Strategy Update: Stay the Course
In spite of the extreme bank-induced market volatility of the last few days, we do not make any major changes to our Strategy views.
Economic outlook: modest recession still expected in the US this year amid an environment of falling inflation rates, with tighter credit conditions partially offset by lower interest rates and a substantial boost to global liquidity. Central banks are close to peak reference interest rates.
Asset class views: Positive on Equities, Neutral on government bonds and Positive on investment-grade credit, Positive on alternative assets including Commodities, Neutral on Real Estate.
Changes in view: we downgrade short-term government bonds to Neutral post the substantial rally over the last two weeks.
Flight to safety has boosted the gold price to around USD2000/oz. We remain Positive on gold for the long term, but for now we would take partial profits after a 9% rally since 8 March.
Quality in Equities: we retain our preference for Europe, UK and Emerging Market geographies. In terms of investment style, we now prefer Quality, given the fall in long-term interest rates and the greater near-term economic uncertainty.
Lower stock indices, high volatility and elevated dividend yields increase the attractions of equity-linked capital guaranteed structured products.
Short duration in investment grade Credit: we like short-maturity euro and US IG credit at this point given the risk that longer-term rates move back higher.
Commodities: post the sharp recession fear-driven drop in crude oil prices, we see opportunities in energy exposure at this level.
Authorities have acted quickly
Central banks have learned the Lehman lesson: central banks (Fed, ECB, Swiss National Bank, Bank of England, Bank of Japan and Bank of Canada) have taken strong and coordinated actions to contain the current banking crisis and avoid a domino effect.
As a consequence, the risks of a systemic impact on the sentiment of consumers and companies have fallen sharply. Consumer confidence has been mainly driven by inflation uncertainty and the strength of the employment market.
We keep our assumption of a sustained fall of inflation over the coming months. For both the US and Europe, it should fall below 3% by December this year (year-on-year). Economic activity and the job market should cool down as a consequence of the recent central bank interest rate hikes.
Unemployment should, however, remain low compared with long-term averages. Even in the event of a bigger fall in activity, the lack of skilled workers should lead to labour hoarding (i.e. companies being unwilling to make workers redundant for fear of being unwilling to rehire later on during economic recovery). The combination of these trends should support consumer sentiment and demand.
The major threat linked to the recent banking turbulence is now the behaviour of banks regarding credit activity. It is likely that they will become more risk averse and tighten their credit conditions.
This could weigh on economic activity over the coming months. Business confidence will probably fall but it will be supported by improving supply chains and a gradual improvement in visibility regarding inflation.
A temporary recession in the US is our base-case scenario. In the eurozone, economic activity is expected to slow further but a recession can be avoided. Even though bond yields could rebound temporarily, we expect them to stabilize again at lower levels by the end of the year when it becomes clear that inflation has peaked and that central banks can lower their policy rates during 2024.
This factor, together with accelerating economic activity in China, should allow growth to recover later this year and accelerate over 2024.
Taking profit on short-dated bonds
Bond yields have fallen sharply: the market is currently pricing a very negative scenario, the end of the tightening cycle for all major central banks and 100bp of rate cuts from June to December for the Fed. The end of tightening cycles may be a premature call as central banks still have an inflation problem and can ensure financial stability with macro prudential tools.
The market reaction seems exaggerated to us as this is not a repeat of the global financial crisis. We expect bond yields to rebound modestly. Hence, we turn Neutral from Positive on EUR and US short-dated government bonds, and on US long-dated government bonds. We remain Neutral on EUR long-dated government bonds.
Higher quality credit has been very resilient: EUR and US investment grade bonds have delivered positive total returns over the past week marked by a bank crisis, as the drop in bond yields has more than offset the widening of credit spreads. On the other hand, high yield bonds have recorded negative total returns last week.
We keep our bias for Quality, and we remain Positive on EUR and US investment grade bonds, with below-benchmark durations (5 years in the eurozone and 7 years in the US). We are Neutral on high yield bonds.
AT1 bonds in focus
The Swiss Financial Market Supervisory Authority decided that Credit Suisse AT1 bond will be completely wiped out, even though shareholders were not. This disrespect of the hierarchy of claims raised questions and triggered a selloff in AT1 bonds. However, rules differ across jurisdictions and issuers.
We are comfortable with the European AT1 as the ECB reaffirmed the hierarchy of claims i.e. “common equity instruments are the first ones to absorb losses, and only after their full use would Additional Tier 1 be required to be written down”. Plus, the European banking sector is well capitalised.
