By Robert Ducker
At the end of 2022, we had anticipated that the narrative would shift from inflation concerns to economic growth in early 2023. We observed a deceleration in inflation (Core PCE), which fell for three consecutive months from 5.1% in September to 4.4% in December. Additionally, the US Federal Reserve's (FED) more dovish tone reinforced our belief that inflation had been brought under control. However, we were unsure about global growth prospects due to the significant tightening in 2022.
However, developments in the early weeks of 2023 significantly changed global growth expectations. Warmer than expected weather in Europe and a faster than expected reopening in China boosted global economic expectations, coupled with inflation moderation and less drag from tight financial conditions. Economic forecasts were revised higher, leading to a smooth transition in narrative shifting away from inflation concerns to economic growth. However, Chair Powell's hawkish testimony on 8th March fuelled concerns around inflation, leading to further flattening in the US yield curve, as the 10-year US Treasury rose to 4.0% (up from a low for the year of 3.4% on 12/01), whilst the 2-year US Treasury rose to 5.1% (a 100bp rise from 12/01). The hawkish tone adopted by Chair Powell during his testimony led to a re-pricing higher of the peak FED fund rate.
We did not anticipate the collapse of Silicon Valley Bank in the US and Credit Suisse in Europe, which unsettled investor confidence in the global banking system. We believe that these banking issues are idiosyncratic in nature, and most of the losses incurred in March were reversed in April. However, the banking stress has clouded the outlook for 2023 and increased uncertainty. Lending standards had already tightened significantly following the aggressive tightening cycle over the past year or so. A sector that may be overly exposed to this expected tightening in lending standards is commercial real estate (CRE). US banks are an important source of liquidity for the sector with CRE loans accounting for roughly 16.5% of US bank loans, and for smaller banks, CRE loans account for around 33% of total loans. Real estate was already under pressure from higher funding costs, and lower liquidity could add to the pressure.
The price action seen across different financial markets is conflicting. Rates seem to be pricing-in a recession with around 62bp of rate cuts expected in 2H23. At the other end of the risk spectrum, global equities are up 9.0% (US$) on a year-to-date basis (calculated to 30th April), which suggests that equity investors expect global growth to remain above-trend. Cyclical strategies (+12.3%) in Europe have outperformed Defensives (+8.8%), providing further support for our view that equity investors do not expect a hard landing anytime soon.
Equity investors in late-cycle are typically undecided on whether to focus on hopes that rates have peaked or recession fears. Yields were largely unchanged during April while inflation news flow was largely supportive. The job-worker gap continues to shrink, implying better demand/supply dynamics in the US labour market and less pressure on wage growth. Overall, the inflation outlook has improved significantly over the past month. However, economic activity seems to have deteriorated during April, particularly when comparing actual data reported against consensus economist expectations. The outlook does not get any better, with more tightening (monetary policy or lending standards) expected to weigh on the macro-economic backdrop.
In conclusion, despite the positive performance during April, with global equities up 1.6% (US$), investor positioning and risk tolerance appear to have shifted. Defensive strategies in Europe have outperformed Cyclicals, indicating cautious positioning compared to earlier in the year. In the coming weeks we could see equities trade in a range, at least until we get a better understanding of the impact of tighter lending standards on economic growth.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.