Murky Waters

It was another quietish week for markets overall with global equities ending up around 1% or so. Meanwhile, government bond yields edged slightly lower following sharp declines the previous week.

The banking sector remained the centre of attention and markets remained in skittish mood. Deutsche Bank led a sell-off of European and UK banks on Friday. Along with almost all serious commentators, we believe this move is overdone as the banks both in the UK and Europe are in pretty good health and Credit Suisse was a special case.

The same is also basically true for the US, albeit more so for the large banks rather than the mid-sized regional banks which are disadvantaged in two respects. They are more reliant on deposits above $250k, which have no explicit government insurance, and also more exposed to the commercial real estate sector which is under pressure from the rise in rates.

Treasury Secretary Yellen has effectively guaranteed all deposits of any bank which should run into problems but a more comprehensive guarantee is not within her powers. Regional banks may well therefore remain under some pressure and are likely to slow their lending, tightening financial conditions in the process and reducing the need for additional rate hikes.

While the Fed did press ahead last Wednesday with a further 0.25% rise in rates to 4.75-5.0%, it turned much more equivocal about the need for any further increases. Yet the Fed also emphasised that it had no plans to ease policy this year.

The bond market, by contrast, is now assuming rates will be cut to just above 4% by year-end. Its rationale seems to be that a recession will force the Fed into a U-turn. An economic downturn, albeit only a mild one, certainly remains quite possible or even probable later this year and has been trumpeted by an inverted yield curve for a while now.

But it has to be said that there is still no concrete sign of one. Indeed, business confidence recovered further in March and is now comfortably above the recessionary mark, not only in the US but also in Europe and the UK.

The Bank of England also hiked rates by a further 0.25% last week to 4.25%. A rate rise had been hanging in the balance until the release of the February inflation data which came in significantly higher than expected. The headline rate unexpectedly rose to 10.4% from 10.1% and the more important core rate increased to 6.2% from 5.8%.

Like the Fed, the BOE kept its options open as to whether rates will need to be raised any further. Most likely rates are now at or close to their peak and should remain around these levels over the remainder of the year, as the market is currently presuming.

Global markets should continue to take their lead from the US. But the picture is more confused than normal as US bond and equity markets are rather at odds with each other. Equities remain up some 4% year-to-date with neither valuations nor earnings estimates seeming to price in the recession now assumed by bonds.

Our view is that the truth may lie somewhere between the two. A mild recession could well lead to some further downward pressure on equities but inflation concerns should prevent the Fed from cutting rates as much as bonds now believe.

In a nutshell, the economic outlook remains murky to say the least and is set to remain so for a good few months yet. Consequently, we plan to retain our well diversified portfolios.

Rupert Thompson – Chief Economist