03 May 2023
Ariel Bezalel, Investment Manager, Fixed Income | Harry Richards, Investment Manager, Fixed Income
After more than a decade of ‘easy money’, the financial system has spent the last year or so trying to adjust to a regime of much tighter monetary conditions, the impact of which is only now starting to be fully felt. We’ve already seen a couple of accidents that have disrupted market, but are there more to come? And how soon might the Federal Reserve choose (or be forced by events) to loosen policy? Ariel Bezalel and Harry Richards give their view.
In October 2022, some weeks after the gilt crisis of September, we highlighted the heightened risk of financial accidents that might be generated from a sharp and abrupt tightening in financial conditions and monetary policy after more than a decade of easy money (see “Crunch time”).
The drama around LDI mandates in the UK last autumn were, as we suspected, just the first of such accidents. Another followed in March this year, as the weakness of US regional banks was laid bare while the fall of Credit Suisse (which already started from a weak position) provided graphic evidence of further signs of stress in the system.
Banking as a business is effectively a matter of managing maturity and liquidity mismatches, so an operating environment of persistently inverted yield curves and sharp increase in government bond yields is clearly unhelpful. This does not mean that every bank should be seen as a potential default candidate (more on the subject in this recent article from our financial credit specialists). However, it is clear that weaker starting positions and business models that worked in an environment of low and stable rates might falter in this new environment.
Potential mistakes in oversight and gaps in regulation can also be a factor to consider. The Global Financial Crisis was effectively a “credit” crisis, hence regulatory intervention mostly focused on tools to avoid a repeat of that, largely ignoring interest rate risk (at least in the US). Recent events also remind us that changes in monetary policy can be slow to manifest themselves, but once that happens the manifestation might be quite meaningful, just like Hemingway’s description of how people go bankrupt (“In two ways. Gradually and then suddenly”).
In recent quarters the trend in leading indicators has already been pointing towards a macro slowdown (e.g., Manufacturing PMIs are still below 50 in the US, Euro Area, UK and Japan, while US CPI eased for the ninth consecutive month, hitting its lowest level since May 2021). Future months will be key to see any material changes in trends, especially in job market data.
For the moment, however, the main possible consequence of recent events looks to us like additional tightening in lending standards. These have been worsening already in recent months in Europe and particularly the United States, where there has been a material flight of deposits from regional banks. Higher rates offered by money market alternatives and the absence (so far) of a full guarantee on deposits above $250,000 are main factors behind this trend. More uncertainty on deposits could further impact the willingness to lend across regional banks.
While regional/small banks (the Fed defines a “small” bank as being below the top 25 by assets) are of course structurally less important, collectively they still represent a big component of US lending particularly to smaller companies, which are a key driver of growth. Commercial real estate is an area of special focus for these lenders, with outstanding commercial real estate loans from small banks being roughly 2.5x the outstanding equivalent from large banks. This comes in an environment where vacancy rates on US offices are at a historical peak.
In our broad terms, it therefore remains our view that the US is edging closer to a hard landing, thanks to weaker credit transmission. On inflation, we continue to see structural factors pointing towards lower inflation going forward, with consumer goods and commodity prices key contributors to that. The lagging nature of shelter inflation (which in February was 70% of Core MoM CPI) implies that some time might still be needed for this to catch up with the flat to low growth we see in real-time rental markets. Recent readings have also seen some slowdown in wage growth.
The upshot of lower growth and lower inflation in the US would be less rationale for the Fed to keep tightening monetary policy. We therefore see that the time could soon be right for the Fed to hit pause.
In our unconstrained bond strategy, and acknowledging that there is still space for materially lower yields in the coming 12 to 18 months, government bonds look once more an effective hedge for credit volatility. Despite some recent re-pricing, we still find good value across yield curves in developed markets (especially United States, Australia and New Zealand) and in some emerging markets (S. Korea and Brazil).
We continue to maintain an allocation to credit markets, with a certain bias to lower duration, defensive sectors and secured paper. In recent weeks, however, we started to see the case for a gradual reduction in our overall credit exposure. Further signs of macro weakness might bring us to assume a more conservative stance on corporates.
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