Job Done – or work to do?

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For financial professionals only

Interest rate hikes in the US, UK and EU remained in line with market expectations in March, despite increased financial sector instability triggered by US regional bank bankruptcies and fears of contagion in certain European banks. Quick and decisive action by the US and Swiss monetary authorities broadly reassured markets and shored up confidence, with corporate credit and equity markets remaining open and continuing to function.

This encouraging reaction supports the view that incidents like these are not indicative of systemic risk, just isolated examples of poor risk management, governance and oversight. However, the implications for global growth and direction of future monetary policy are worth considering, especially when the macroeconomic data in some western economies already appears to be wavering.

US financial fragility is starting to be exposed

The Fed has a dual mandate of full employment and financial stability, based on a 2% average inflation target. With inflation currently just over 6%, this is clearly not being met. However, their mandate extends to overall financial sector stability and the effective and efficient functioning of markets. Having raised rates over the past year by 4.75%, the fastest pace since the early 1980s, it’s not surprising that strains and stresses are beginning to appear with the higher costs of servicing debt for households, corporates and the US government. 

It's also important to acknowledge that monetary policy works with a long and variable lag. Given the Fed first started raising interest rates in this cycle 12 months ago, the effect of these higher rates probably hasn’t been fully felt yet. Arguably, the Fed should proceed more cautiously from here, especially with a growing probability that economic activity will slow. If they carry on raising rates in an attempt to quash inflation, the risk of over tightening grows. This increases the odds of a deep recession and therefore a hard landing, something that, in our opinion, the market isn’t priced for.

Growth is already slowing

High frequency data shows that economic activity in the US is slowing (as seen in the charts below).  The housing market has been in a recession for over 8 months and contributes just under 20% of GDP. With the number of unsold completed units rising and increasing cashflow challenges for property developers as credit availability tightens, falling prices are anticipated. The highly documented tightness in the labour market is easing quickly with job vacancies contracting and layoffs accelerating. Layoffs aren’t in the unemployment statistics yet because most were given severance pay, so can’t claim unemployment benefits for a period of time. Small businesses, which are core contributors to GDP growth and employment, are seeing a softening in demand from less confident consumers, as well as feeling the liquidity squeeze from higher interest rates. As a result, The National Federation of Independent Business (NFIB) small business optimism index is depressed and demand for corporate loans is decreasing (current levels are even lower than after the early 1990s recession).

Source: Alpine Marco 2023

Financial conditions are expected to tighten even further

Add the increased strain on liquidity that’s being experienced by the regional US banks, which makes up 50% of commercial & industrial loans, 60% of residential mortgages, 45% of consumer credit and 80% of commercial real estate loans, the negative implications for economic growth are clear.

The result is a marked tightening of financial conditions, as shown in the chart below of the Senior Loan Officer Survey plotting tighter lending standards. This brings an increasing risk of a looming credit crunch.

Job Done 2

Source: Pantheon Macroeconomics

Why did central banks raise rates in March?

Central banks were caught between a rock and a hard place. If they hadn’t raised rates, their inflation fighting credibility would have been further questioned. Some would argue that’s already in doubt. And given the strength of their signalling higher rate rises just a few weeks before, doing nothing could have undermined confidence in the system, raising the risk of increased financial sector instability – something they’re at pains to avoid. They’re now treading an increasingly narrow path of assuredness and calm in the hope of winning investor support to help them achieve a soft landing.

We’re cautious on the likely success of this approach. Within our Tactical solutions, we moved underweight US equities earlier this year, due to relatively elevated valuations and consensus earnings expectations being susceptible to downside. This allowed us to add to our overweight to global government bonds in expectation that duration would offer some protection for portfolios if macroeconomic uncertainty picks up. This has largely played out during the recent market volatility, with more attractive yields in government bonds and quality corporate credit supporting lower and even negative correlations with equities, albeit over a short time period, validating their inclusion within a diversified portfolio. We’ll continue to monitor this over a longer time period.

What's the probability of policy error?

If the Fed and other central banks continue to be data dependent, which invariably means looking at backward looking data such as inflation and unemployment, then the risk of policy error grows. Our Asset Allocation Committee will continue to monitor this, but our current view is that while we are late cycle, we’re at the early stage of contraction. Given the rising risk of tightening financial conditions this may well accelerate the contractionary phase. The positive is that this will bring us closer to a ‘pivot’ in monetary policy as central banks shift from raising rates to pausing and then cutting. In time, this typically leads to the prospect of a recovery, a period which tends to often be supportive of growing returns for investors.

How to ride out the storm?

Maintaining a disciplined and diversified approach with strong governance and oversight remains key. As supply of liquidity tightens and becomes more costly, the areas that most benefitted from the extended period of very low rates are likely to be the most affected. Further accidents and casualties would be unsurprising.

Our fund selection process deliberately favours quality as a style – with cashflow, profitability and balance sheet strength common hallmarks. This approach should help us through this period of uncertainty, and set us up nicely for the recovery, as and when it comes.

For investors with a higher risk appetite, we have a positive view on Emerging Markets. Their proactive central banks moved ahead of their developed market peers in the fight against inflation during 2022, and are therefore nearer to easing monetary policy today. China’s reopening post Covid is expected to support positive upside surprise to GDP growth, US dollar strength is expected to wane which will act as a tailwind to the asset class, and valuations are near to historical lows on a relative basis.

At times like these when it feels the least comfortable, often the best investments are made. Investors can look forward to building on their agreed financial plan with the support and guidance of their advisers.

Financial markets are one of very few that when ‘for sale’ signs go up with cheaper prices, people tend to walk away! As seen in the CNN Fear & Greed Index below, the ‘for sale’ sign is currently hoisted. This could be a nice long-term opportunity, especially as and when the Fed decides their monetary tightening job is done. Forward looking, disciplined and long-term investors can often be rewarded.

Job Done 3

Source: Fear & Greed Index – Investor Sentiment, CNN Business

This article is for financial professionals only. Any information contained within is of a general nature and should not be construed as a form of personal recommendation or financial advice. Nor is the information to be considered an offer or solicitation to deal in any financial instrument or to engage in any investment service or activity.

Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.  

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