2023 Q2 Outlook: Moving Fast and Breaking Things

We enter the second quarter in the wake of a mini (so far) global banking crisis following the collapse of Silicon Valley Bank (SVB) and Signature Bank in the U.S. and Credit Suisse in Europe. Policymakers have reacted aggressively to resolve the individual cases and provide backstops through enhanced deposit guarantees and significant liquidity provisions to try and prevent further contagion. At least some lessons have been learned from the Great Financial Crisis and the Euro crisis of the prior decade.

The key questions are:

1. Will the measures implemented by policymakers be sufficient?

2. What has changed, and what are the implications for economies and markets going forward?

1. Will it be sufficient?

Will the measures to stem contagion be sufficient to stabilise the situation and allow markets to calm down in the coming weeks, or are we likely to see further contagion and crisis roiling markets? The only honest answer is that it is simply too soon to know. At this time, uncertainty and fragility remain the dominant factors underlying economic or market outlooks; but there is much we can observe both currently and moving forward.

Ode to a banking crisis: fragility

The failure of SVB appears to be a singular case of extreme management incompetence mixed with massive balance sheet mismanagement. This is what left the bank vulnerable to a run-on deposits rather than an a priori insolvency or credit issue. While the rising rate environment was clearly a factor in the outcome, the root cause was balance sheet mismanagement by the bank, rather than broad systemic factors, as was the case in 2008.

All banks are vulnerable to bank runs as they retain only a fraction of their deposits and lend the rest out longer term. That is why we have central banks, to act as lenders of last resort to provide liquidity to banks and instill confidence in depositors that their money is safe. Without such a backstop, history shows that fears of bank failures become self-fulfilling. This is why we’ve seen such a rapid and aggressive policy response to rollout extended deposit guarantees and liquidity provisions.

In a similar vein, Credit Suisse had been undergoing significant restructuring, trying to regain sufficient levels of profitability following years of scandals and poor returns. This has left the bank exposed to turmoil in global financial markets. Truly a known weak link amongst the largest global banks, albeit still quite a shock.

What we are watching

For now, we, and policymakers, remain on high alert for signs of further contagion versus signs of increasing stability. The situation remains fragile, and it’s too soon to think of waving the all-clear flag. So far, markets have remained reasonably well-behaved with limited signs of risk of contagion across asset markets. While interest rate volatility, as measured by the MOVE index, spiked to levels not seen since 2008, equity market volatility, VIX, increased only modestly and has quickly subsided. While the MOVE index has subsided from peak levels, it remains elevated from a historical perspective. At the very least, we need to see it back within a more normal range without inflicting further systemic collateral damage.

Credit markets have remained reasonably calm, with spreads in the financials area widening; but with limited impact across other sectors. Again, this is a sign that markets are factoring in increased idiosyncratic risk within the financial sector but not seeing contamination in other sectors of the economy. While credit markets initially shut down to new issues, that too has proven transitory with investment grade access reopening and higher quality high yield also being able to selectively access markets. So again, signs from credit markets are pointing in the right direction, but access to credit will remain a key focus area for signs of easing or escalating tensions.

From just before the SVB collapse to the end of March, three weeks later, the S&P 500 Index is up from 4000 to 4100, U.S. 10-year bond is down from 4% to 3.5%, and the U.S. 2-year bond is down from 5% to 4%. Clearly, no broad-based signs of panic with equities up, while lower rates reflect expectations of an earlier end to the Fed tightening cycle.

2. What has changed?

What has changed is a definite tightening of financial conditions through bank credit channels. Banks will be less willing to extend loans to customers. Loan officer surveys were already indicating a tightening of lending standards prior to the bank failures. This will accelerate due to heightened concerns regarding credit outlook, while the significant decline in deposits at regional banks will further limit their ability to extend the same level of loans. As the bank credit channel tightens in coming quarters, this will drive a slowdown in economic activity, other things being equal. The big challenge is we have no idea, at this point, by just how much.

Recession, or waiting for Godot?

For the past year, the Fed has been raising interest rates in an effort to tighten financial conditions, slow down an overheating economy and bring inflation back in line with their target. Now, with an expected tightening of financial conditions through the bank credit channel, credit markets will be doing the job for the Fed. It should be noted that there is nothing unusual about this dynamic, as one normally expects bank credit to tighten when the Fed is tightening.

The real surprise has been how resilient the economy has been even with tighter financial conditions. Despite what appears to be a bit of a resurgence in the economy as we entered 2023, we still expect to see a significant slowdown and mild recession this year. Slumping manufacturing activity, accelerating job cuts and weak house sales are all consistent with a slowing economy. Meanwhile, robust job numbers and still strong wage growth reflect ongoing economic resilience. It’s very confusing.

What appears to be part of the story is an expected slowdown in the cyclical and interest-rate-sensitive parts of the economy being partially offset by some lingering pent-up reopening demand in parts of the services and consumption sectors that were slower to reopen last year. This, coupled with the broad deleveraging of household balance sheets in recent years and recent robust wage gains, has resulted in a much milder slowdown than many anticipated.

