Is this 2008 again?
April 11, 2023
Warren Buffet once said, “Only when the tide goes out do you learn who has been swimming naked.” And the tide went out in March. The collapse of Silicon Valley Bank and Signature Bank, followed by the forced merger of UBS and Credit Suisse, brought back memories of 2008.
However, we don’t believe that the global economy is on the verge of another financial crisis. Banks are much better capitalized than they were in 2008, and central banks have a wider suite of tools for mitigating panic.
Given the fact that the vast majority of the smaller U.S. banks are not subject to the same stringent capital and liquidity requirements that the larger systemically important financial institutions are subject to, we are likely to see a large flow of deposits from small banks to large banks.
As smaller banks are active lenders to smaller and midsize companies and to the real estate market, tightening credit conditions will weigh on economic growth. This means that economy will slow in the coming quarters. However, this is exactly what the Fed was trying to achieve by raising interest rates.
Could The Banking Crisis Be Positive For Stocks?
The turmoil engulfing US regional banks will invariably weigh on economic growth.
The thing is, the Fed wants slower growth. Arguably, it would be better for the broader stock market if growth slowed because banks became more conservative in their lending than if it slowed because the Fed had to raise rates to over 6%. In both cases, economic growth would decelerate but at least in the former scenario, the discount rate applied to earnings and stock valuations would not be as high.
The catch is that the Fed would need to calibrate monetary policy correctly to ensure that growth slows, but does not collapse, in response to tighter lending standards. This is very hard to do in practice, especially at a time when the public perception of inflation remains uncomfortably high.
The Fed’s predicament is mirrored elsewhere. Still worried about inflation, the European Central Bank (ECB) raised rates by 50 bps in March. However, in a nod to the woes facing Credit Suisse and the potential risk to the European banking system, the ECB withdrew guidance on future interest rate hikes. European banks are much better capitalized than they were in the past. However, just as in the U.S., bank lending standards were tightening in Europe even before the latest cracks emerged.
If that were all there was to the story, it would be easy to conclude that, all things equal, recent banking strains will expedite the onset of the next recession. All things are not equal, however. Most importantly, interest rate expectations have plummeted over the past month. Lower rates will cushion the blow to growth. It is possible that lower bond yields will offset the hit to aggregate demand from a further tightening in bank lending standards.
If that were to occur, stocks would benefit. This is simply because the discount rate would end up being lower in a scenario where growth slowed because banks became more conservative compared to a scenario where the Fed keeps raising the interest rate. It is even possible that lower interest rates will end up more than offsetting the drag on growth from tighter bank lending standards.
The end result could resemble what happened back in 1998. In the autumn of that year, the Fed cut rates by 75 basis points in response to the collapse of Long-Term Capital Management. After bottoming on October 8, the S&P 500 proceeded to rise by 68% over the subsequent 17 months.
The big difference is that the U.S. economy was in better shape in 1998. Productivity was soaring, while inflation was well contained. Therefore it is not likely we will see a repeat of 1999 as this would require not only resilient economic growth but also falling inflation amid continued low unemployment.
How likely is that? Perhaps that is a difficult outcome to achieve but the odds of a benign disinflation where growth temporarily stays resilient and inflation falls anyway are not as low as widely believed. So, although we do not expect that a 68% rally in the S&P 500 is imminent, it is definitely possible that we see a market environment where equity markets keep rising.
Especially as corporate earnings seem to be holding up well. The U.S. 12-month forward earnings estimates rose in March for the first time since June 2022. Outside of the banking sector, estimates could surprise on the upside in the remainder of the year, before potentially falling again in 2024.
International Equity Markets
Earnings have held up better outside the US over the past two quarters, especially when measured in dollar terms. At least for the remainder of this year, we expect non-US stocks to outperform their US peers. Not only has the cyclical acceleration in growth been stronger outside of the US, but valuations are much more favorable abroad. Non-US equities are currently trading at 12.5-times forward earnings, compared to 18.2-times in the US. A softer dollar should also bolster returns on international stocks.
Equity sectors set to benefit most from falling rates and easier monetary policy, such as technology and consumer discretionary, have been rallying over the past month despite the problems in the banking sector. After all, equities celebrate the end of the hiking cycle no matter what the reason may be.
The Fed and Inflation
The trend in inflation in the coming months will remain a key driver for Fed policy. In March we saw large movements in short-term bond yields as Fed Chair Powell testified to the U.S. senate banking committee that economic data in the U.S. was stronger than anticipated and that therefore the Fed would likely need to raise interest rates faster and further. However, two days later reality hit with the collapse of Silicon Valley and Signature Bank.
This completely changed the expectations for further rate hikes. Two-year bond yields dropped from 5% to about 3.7% now. This means the markets went from expecting more rate hikes to basically saying the rate hiking cycle is over in the span of a week. As of now, it is likely that the Fed will not raise interest rates much further. However, the wild card is inflation. If inflation stays strong or reaccelerates the Fed will have no choice but to hike again.
