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Markets are pricing in a rosy scenario in which economic deceleration will force the Fed to cut rates in 2023. However, we believe the Fed will stay on hold for 2023 and cut rates only in 2024. Inflation is cooling slowly, and the US economy is cooling down as well. From an equity perspective, we remain concerned about future profits, which leads us to stay defensive on equities and credit. On the fixed income side, we stay constructive on US duration and expect the US yield curve to steepen.
The current US debt ceiling was reached in January and the US Treasury warned that it would run out of cash to meet its expenditure commitments around June 1st, although a precise date is impossible to predict. The Republicans’ initial proposal asked for spending cuts to the tune of a 1% limit on the annual growth of nominal government expenditure over the next ten years. This fiscal contraction, along with a tight monetary stance, would be negative for economic growth. However, a default would be even worse for the economy.
Our assessment is that most banks are much better prepared to withstand financial volatility today than they were in 2008-9. As a result of the systematic application of much greater regulatory oversight, US banks have much higher levels of equity capital, better funding and liquidity, less leverage and much lower asset risk. With the potential for stronger supervision and regulation across the sector, we suggest investors carefully select securities from larger, well-capitalized banks with diversified business models and conservative lending strategies.
By incorporating both a fixed income and equity component, equity-linked notes (ELNs) can allow investors to benefit from higher interest rates while also participating in equity market performance. Learn why ELNs can be attractive investments in today’s economic environment.
Investor sentiment is downbeat, but not overly bearish. With tightening credit conditions, our US growth outlook is lower compared to that of the International Monetary Fund (IMF), while we are more optimistic on China. This supports a cautious stance and a search for opportunities across the emerging world. There are some signs of complacency on Europe, while debates were mostly focused on geo-economic fragmentation and the urgency of policy action regarding crisis management and to secure artificial intelligence development.
US Federal Reserve Chair Jerome Powell addressed concerns about the banking system, stating that conditions have broadly improved since early March, and re-emphasizing that Fed focus will now be on credit tightening. He said the Fed needs a few months of data to determine if monetary policy is sufficiently restrictive and continued to reiterate the importance of lifting the debt ceiling. While the financial markets may become excited about the prospect of the Fed moving to or near a pause, we would advise caution regarding any near-term course reversal by the Fed since the incoming inflation and economic data are not likely to support rate cuts.
We see a deteriorating US economic environment amid the Fed's slowing monetary tightening, rising costs of credit for the real economy, and stubborn core inflation, particularly in Europe. A weak US economy is unlikely to leave Europe untouched. Thus, we suggest maintaining a cautious tilt on risk assets, strengthening hedges, and utilizing the safe haven characteristics of US Treasuries. On the last issue, the Fed is close to the end of its tightening cycle and this may create opportunities in the medium term range of the yield curve.
High yield market conditions opened January on a positive note, with decreasing yields and tightening spreads as investors put cash balances to work that had grown over the year-end holidays. The release of US December inflation figures in mid-January furthered the narrative of inflation coming under control, fueling market optimism. However, the release of the January inflation figures in February had the opposite effect, with slower declines in inflation provoking statements from US Federal Reserve officials that rates would need to remain higher for longer, thus depressing markets.
Despite the failure of a handful of banks in the US and one in Europe, our view is that 2023 will not present a financial crisis in the magnitude of the Global Financial Crisis (GFC) of 2008. Furthermore, we believe now is an opportunity to take advantage of the volatility in the banking space by increasing allocations to the banks that we believe to be structural winners—those that have invested in technology or have enviable deposit dynamics.
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