Emmanuel Petit
General Partner, Head of Fixed Income
Earlier this year, investors were wondering how effective the main central banks’ action would be. Then the shock in the banking sector cast doubt on whether restrictive monetary policies would continue, even as inflation remained high.
Stubborn inflation
ADuring the quarter, inflation driven by job market pressures forced central banks to stick to their firm language and restrictive monetary policies. Even so, concerns have remained very much alive over stubbornly rising inflation, particularly core inflation(1). These fears have pushed key rate expectations up so much that yield curves have inverted(2) to an extent not seen in the past 40 years. And this environment has shaken the banking sector to the breaking point.
An initial alert
On 10 March, Silicon Valley Bank (SVB), the US’s 16th largest bank by balance sheet size, suffered massive losses in an attempt to honour massive, simultaneous customer withdrawals, triggering its collapse. This was the largest bank failure since Lehman Brothers in 2008 and revived memories of a risk of contagion to the entire global banking system. To soothe these fears, the Fed and the FDIC(3) stepped in rapidly to guarantee deposits and offer lending facilities. This prompt reaction, while well received by the markets, was unable to head off flight to quality(4) throughout the yield curve. Rate-hike expectations collapsed as a result.
A second shock
The following week, between 15 and 17 March 2023, Credit Suisse, Switzerland’s second-largest bank, suffered massive deposit flight after some ill-considered statements by its main shareholder. Already shaken by a series of controversies and latent governance issues, Crédit Suisse’s shares went into a tail-spin. Here again, to head off the risk of contagion, the Swiss regulator and Swiss government took prompt action. The episode culminated in the following days with the Crédit Suisse’s takeover by UBS.
Clearly restrictive financing conditions
As these successive crises are due essentially to errors of management at the two banks, it would be overstating matters to suggest that an across-the-board loss of confidence has occurred in the banking sector. All of this is nonetheless revealing of the nascent fears over the consequences of restrictive monetary policies that central banks have conducted to rein in inflation. Moreover, these two events may be regarded as the first visible indicators of the efficiency of monetary tightening. Since they occurred, banks have been far more cautious in their loan practices, toughening their access to lending drastically. This has considerably accentuated the effect of monetary policies, confirming their impact, which is now spreading to both households and companies.
A clean bill of health for the European banking sector
One crisis after another, and in particular the failure of Credit Suisse in March, have cast a pall on the European banking sector. And yet, on the profitability level, first-quarter earnings reports revealed robust banking income (NBI), driven mostly by interest income, due, in turn, to central bank rate hikes since mid-2022 in Europe. With costs under control and a still-moderate cost of risk, consensus forecasts have even been raised for the current year.
The big question after the March shock was solvency, and banking groups have also reported excellent numbers in that area, with a surplus of 4.4 points(1) over central banks’ minimum requirements. Lastly, following the recent stress triggered by the standing of US regional banks and deposit flight from Credit Suisse, banks have made a point of reporting on their liquidly buffers and their stock of highly liquid assets. Highly liquid assets consist, on average, of 60% in cash held at a central bank, 20% of saver deposits(2). Such levels reassure investors on the solidity of the European banking system.
(1) Sources : Companies, ECB, May 2023.
(2) Sources : Companies, Rothschild & Co Asset Management, May 2023
On the eve of a recession
In reaction to these crises, yearend US rate expectations have dropped to 4.25%, down from 5.75% at the start of 2023. It now seems to be a given that most of the rate hikes are behind us. In the US, the markets appear to believe that the last 25-basis-point hike was made at the 3 May FOMC(5) meeting, raising the key rate to 5.25%. The markets are also pricing in three rate cuts by yearend. The message that these market expectations are sending out does not augur well for the solidity of economic growth.
So what are some possible scenarios for the months and quarters to come? Either: 1/ core inflation remains high (or recedes only slightly), which would be consistent with the tightness of the job market in particular, and this shift in expectations looks premature; or 2/ growth momentum crashes more violently. And that is indeed the message that the bond markets appear to be sending out via these retreats in key rate expectations or the yield curve inversions, as well as in some leading indicators, such as the Conference Board’s Leading Economic Index.
While generally reliable, these signals cannot gauge the extent of a potential recession. Moreover, there is no correlation between the extent of a recession and the correction that could then occur on the markets.
A two-track economy
While rates have risen at similar paces on both sides of the Atlantic, they are still far lower in Europe than in the US. In Europe, real rates are still negative, while inflation continues to gain ground. A slower pace is therefore highly unlikely. The ECB accordingly has some manoeuvring room, and is likely to stick to its tightening bias.
Meanwhile, in the US, on top of the signs of recession, evidence is emerging of a slower pace of inflation. This desynchronisation between the US and Europe suggests that European rates could fall solely because the Fed may end its monetary tightening cycle. Indeed, as soon as reassuring numbers are released in the US (on jobs, unemployment rate, etc.), rate expectations in both Europe and the US will fall without distinction between the two.
How to react to this context?
This gap between the US and Europe makes investors’ task more complicated, particularly as regards timing. The uncertainties surrounding monetary policies and when the pivot will come have stoked steep volatility on the markets. Even so, now that most of the monetary adjustment has been made, bond yields are once again attractive.
We therefore are taking a cautious view in environment of volatile government bond yields, and are avoiding too much risk in corporate bonds. Accordingly, we are steering a course between short maturities when rates are high, and longer maturities when rates are lower in both government and investment grade corporate bonds(6). While the latter underperformed all other asset classes in 2022, due to rising interest rates, it is nonetheless a low-risk asset class that is now paying off more than in the past 10 years. It also offers an especially attractive risk-reward pairing, and investment grade companies have resilient profiles that are likely to more fully absorb an economic downturn by exploiting lower interest rates. Moreover, during the March market correction, we noted that the situation had “normalised” somewhat, with investment grade recovering its “protective” profile during a period of high tensions.
In parallel, we are investing in high yield(7) highly selectively while avoiding its riskiest segment. The main issue now is on the level of portfolio protection, assuming that rates rise any further or in the event of a global recession. If this does occur, the important thing will be to determine its extent, in order to decide on the best possible hedging instruments.
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