Gov Sovereigns/Treasurys

High rates have hurt real estate and, now, banks. The next shoes to drop: Loan growth, profits, and employment. Stay defensive. Recession is probable, but risk assets have not priced it in.

In this Strategy Outlook, we present the major investment themes and views we see playing out for the rest of 2023 and beyond.

In Section I, we discuss the implications of the banking crisis that emerged in March. We do not expect what happened in the US or Europe to morph into a full-blown meltdown of the financial system, but this month’s events will likely lead to a further tightening in bank lending standards, raising further the odds of a US recession over the coming year. We continue to recommend an underweight stance toward risky assets versus government bonds over the coming 6-12 months, and defensive positioning within a global equity portfolio. In Section II, we estimate the impact of recently-passed US legislation on US business investment over the structural horizon and conclude that it will indeed boost capex growth over the coming several years. Assets poised to benefit from this trend will likely underperform over the coming year but should be bottom-fished following the next recession.

The recent uncertainty regarding the health of the banking systems in the US and Europe is not having any material impact on overall financial conditions or economic sentiment. The aggressive rate cut expectations, especially in the US, are unlikely to be realized. Although the macro growth and policy backdrop remains unfriendly for corporate debt on both sides of the Atlantic.

It is too early to know whether the drop in bond yields will offset the drag on growth from tighter lending standards. But if it does, the net effect on equity valuations could be positive. This is enough to justify a modest tactical overweight to equities, with the proviso that investors should look to reduce equity exposure later this year in advance of a mild recession in 2024.

The Fed lifted rates 25 bps yesterday while also signaling that the tightening cycle is near its peak. We discuss the short-run and long-run implications for Treasury yields.

Some quick takes from today’s FOMC meeting.

The Bank of Japan is about to get new leadership when Kazuo Ueda takes over as governor in April. Will there be a new monetary policy to go along with the new governor? We attempt to answer that question, and what that means for global bond markets and the yen, in this Special Report.

The turmoil in US regional banks will weigh on economic growth. Arguably, it would be better for the broader stock market if growth slowed because banks became more conservative in their lending than if it slowed because the Fed had to raise rates to over 6%. In both cases, economic growth would decelerate but at least in the former scenario, the discount rate applied to earnings would not be as high.

Depending on market volatility during the next few trading days, the Fed will either lift rates by 25 bps next week or pause its tightening cycle. Either way, the Fed’s hiking cycle is close to its peak but rate cuts won’t be coming anytime soon.