No. We continue to think investors should tightly manage risk by keeping equity allocations and bond duration in line with broad policy targets and resist the temptation to time the market. We entered the year with those views, which depended on our expectation that recessions in the United States and euro area were likely, given the rapid rise in interest rates and our perspective that major central banks would be slow to cut rates to support economic activity. Last week’s bank failures and the related market stress have increased our conviction in these views.
Last week’s US bank failures sparked a sharp sell-off centered in the US banking sector and fueled concerns about financial contagion and risks to the broader economy. The steps government officials took over the weekend have failed to fully stem the tide, as bank stocks have remained under pressure. Since close of business on March 8, two days before the collapse of Silicon Valley Bank (SVB), the S&P 500 Regional Banks Index and S&P 500 Banks Index fell 31% and 15%, respectively. The spill-over to global markets accelerated on Wednesday, as fresh concerns about Credit Suisse added to contagion fears, pulling down other major European banks in the process. The company’s plan to borrow up to CHF 50 billion from the Swiss central bank has for now pacified the sector.
More broadly, markets, especially sovereign bonds, have priced in increased odds of a recession. While global equities have declined just 3.1% 1 since March 8, global bond yields have sharply declined as investors have flocked to the safety of Treasuries and abruptly adjusted their outlook for monetary policy. For example, in the United States, before SVB collapsed, US rates markets were pricing in that the Federal Reserve would raise rates by approximately 1 percentage point more this year before pausing tightening. Today, markets still expect a 25- to 50-basis point (bp) increase in rates over the next few months but are pricing in significant rate cuts thereafter. As a result, two-year US Treasury yields fell more than 100 bps in less than a week, one of the sharpest declines on record.
Further financial instability cannot be ruled out, given the potential disruption from the sharp and globally coordinated increase in rates. Although the situation remains uncertain, we expect the issues at SVB and Signature Bank are idiosyncratic. Most large, systemically important banks do not appear to be at risk, given they have better liquidity, stronger capital ratios, more diverse business models and deposits, stronger risk management practices, and closer regulatory oversight. Still, we expect this crisis will further tighten lending, which increases our confidence that the United States and euro area will enter recessions later this year.
A pivot to cutting rates by the Fed, however, would likely need to be preceded by either a material increase in banking sector stress that risks macroeconomic stability or a severe deterioration in economic data that risks a deeper recession than we expect. Overall, given elevated inflation, the bar for the Fed to ease this year is high. If concerns about financial stability recede, we expect the Fed may hike rates more than the market expects. Today’s decision by the European Central Bank to raise rates by 50 bps, despite the increase in concerns about financial stability, is a clear indication that central banks are committed to bringing down inflation.
Given our views on the economic and rates environment, it could be tempting to underweight equities and bonds and overweight cash. After all, tightening financial conditions not only slow economic growth but also sales growth, and, as a result, earnings growth. However, markets base prices on discounted expectations that can change rapidly over time. Equity market bottoms typically precede economic bottoms and timing these inflection points is difficult. Consider that global equities remain 19% below their November 2021 highs. Underweighting equities now would mitigate further declines, but also lock in losses. When markets move violently in one direction, they tend to correct violently in the other direction. If you are wrong about timing, you can fail to achieve long-term return objectives, given much higher long-term expected returns for stocks than cash or bonds.
Similarly, given elevated inflation and our expectation that the recent rally in rates markets will at least partially unwind if concerns about financial stability ease, it begs the question, why not reduce duration within fixed income portfolios? After all, shorter-duration bonds and cash still yield more than ten-year US Treasuries. However, recent market action highlights the benefit of holding some longer-duration Treasuries. They may underperform short-duration bonds in the near term, but they can provide a valuable ballast to portfolios during periods of market stress. This is particularly true near the end of tightening cycles when the upside for interest rates is limited, and the risk of a deflationary recession is elevated. Therefore, we continue to recommend neutral duration relative to policy within fixed income portfolios.
The turmoil in the banking sector reinforces our view that recessions in the United States and euro area are on the horizon, yet the timing and impact are always uncertain. In such environments, investors should carefully monitor and manage portfolio exposures to maintain broad policy targets.