We believe that headline inflation data will weaken in the coming months. Partly because of a base effect compared to last year but also because the largest component of inflation, shelter, is showing signs of softness. Shelter means the cost of property whether it is through rent or the value of the property you live in. There are clear signs that global property markets are softening.
In January we had stronger inflation data and that was a bit of a surprise but that might simply have been just noise in the data, caused by the difficulty of performing seasonal adjustments around the turn of the year.
Unlike in the 1970s, long-term inflation expectations are well anchored. While short-term inflation expectations did rise in the midst of the pandemic, they have declined quite noticeably in recent months.
The biggest risk to our outlook is that inflation reaccelerates in the second half of this year, which would force the Fed to become more hawkish again. That would be a negative surprise for equity markets. Especially, if it happens at a time that the economy continues to slow. This is one scenario that we pay careful attention to.
China continues to benefit from reopening. There is little doubt that the post-Covid reopening boom will eventually fade. However, it is likely that the government will take steps to limit downside risks to the economy. The Chinese government will especially stimulate domestic spending this year, as well as supporting the housing sector.
China’s housing sector could surprise on the upside for two reasons: First, the government is providing developers with financing to allow them to complete a large pipeline of projects. This will support construction activity. Second, after hunkering down for three years, Chinese households are sitting on a huge amount of pandemic savings. Chinese savers like to invest in property and in the past two months both home prices and new home sales have rebounded.
We like the Japanese equity market because of relatively low stock valuations and decent earnings growth but more importantly because we think there is more upside for the Yen. Not only is it 39% undervalued on a purchasing power parity basis, but it will benefit from a potential dismantling of the Bank of Japan’s (BoJ) Yield Curve Control program under the new BoJ governor.
Thanks to many years of current account surpluses, Japanese external assets exceed liabilities by 71% of GDP. As Japan’s population continues to age, some of these external assets will be brought back home and converted into yen, which should provide some support for the currency but would also benefit Japanese companies.
We are currently neutral on bonds. Historically, US Treasury yields have peaked a month or two before the last rate hike. It is possible that the Fed will hike rates again in May, but even if it does, we are probably near the end of the Fed’s tightening cycle.
The biggest risk to a bullish bond view is that inflation could fail to come down. That risk has subsided in light of recent banking stresses, but it has not completely gone away.
The U.S. Dollar
Since peaking in September 2022, the trade-weighted US dollar has depreciated by 6.8%. Despite this retreat, the greenback remains quite expensive, trading 19% above its Purchasing Power Parity (PPP) fair value. Historically the dollar’s deviation from PPP has been a reliable guide to the long-term direction of the currency.
While valuations are an important driver of the dollar over the long run, business-cycle considerations dominate over shorter-term horizons. In general, the dollar is a countercyclical currency, meaning that it tends to strengthen when global growth is weak and weaken when global growth is strong. This is especially the case when the acceleration in global growth is more pronounced outside of the US, as has been the case recently.
As with most currencies, interest-rate differentials are also an important driver of the dollar. Real 2-year rate differentials have narrowed against the dollar since last October, which explains much of the dollar’s weakness.
The risk to this view is that if growth fails to slow at all and the U.S. experiences a second wave of inflation, then the Fed will have to hike rates, rather than cut them as the market expects. This would also cause the dollar to appreciate.
Upside for Oil and Industrial Metals
Consistent with our view that global growth will surprise positively over the remainder of 2023, we see near-term upside for commodity prices this year.
The good news for commodities is that tight supply conditions will limit the extent of price declines during the next recession. Globally, capital spending per barrel of oil produced is down two-thirds from its peak. Most oil companies continue to prioritize returning cash to shareholders over new investment.
In the metals sector, new capital investment has also been weak. Metals inventories remain at exceptionally low levels. In many countries, political uncertainty continues to hamper investment.
Over a multi-year horizon, the outlook for metals is better than for oil. The transport sector currently accounts for about 60% of global petroleum demand. The shift towards electric vehicles will steadily erode the demand for oil. The adoption of EVs will benefit industrial metals, as they are heavily used in both the production of electric vehicles and in the electricity distribution networks necessary to support them.
We have not made changes to our portfolio recently as we were well positioned for the recent rebound in equity markets. We are overweight international markets, especially Asia at the cost of an underweight in the U.S. However, in the U.S. we have a slight overweight in the higher beta cyclical sectors, which have performed well on the back of the lower bond interest rate expectations.
We do have an overweight in the global financial sector, but mostly geared towards the large banks and insurance companies, which ironically are likely to benefit from the recent stress in the banking sector.
DISCLAIMERS & DEFINITIONS
This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results.
Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.
Investing internationally carries additional risks such as differences in financial reporting, currency exchange risk, as well as economic and political risk unique to the specific country. This may result in greater share price volatility. Shares, when sold, may be worth more or less than their original cost.
Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices do not account for any fees, commissions or other expenses that would be incurred. Returns do not include reinvested dividends.
The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value-weighted index with each stock’s weight in the index proportionate to its market value.
Investments in commodities may have greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.