Equities: quick banking reflexes
In Equities, we do not fundamentally change our views. We consider both the recent failures of certain US regional banks, and also the multiple Credit Suisse issues leading to its eventual sale to UBS as idiosyncratic, i.e. special situations that do not reflect systemic issues within the global banking system.
We would note the following:
1. The UBS solution was arrived at swiftly amidst the current turbulence (compared with the slow pace of decisions that were taken during the Global Financial Crisis);
2. US authorities were also quick to intervene in the case of three failed US regional banks;
3. Overall, the US and the European banking systems have never been so strong, well-capitalized, well-regulated, with profitability that is improving due to the sharp rise in interest rates/yields over the last 12 months.
Equities: Favour Quality
In the short-term, quality defensives could outperform further while economic uncertainty (and thus volatility) stays high in financial and cyclical sectors. Attention is likely to shift back to the US where a more structural solution could also be needed for First Republic Bank. The market will also observe what the Federal Reserve will decide and comment after its scheduled FOMC meeting on Wednesday.
In this risk-off context, among defensives, we think the best opportunities are in the health care and in the utilities sector.
But recall that cyclicals are trading at historically low valuations and possess solid balance sheets, especially in the case of European financials and commodity stocks. This typically creates great medium-term buying opportunities.
Many cyclicals are still expected to generate cash flow yields at levels never seen before, allowing them to pay fat dividends, to buy back their own shares, and now, for the strongest ones, to possibly expand via opportunistic acquisitions. However for now, we would wait for a clearer entry point on cyclicals.
Constructive on China
We are still Positive on China. The surprise Reserve Requirement Ratio (RRR) cut last Friday indicates that China’s monetary policy still has an easing bias. There are also different measures from different cities to boost consumption.
Recent momentum in economic data suggests that the economy could exceed the government’s 5% growth target for this year.
The Chinese domestic A-share market could be more immune to the banking turmoil in the short term. Once the dust settles, we expect outperformance of this broad-based Chinese market.
Outlook for Oil and Gold
The higher perceived risk of recession on tighter credit conditions explains recent weakness in commodities. Oil prices have dceclined significantly in the last two weeks, with Brent crude oil hitting USD72 and WTI USD66. Base metal prices have lost more than their January gains.
In contrast, gold prices have jumped to USD2000/oz given rising uncertainty, as interest rates decline and central banks are ready to provide banks facing a bank run with huge amounts of liquidity.
In our view both the oil and base metal declines and the gold surge are exaggerated as we do not attach a high probability to a deep recession
As the US Biden administration wants to reconstitute their strategic oil reserves at prices below USD70 for the WTI and as Chinese consumption returns to normal, demand should increase while supply remains constrained given persistent underinvestment and Russian sanctions. The slow recovery of China has weighed on industrial prices of late, but we know that heavy demand from energy transition should support prices going forward. So we advise keeping existing positions and would take advantage of exaggerated declines to add.
Taking partial profit on gold tactically at around USD2000/oz also makes sense as a failure to break above the two preceding highs might lead to a sharp correction. However, we remain Positive on gold for the longer term. It remains our favourite hedge against extreme risk events.
Conclusion: Stay the course
Over the last two weeks, we have witnessed some historically volatile moves in both bond yields and equity sectors such as Banks.
However, we should take a step back and survey the broader macro and financial market landscape. I would point out that:
1. The near-term economic growth outlook has not changed dramatically – in the US, the Atlanta Fed GDPnow indicator forecasts 3.2% GDP growth for Q1 2023, well above potential. Europe’s economic surprise index remains well above the zero breakeven level at +48, highlighting stronger-than-expected eurozone economic momentum.
2. Central banks, such as the US Fed, the ECB and the UK’s Bank of England are all close to the end of their interest rate hiking cycles – with inflation rates trending steadily lower.
3. Both short- and long-term bond yields have dropped sharply. The US 2-year Treasury yield has declined 1.2% since 8 March to 3.9% presently, the German 10-year bund yield has declined by 0.65% to 2.1%, and the US 10-year real yield has reset 0.4% lower to 1.3%.
4. Stock markets have been surprisingly resilient aside from the bank sectors: the Euro STOXX 50 is less than 5% away from recent highs, while the Nasdaq 100 has actually risen in the wake of this recent bank-related turmoil.
Given these points, we do not see any conclusive reasons to make dramatic changes to our current asset allocation views.