accelerate inflation’s slowing as small and medium regional banks will tighten lending further to improve their balance sheets and stand ready in case they are next.  Credit creation will likely be slower in the quarters ahead, which will bring down inflation and, in 6-9 months, may start to have an effect on employment.  While we expect a near-term relief rally and a reasonably good (vs. expectations) Q1 earnings season, we will monitor equities into the summer for signs of a growth slowdown.

Fixed Income

In February, 10-Year Treasury yields jumped from 3.4% to 4%, wiping out all gains for the year. Then last week, the collapse of Silicon Valley Bank happened, which is a sign that fast-rising interest rates are threatening stability in the banking system. Over the last few trading sessions, bond yields have retreated back to pre-February levels along the curve. Basically, the bond market no longer believes that the Fed will be able to be as aggressive as they said just a week ago.

We are neutral on a fixed income as we do not believe that longer dated yields will rise much from current levels. Either inflation cools, and interest rate expectations come down, or the Fed becomes more hawkish, and recession risks will rise. Either way, it is more likely that yield falls rather than rises. If a recession is not imminent and money market rates are rising, then the yield pick-up on U.S. private credit is still particularly attractive.

Commodities 

We think that energy can outperform metals in the coming months, but the structural drivers for commodities should be supportive of all commodity prices this year. Economic growth remains solid, lower interest rate expectations could lead to a weaker dollar, and the green energy transition is still in full swing. All these factors would be positive for commodity prices.

Portfolio Actions

In our core ETF portfolios, we took advantage of recent market movements to improve portfolio resilience throughout February.  Following January’s low-quality stock rally in equities, we increased our tilts to stocks with quality and value characteristics. In fixed income, as yields rose during the month, we extended duration marginally to capture a higher yield and increase downside protection.  Our portfolios continue to have a balanced exposure between equities and fixed income, with a preference for global diversification and a bias to quality and value styles.

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