It is feasible to consider that the relative health of the household sector has been able to blunt the impact of the unfolding manufacturing/cyclical recession. This results in more of a rolling desynchronised recession that impacts different segments of the economy at different times such that the net aggregate effect looks like a soft landing or mild recession stretched out over time. Rather than a sharper slowdown as is the case when all sectors slow down all at once.

Time will tell whether we are in the midst of such a rolling recession or if a more severe downturn is just around the corner. For now, the surprise has been the tardiness of any recession showing up despite some calling for a recession since last summer. Regardless, any significant tightening of bank lending will serve to bring forward the timeline for an expected recession. Given the lack of any significant economic imbalances, my base case remains for only a mild recession in response to the tightening financial conditions. Further, to the extent that inflation continues to fall, alongside the slower economy and ongoing supply-side easing, the timeline for the Fed to begin to ease interest rates will also be pulled forward.

From an equity market perspective, it will be the trade-off between the expected decline in earnings due to the slowdown versus the lower expected discount rate reflected in lower interest rates that will matter. While earning will be a function of economic activity, the outlook for interest rates will be dependent on the Fed’s policy reaction function which will be driven primarily by the outlook for inflation.

The Fed is done (or not)

The more credit tightens through private channels, the less the Fed needs to do through the Fed Funds channel. The big challenge for the Fed is understanding how severe an impact, or not, such a credit shock will ultimately have on the economy and inflation. One thing is clear. The enhanced uncertainty stemming from the bank failures has seen the Fed and the European Central Bank (ECB) back away from their prior hawkish stance toward a ‘let’s wait and assess the impact’ before committing to further rate hikes. Both the Fed and the ECB, while hiking as anticipated in their March meetings, have in effect suspended any forward guidance on further hikes in favour of a data-dependent ‘we shall see’ stance. Both central banks are adamant that inflation remains public enemy number one, and that they have the tools to address financial instability issues without compromising their focus on inflation.

The hurdle to pause is low

Given that the Fed has already increased the federal funds rate to 4.75%-5%, having started with rates at zero a year ago, it is clear that we are at or approaching the end of the hiking cycle (the ECB has lagged so may have a bit further to go). In effect, the Fed is Done!

Now that interest rates are within the Fed’s ‘moderately tight’ zone, which they felt was necessary to bring inflation back down towards target, the hurdle for the Fed to hit pause and watch how things unfold is quite low. Unlike last year, they now have the luxury of time to assess whether further hikes are needed or if just holding rates at current restrictive levels is sufficient. With elevated uncertainty around any fallout from the bank crisis, I expect the Fed will/should pause in May from a risk management perspective. Even if they decide on a further 25 basis points (bps) hike, we are clearly approaching the end game for Fed hikes. This has been well reflected in the significant softening of interest rates across the curve in recent weeks.

The hurdle to cut is high

Where I disagree with current market pricing is in the expectation that the Fed will cut interest rates in the summer. Not a chance! Unless something truly bad and unexpected unfolds.

The Fed has been unambiguously clear that inflation is the primary public enemy. While inflation is falling, it remains too high for comfort. Key lesson from the 1970s: do not cut prematurely. The implication for policy going forward is that inflation will have to fall definitively toward their targets, not just be trending toward the target. The Fed will not be pre-emptive in loosening policy and will require the data (even though it is lagging), to signal that the inflationary threat has been extinguished.

I expect this will mean holding rates higher than many currently expect, but this also brings us back to the key area to watch. Despite all the volatility and other noise in markets and economies, it remains all about inflation. Almost nothing else matters. While we expect inflation will continue to decline, and likely surprise to the downside versus consensus, the Fed will not be cutting interest rates until it actually happens. I expect that we will reach this point before the end of the year, but that the current expectation of cuts this summer is too optimistic, pencil in year-end if the inflation data cooperate.

Market outlook

One caveat to waiting for the Fed is that markets will move in anticipation. This means any cut will be well discounted by the time it does arrive. For now, it just feels too soon. Broadly for asset markets, I still expect another quarter or so of choppy sideways-range trading, much as we have seen since last May.

Equity and bond markets fell (rates rose) through the first half of 2022 and both bottomed last October. Markets have been range bound ever since. I expect that the October lows for both bond and equity markets will prove to be the lows for this cycle, but feel it is too soon to break out of the current ranges (roughly 3800-4200 on the S&P 500 Index, 3.5%+/- 25 bps for the U.S. 10-year bond).

Markets have digested the rate increases and are now trying to reconcile the trade-off from reduced earnings in a recessionary outcome against the time and pace of potential rate cuts. This battle has been underway for a few quarters, and upcoming first-quarter earnings will set the stage for the next skirmish. Keep in mind inflation remains the referee and until she sings her swan song, the battles will continue.

Finally, a spoiler alert for the coming quarter. The U.S. debt ceiling showdown is promising to be a bit of a political bun fight and will likely require some elevated market turmoil before both sides can agree on a compromise. The shenanigans should begin sometime in June and will likely drag well into summer before any resolution is agreed upon. While unlikely to cause any major economic damage, there should be plenty of angst, fireworks and gnashing of teeth to drive some elevated market volatility at the time.

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