Asset allocation: crunch won't trigger big rate cuts
Aggressive monetary tightening from the US Federal Reserve and other major central banks has triggered turmoil in parts of the banking industry, inviting comparisons with the global credit crunch that upended financial markets 15 years ago.
We believe fears of a 2008-like financial crisis are overblown. Nevertheless, the economic convulsions resulting from bank closures in the US and the state-aided takeover of Credit Suisse in Europe will soon become apparent: global GDP growth will be slower and below its long-term potential over the rest of this year.
For all this, investors seem to be getting ahead of themselves in expecting the Fed to begin cutting interest rates by as soon as July. Like other central banks, the Fed's hands are tied - high inflation will prevent it from providing monetary stimulus in the coming months even if it sees fit to introduce other short-term measures to ease strains in the banking system.
The overly dovish scenario discounted by fixed income markets is one reason why we have downgraded bonds to benchmark weight. It’s a tactical move. Yields on shorter-dated government bonds have fallen too far, too fast. Cash moves up to overweight as a result.
Our expectations for a renewed bout of economic weakness, meanwhile, mean we remain underweight equities. Not only will stocks’ price-earnings multiples struggle to expand but corporate earnings also look set to stagnate as business conditions worsen.
Our business cycle readings show the banking crunch will weigh on economic growth over the medium term. GDP growth among advanced economies is on track to slow to 1 per cent this year from 2.7 per cent last year.
In the US, recent financial turmoil could prompt small to medium-sized banks - responsible for a third of total lending in the country - to tighten their credit standards, which in turn would weigh on consumption and business investment.
These lenders are likely to remain vulnerable as savers with an estimated USD8 trillion of uninsured deposits could yet park this cash with larger, safer banks or seek other assets to secure higher yields, creating further losses on regional banks' balance sheets.
But there is a reasonable possibility the US economy could avoid a recession.
The country’s households still have USD1.5 trillion of excess savings, while the Fed has provided backstops to prevent more banks from collapsing. Much depends on how resilient consumer and business sentiment prove to be in the face of ongoing turmoil among reginal banks.
The outlook for Europe is not especially positive either, but the region’s financial sector is likely to hold up better than its US counterpart given European banks’ plumper capital and liquidity cushions.
That said, credit conditions are expected to become even tighter as the European Central Bank raises interest rates to tame stubbornly strong price pressures, which should weigh on risky assets.
A bright spot within the global economy is emerging markets, where growth is likely to accelerate to 3.2 per cent this year, led by China, which is enjoying a strong bounce from its post-Covid reopening.
We are also encouraged by signs that Beijing’s regulatory crackdown on corporations is easing, which could brighten prospects for the country’s stocks and bonds.
Declining inflation and recent dollar weakness also bode well for emerging market economies.
Our liquidity model presents a mixed picture. The Fed was quick to respond to the banking crisis, rolling out an emergency lending programme to banks through which it provided liquidity totalling some USD400 billion.
This has had a quantitative easing-like impact on markets, increasing what we consider to be the fair value of S&P 500 index, boosting liquidity-sensitive and growth-oriented equities and trimming yields on longer-maturity bonds.
Given persistent inflationary pressure and resilience of the economy, however, our models suggest that market expectations for Fed rate cuts of as much as 100 basis points this year and a further 100 basis points by 2024 look very unrealistic.
A key indication from our valuation framework shows bonds are less attractive after problems in the banking sector precipitated a sharp drop in yields.
All other assets are trading at fair valuations.
When it comes to profit forecasts, model implies near flat corporate earnings growth globally in 2023. Emerging markets remain the most dynamic region. Here, we expect company profits to grow over 11 per cent this year, significantly more optimistic than the consensus view, which is for a mild contraction.
Our technical indicators provide conflicting signals. With money market funds attracting inflows of some USD340 billion in the recent four-week period, the largest outside of the Covid crisis, it would be tempting to view this as a defensive shift.
The inflow, equivalent to 10 per cent of US money market fund assets, mirrored a flight from bank deposits. Counteracting that signal, however, outflows from equities were limited as redemptions from US stocks were offset by inflows into emerging markets equity funds.