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What to expect after the failure of Silicon Valley Bank
Every month, our Asset Allocation Committee meets to discuss and debate our market outlook.
How has our asset allocation changed month-on-month?
Chief Investment Officer, Bernard Swords, presents our views.
Macro Background
As this is being written (14th March, 2023) the largest US bank failure in over a decade is being dealt with and this is still an evolving story. Two banks, Silicon Valley Bank and Signature Bank have been closed by regulators. The authorities in the US have moved swiftly to deal with the situation guaranteeing deposits in the failed banks and providing more liquidity to other banks that may need it to meet their obligations. At the moment it does not look like it will cause any major problems for the US economy or financial system (see our Market Pulse March 13th for further details here). However, it is a reminder that impacts from monetary tightening will be felt later and there are probably more issues that will emerge, a major reason why we have a cautious outlook.
Until this event the markets were focused on the inflation reports which, so far this year, are showing some increase in pressures in the Developed World and inflation forecasts for 2023 are rising. In the euro area, the Consumer Price Index (CPI) report showed a re-acceleration in core inflation. The inflation path in the euro area has been disappointing. It started to rise later than in the US, so one would have expected a time lag before it copied the down trajectory of the US. However, the time lag on the inflation path down is now longer and the level of inflation is now higher in the euro area than in the US. This has surprised people and has led to a significant increase in interest rate expectations. The Federal Reserve has also got more aggressive noting that the stronger growth data could mean interest rates going higher than currently expected and staying higher for longer than expected. All thought of a pivot from central banks had disappeared but now the failure of the two banks in the US is bringing this back into question. It is also leading to reductions in interest rate expectations in both the US and euro area over the short-term.
On the brighter side, the growth data from all regions is improving and there is a series of upgrades to the growth outlook for the global economy. This process started with a more resilient performance from the euro area over the winter months followed by China’s move towards reopening and the US is now starting to show more momentum. This drive is now being called into question by the bank insolvencies in the US, but then again, their problems do seem to be quite idiosyncratic, and the authorities have moved to ensure a smoothly functioning banking system. So, the growth damage may not be great, but it does indicate the challenge that the global economy faces as we travel through 2023.
Fixed Income
As we write today, there has been a significant change in market mood and nowhere can this be seen more clearly than in the fixed income markets. After the rally in January, fixed income markets had gone into reverse and 10-year yields were heading back towards the highs of the last 12 months. This was being driven by stronger economic growth and labour market data showing that economies are proving more resilient to central bank rate hikes than initially anticipated. Along with this were continued signs of more persistent inflation, leading to higher terminal rate expectations for central bank policy rates.
Over the last week, this has turned around again, and we are seeing one of the biggest rallies in fixed income markets in over the last 50 years. Undoubtedly some of this response is somewhat ‘knee jerk’ and there will be some normalisation. It is important not to lose sight of the fundamentals. Developments in the US are not friendly to economic growth and remind us of the risks that exist after the interest rate increases that we have had. This is a good background for fixed income markets. However, we still have the inflation issue to deal with and what it means for interest rates. As a result, we maintain our preference for short-dated bonds. The US authorities have moved to limit the damage from the bank insolvencies on the wider economy so picking up extra yield from short-dated investment grade credit is still a sensible strategy.
Equities
As in the fixed income markets, the equity markets have also seen a turn in mood. They were quite resilient as the stronger growth data was released. Another positive was the stable earnings forecasts. Over the last month we have had approximately a 0.5% cut to the global earnings level, the smallest cut we have had since last September. Optimism also fed into sector performances with the defensive sectors (Healthcare, Consumer Staples and Utilities), the laggards this year.
This has flipped around over the last few days with equity markets very weak and the defensive sectors coming to the fore. The short-term reactions are probably extreme, but we believe that this tone will stay with us for some time. We have only seen some glimpses of what the monetary tightening to date will do to the real economy. These measures take time to put into place, but it looks like that lag is coming to an end. This year will be a challenging one for economic growth and therefore profit growth. Investors would be wise to stay in dependable and defensive profit streams.
Asset Allocation: Cautious Outlook
Positioning
There has been a rapid turnaround in financial markets over the last couple of days and no doubt the extent of the moves will not prove sustainable in the short-term. However, there are some lessons we can take from the recent events. Firstly, we have not seen the full economic impact of the monetary tightening that has occurred over the last 12 months. 2023 is going to be a challenging year for economic growth and thus for risk assets. Should interest rate expectations be cut as a result of this type of turbulence, risk assets will bounce in value but that is unlikely to be sustainable. We remain cautious on equities.
Fixed Income’s ability to provide an offset in turbulent times has returned and we are now getting paid for holding it in the calmer times. We expect 2023 to be challenging and thus we would favour fixed income over equities. The course of inflation is still uncertain, where will it peak in the euro area and how quickly will it subside globally, this keeps our duration short.
Bernard Swords,
Chief Investment Officer
Bernard joined Goodbody in 2002 and is Chief Investment Officer. As CIO, he formulates and implements the global investment strategy and chairs the asset allocation committee. Bernard also leads the investment research team.
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