While investors appear to have largely made their peace with the banking sector’s temporary crisis of confidence the speed of monetary policy post-Covid has highlighted specific pressure points. The mismatch between liabilities and assets at certain specialist US banks has not spiraled into a systemic risk, the quick conclusion to First Republic’s issues made it possible to avoid renewed fears regarding US bank deposits, while Credit Suisse has been all but underwritten by the Swiss government via UBS. And while confidence has been damaged, European banks have liquidity coverage ratios of 160% and net stable funding ratios of 130%1 and are still, for now, benefiting from the lagged impact, compared to the US, of the interest rate cycle. However, the episode neatly highlights how protracted the process of adjusting to rapidly rising interest rates can be across the global economy.
In a period of monetary policy adjustment, the financial sector becomes the primary mechanism of transmission. In the US, M2 money supply has contracted for eight straight months and the impact of such contraction generally has a lag of between four to six quarters. In a context where “money has a cost again” industries and consumers will ultimately be impacted, although in an initial phase of inflation deceleration, real income will improve and support consumption. Some economic indicators are also deteriorating, albeit slowly. The latest manufacturing PMIs (Purchasing Managers’ Indices) in the US, Eurozone, UK, and China all declined by 1 point in their latest readings, with the US firmly in contraction at 47.1. US jobs numbers similarly show that while unemployment remains at a multi-decade low, the pace of hiring is decelerating. However, while all lead indicators are pointing down, the “time to impact” – in terms of potential recession – is being delayed by excess liquidity injected during the pandemic.
At the same time, with China reopening, and India continuing to grow healthily, we see, as so often in the past, a divergence in growth paths between the two Asian behemoths, and the G7 economies, which are stagnating. Indeed, looking at the growth recorded by China and India in Q1 2023, we expect that they will contribute 50% of the world’s economic growth in 2023. So, while there are some contradictory signals, with equity markets remaining relatively buoyant in the face of an inverted yield curve that is often an omen of recession, the outlook remains cloudy. While the major economies have managed to shrug off the danger of recession in 2023, the prospects for 2024 are much less clear.
Softer economic data has combined with easing inflation numbers. In the US, the consumer price index (CPI) for March rose 5% year on year, easing to its lowest level in nearly two years. Recent financial stress has further reduced banks’ willingness to lend, with European bank lending falling 22% in Q1. As a result, market participants now expect the US Federal Reserve to start cutting interest rates as early as September, with a peak of 5% in June.
Yet with core CPI (which strips out volatile energy and food costs) rising 5.6%, there is reason to believe that price pressures for services will remain resilient, even as economies potentially begin to slow, especially with wage demands and labor costs, a lagging indicator, rising in many sectors. The risk of stagflation cannot be ignored, and central banks thus continue to face the difficult task of determining a policy stance that is sufficiently restrictive to lower inflation, yet not so high as to risk financial stability. And, of course, given so many unknowns, there is the risk of a policy mistake. The market currently views erring on the dovish side as most likely, pricing in a rate cut by July of this year with further easing to come.
The rhetoric from central banks so far suggests that policymakers will still want to see clearer signs of inflation decelerating before pivoting. Indeed, in the Eurozone, prices rose 7% in the year to April, compared with a rise of 6.9% the previous month – the first rise in six months – while core inflation fell marginally to 5.6%. Weighing the risk of a policy mistake, central banks may still take the view that recession and significant damage to labor markets are the necessary prices to pay to mitigate cyclical inflation.
Persisting uncertainty on these fronts continues to create volatile equity markets. A recession seems to be looming, but leading indicators may be giving us lagged predictions due to extreme monetary policy at the height of the pandemic. As investors shift their focus from inflation and rates to recessionary pressures, the key for their portfolios will be keeping strong companies across the style spectrum, with an emphasis on quality, dividend, and sustainability, anchored around reasonable valuations and long-term structural trends. Understanding margin resilience for the rest of 2023 is critical as volatility around the US debt ceiling and US elections will also arise. Particular themes which we believe remain attractive include profitable technology and selective industries – such as those companies benefiting from reshoring, automation, or climate solutions. Consumers’ real income should also appreciate in an environment of slowing inflation albeit dependent on economic growth or lack thereof. China’s historically counter-cyclical economy also continues to present selective opportunities.