This February/March 2023 market update is brought to you by LGT Wealth Management

Following a positive start to the year, February was marked by rate volatility, increased fears of persistent inflation, and falling bond prices. Strong US payroll and retail numbers raised expectations of continued rate hikes. However, the events of March so far have been profound and may alter the course of central bank tightening.

It has been difficult to escape the story surrounding the failure of Silicon Valley Bank (SVB), which was the 16th largest bank in assets in the US. The SVB rise and fall was perhaps a consequence of its previous success. It was once considered “the” go-to bank for US venture capital (VC).

During the post-pandemic economy, when the IPO market saw a wave of massive liquidity injections for private tech companies, SVB was the main beneficiary of these proceeds, with its deposits increasing threefold between 2019 and 2021. SVB invested the bulk of these cash deposits in longer-dated interest rate sensitive assets. This poor risk management meant that the bank faced increasing paper losses as rates rose, resulting in the bank quickly running out of capital.

Fears of contagion following the collapse of SVB led people to question their faith in other banks. In the immediate wake of SVB’s collapse, US regional banks faced a large sell-off, with some individual stocks down as much as 78% on the day at one point.

In response, the Federal Reserve (Fed) quickly announced emergency measures to stabilise the US banking system. The Fed has announced the creation of a new facility, allowing deposit-taking institutions to pledge Treasuries, Mortgage-Backed Securities (MBS), and other assets for collateral to avoid further distressed sales of assets. Furthermore, all depositors will be protected in joint action by the Treasury, Fed and Federal Deposit Insurance Corporation (FDIC), resulting in no company facing losses on its deposits.

This volatile situation remains ongoing, with Signature Bank having been taken over and First Republic receiving support from the Fed and larger banks.

Following events in the US, investors quickly turned their attention to Europe and, in particular, Credit Suisse. Following news that one of the key shareholders of Credit Suisse, Saudi National Bank, ruled out any additional support, Credit Suisse shares fell by as much as 30%. Much like the Fed, the Swiss National Bank and the Swiss regulator FINMA responded quickly, making a commitment to provide Credit Suisse with liquidity.

The swift action by central banks and regulators has staved off further pressure on the banking system for the time being, with banking stocks bouncing off their lows. The announcement of the acquisition of Credit Suisse by UBS should help shore up confidence in the global financial system. However, the long-term implications of the deal will only become clear over time.

One would expect the SVB situation and the subsequent distress in financials to have an impact on the Fed’s hiking cycle. SVB is the first notable casualty of this rate hiking cycle. These events have brought into question how the Fed proceeds from here.

The most recent CPI print for February served as a reminder that inflation remains elevated. Headline CPI rose +0.4% for the month, pushing the annual figure down to 6%. Core CPI came in slightly ahead of expectations, at +0.5% for the month.

Though inflation remains elevated, recent events may alter the availability of credit and consumer confidence, making the Fed’s job incredibly difficult.

Despite recent turmoil, the European Central Bank (ECB) went ahead with its promised 50bps hike. It is clear that tackling inflation remains key. While the ECB guided that “inflation is projected to remain too high for too long”, they offered no forward guidance on future interest rate hikes. However, following the meeting, reports suggested the ECB feared that veering off its course may deepen the rout in the banking sector.

With events in banks taking centre stage, one would be forgiven for being distracted from the Chancellor’s spring Budget. Jeremy Hunt outlined what he billed as a “budget for growth”, with various reforms to childcare and removing barriers to work. He also announced that government support for energy bills will continue for another three months.

Given that the aim of Hunt’s previous budget was to reassure the UK’s fiscal credibility in light of the chaotic “mini-budget”, a return to somewhat of a “reassuringly boring” normalcy was welcome.

The events of March so far serve as a reminder that monetary policy operates with long and variable lags. Central banks tend to stop hiking once something “breaks” and so it poses the question of whether the Fed sees this as evidence that conditions are tightening sufficiently. However, inflation remains well above target and we expect central banks to remain data dependent, with an increased emphasis on financial conditions.

It is important to highlight that the regulatory regime imposed in the wake of the financial crisis has left larger systemic banks much better capitalised to withstand these shocks. The loosening of regulation for regional banks during the Trump Presidency arguably sowed the seeds for the current crisis.

These episodes highlight the need to focus on quality businesses that have survived the test of many economic cycles. We continue to believe that a selective approach towards businesses with strong balance sheets and stable cash flows will be the best guide through any further volatility.

Market View Changes

• No changes

Currencies

The US Dollar remains the reserve currency of the world and has benefited from its safe haven status. While the Fed policy rate is higher than most other developed markets, improving growth prospects elsewhere has taken some of its shine. Ongoing volatility in the banking system and its impact on hiking cycles are likely to cause swings in the shorter term.

The growth prospects considering declining energy costs and the subsequent impact on the hiking cycle will determine the outlook for both the Euro and the Pound. This continues to drive volatility across currencies, without any clear direction.

Fixed Income

Government bonds have found favour following the financial impacts of the hiking cycle that unfolded in recent weeks. This will likely result in a shallower peak to the rate hiking cycle. Given this backdrop, the gilt market and the yields on offer are looking somewhat more attractive.

