Capital Ideas^TM

Markets appeared optimistic amid strong macro indicators until early March, when the collapse of two US regional banks and forced sale of Credit Suisse led to a risk-off sentiment. Treasuries rallied sharply, the yield curve steepened significantly and credit spreads widened. The Bloomberg US Aggregate Index ended the quarter up 3%, the yield on the 10-year Treasury fell 41 basis points (bps) to 3.47% and investment-grade credit spreads widened to 138 bps, from 117 bps in late January.

In our view the banking crises in the US and Switzerland are not a broader threat to the stability of the global financial system. They crystalised lurking concerns investors had regarding the impact of rising rates on bank balance sheets and their potential impact on the liquidity position. However, the fallout will likely create tighter credit lending standards and increase cost of funding for regional banks. We believe these impacts are disinflationary and will affect consumers, potentially slowing down the path of the Federal Reserve’s interest rate hikes and pulling forward or increasing the probability of a recession.

Despite an aggressive rate path in 2022, inflation rates remain high globally, though some signs of relief are emerging. Supply chain tensions continue to improve reducing pressure on goods prices. Energy prices are lower, and services inflation appears to be leveling off but at an elevated rate. In Europe, inflation continues to decelerate though underlying pressures remain stubborn. Inflation will likely continue to fall as monetary policy tightens in the US and other parts of the developed world and stress in the banking system leads to tougher lending standards in the US and Europe. However, strength in wage growth and tight labour markets will likely keep inflation above central banks’ targets by year end.

Tightening monetary conditions are starting to bite. A report by the Institute for Supply Management indicated that manufacturing activity fell to 46.3, on the back of weakening new orders and inventory. Services, the largest segment of the economy, fell to 51.2 in March as a result of weaker new orders and lower business activity. A reading below 50 means contraction. Additionally, companies moderated their pace of hiring in March, underscoring that rate increases may begin to impact the labour market. Coupled with tougher lending standard across the financial sector, we believe the Fed may soon pause rate hikes.

Despite the turmoil caused by the failure of Silicon Valley Bank and loss of confidence in Credit Suisse, the European Central Bank raised rates by 50 bps and maintained its pace of running down an asset purchase programme at €15 billion a month until June, at which point it will reassess. The current tightening of financial conditions, a stronger euro and weaker demand in the eurozone implies a lower terminal rate than we might have expected before the European bank concerns. It’s possible we are now close to the terminal rate in Europe.

Despite the increased probability of a recession, the economic outcome of higher rates and slowing growth remains uncertain. Valuations across credit sectors are pricing a more challenging environment, but a recession would push spreads wider. A bias toward higher quality credit persists. Yield curve positioning remains a significant consideration as further steepening is expected. Forward returns in fixed income remain attractive as current valuations suggest that returns from rates could offset weakness in spreads for credit sectors.