The Federal Reserve is considering to end the monetary tightening cycle, but it has no intention to cut interest rates - markets take a different view. Equity investors are currently better compensated in Europe than in the US, therefore we upgrade European equities to “neutral”. The banking crisis has caused severe turmoil in credit markets, thereby putting subordinated bank bonds to the test.
In March, we literally experienced a banking earthquake. Several financial institutions in the US got into trouble. Silicon Valley Bank, a well-known regional bank, had to cease operations, and First Republic Bank is still experiencing payment difficulties. Even one of the thirty systemically important banks, the Swiss banking group Credit Suisse (CS), was affected. In a dawn-to-dusk operation, the financial institution was pushed by the Swiss government, the Swiss National Bank (SNB) and the supervisory authority (Finma) into a forced marriage with Switzerland’s largest bank, UBS. On its own, CS could no longer survive.
By the textbook, investors would expect central banks to stop tightening monetary policy. But the SNB (+50 basis points), the Federal Reserve (Fed, +25 basis points) and the European Central Bank (ECB, +50 basis points) have all continued to raise key rates despite the tense situation. The SNB and the ECB have also announced further rate hikes. The fight against inflation, which is proving to be very stubborn, thus remains the top priority for the monetary authorities.
Fed Chairman Jerome Powell, on the other hand, has talked about an imminent end to the hiking cycle and indicated that the US central bank will take a pause. A pause, however, does not mean a turnaround. Powell has made it clear that the Fed has no intention of cutting rates any time soon. Capital markets see things very differently. They are pricing in interest rate cuts of around 100 basis points in 2023 and anticipate an easing of another 100 basis points the following year. We do not expect any immediate rate cuts unless the US falls rapidly into recession in the second half of the year.
In our view, the big unknown in the coming weeks remains how many banks have a mismatch of assets and liabilities on their balance sheets. Central banks, led by the Fed, are acting very decisively and are providing a lot of liquidity to financial institutions, which has also led to a further expansion of balance sheets. In this situation, investors should know exactly what risks they have in their portfolio. The example of AT1 bonds issued by Credit Suisse shows how important it is not only to know the risks in the portfolio, but also to actively manage them. Selection is crucial in all asset classes and applies not only to stock selection but also to credit selection in a bond portfolio.
The macroeconomic environment is likely to remain challenging in the second half of the year. Growth momentum is expected to weaken further and the probability of a recession in the major industrial countries has increased in recent weeks. A deep recession in the Western world is still not our main scenario. At the same time, core inflation is likely to remain high for longer. Therefore, we expect an ongoing tight monetary policy by central banks, and especially the Fed and the ECB. Against this backdrop, we are sticking to our defensive investment strategy. We favour bonds and alternative investments and are neutral on liquidity. We maintain our “underweight” in equities, as earnings yields and risk premiums are currently too unattractive, especially compared to short-term bonds.
Earnings revisions are beginning to stabilise, but the risk of an earnings recession in the second half of the year has not yet been averted. Given the different valuation levels at regional and sector levels, stock selection is likely to become more important. We are upgrading Europe to “neutral”, emphasising our preference for the “rest of the world” over the US. At sector level, we upgrade consumer discretionary to “neutral” and energy to “overweight”. In addition, we confirm our underweight in technology and our overweight in healthcare.
Despite slightly lower interest rates at the long end, we consider the fixed income space to be attractive. Especially the short-term segment continues to offer return potential. On a portfolio basis, we recommend a neutral duration relative to the benchmark. Within credit, the macro environment continues to favor investment grade bonds over high yield.
Not only do we consider gold to be an important long-term portfolio component, we are also overweight in our current tactical asset allocation (TAA). In addition, we have a preference for hedge funds. As for insurance-linked securities (ILS), we are moving from “underweight” to “neutral”.
The US dollar may have peaked last autumn, not least because of purchasing power parity (PPP) – the US dollar is very expensive against the euro. At current levels, PPP and the carry differential argue against a US dollar rally, but in times of crisis the US dollar is seen as a safe haven. We expect volatility to increase in the coming months due to heightened uncertainty caused by the banking earthquake.