However, we would continue to stress caution on the long duration nature of index-linked gilts. While Treasuries and Bond yields have moved lower in response to recent concerns, they are still at attractive levels. However, central banks are still reducing their balance sheets and given the uncertainty surrounding the inflation outlook we still believe a neutral stance is appropriate.

As central banks have normalised policy, we have seen both government bond yields and credit spreads move higher. With the Bank of England and the Fed unwinding their balance sheets, this is taking liquidity out of the market. Given the elevated yields on offer, investors have moved to take advantage and have been heavily favouring corporate debt.

While yields look attractive relative to history, the additional compensation for corporate bonds has become less attractive. As such, we would advocate a highly selective approach.

As financial conditions tighten further, this typically results in an increased level of defaults. While companies have extended maturities, resulting in less acute pressures, sentiment may weigh on this market. The overall yield looks attractive, but we would stress selectivity and likely ongoing volatility.

Emerging Market Debt

With developed market central banks still set to tighten policy somewhat further, this historically has weighed on emerging markets. Though, many emerging market central banks have already raised rates substantially, which is likely to result in a much smaller impact than previous hiking cycles.

With China seeing a boost in economic activity following its reopening, this has seen risk assets in the region rebound. However, certain countries are facing debt sustainability issues. Therefore, we emphasise that selectivity remains as important as ever, and we retain our neutral stance across this diverse asset class.

Equities

While the energy and materials exposure had buoyed the FTSE 100 Index earlier in the year, recent concerns around financials and recession have seen it give back some of its performance. The market continues to trade at valuations that look cheap compared to markets elsewhere in the world, which may offer investors the opportunity to pick up companies at discounted prices.

However, the UK domestic economy faces significant headwinds from inflation and interest rate rises, weighing on more domestic stocks such as those in the FTSE 250. Considering the mix of factors, we recommend a selective approach in this market.

After a torrid time last year given the outbreak of war on its borders, the combination of a less acute energy crisis and the reopening of China has improved the outlook for Europe. However, the issues surrounding longer-term energy security remain and may weigh on future growth potential. Furthermore, the ECB’s aggressive hiking cycle may exacerbate longstanding issues between nations of the Eurozone. As such, we retain our neutral view.

The ongoing volatility surrounding growth, inflation and its impact on the long-term discount rate has continued to cause gyrations between cyclical and less-cyclical companies. The recent woes have seen bank stocks fall out of favour. Furthermore, the outlook in the face of rising input costs and slowing demand may be more challenging for earnings. Hence, we expect volatility to continue.

Nonetheless, the US market remains a source of attractive companies with good long-term prospects, with relatively high self-reliance in terms of energy and food supply.

The Bank of Japan’s moves at the end of December have driven material shifts across Japanese equities. While a new Governor has been appointed, markets still await to see whether there will be a significant shift in monetary policy when he takes over in April. The speculation surrounding future moves should put a floor on the Yen, which had been the worst performing currency in the G10.

While a strengthening currency weighs on exporters, this has sparked some life back into its financial sector. Given moderate valuations and limited international investor interest, Japan could have room to perform should the global economic situation improve.

China is finally starting to emerge following a swathe of lockdowns over the past few months. It has now abandoned its ‘zero-Covid’ policy, while also addressing the weakness in its property sector. The combination of fiscal and monetary support should see it more able to boost growth over the coming quarters. However, the risks of political business interference in China remains high, but this is cushioned by the cheap valuations relative to other markets.

A growing China tends to provide support for the wider region. Domestic growth elsewhere has been strong because of earlier easing of restrictions. The lack of sanctions on Russia confirm that energy headwinds are less of an issue for some countries in the region. As such, we think the potential for long-term growth is higher than elsewhere.

Though the rise in commodity prices has a natural benefit for resource rich countries, the war in Ukraine and recent political turmoil in Brazil have highlighted how extreme the geopolitical risks may be. Food shortages and higher prices threaten political stability; we have already seen this in Peru, Pakistan, and Sri Lanka. Developing countries need continued foreign investment but events like these deter investors, compounding the risks.

Despite this, long-term growth prospects for many emerging markets remain high. Hence, we continue to stress a highly selective approach in this diverse universe, emphasise its volatile nature and maintain our neutral stance.

Alternative Investments

Hedge Funds/Targeted Absolute Return

Given pronounced movements across interest rate expectations, this will undoubtedly weigh on financing costs which may temper some merger and acquisition (M&A) activity. Conversely, the elevated levels of interest rate volatility may present opportunities elsewhere.

On the regulatory side, geopolitical fronts mean that regulatory intervention has become more commonplace. This has tempered our enthusiasm for event-driven strategies.

More broadly, when allocating to this space, we look for funds that could diversify returns away from the directionality of conventional bonds and equity markets. Nevertheless, we continue to stress the importance of finding the right vehicle and investment manager, which requires extensive due diligence on the strategy and fund.

Property

Rising borrowing costs continue to weigh on property markets globally. Tightening financial conditions, exacerbated by recent events, are likely to further dampen enthusiasm for long-term assets with limited liquidity.

Given recent notable lockups by large property funds, we continue to stress that any exposure to property should be selective and closed-ended over open-ended vehicles. Although property has historically been a good hedge against inflation, the sharp rise in borrowing costs may alter that characteristic, at least in the short to medium term.