Dear Investors,
Central banks – fed should now pivot
For Moodys Analytics Surging interest rates by central banks coupled with an increased share of fixed rate securities over the past year have made many banks vulnerable to evaporating deposits and duration risk.
Deposit outflows appear to have abated, especially at small banks that are the most vulnerable, and inflows into money market funds have normalized.
The tightening will be most pronounced for the always especially risky land and development loans, which are critical for small and midsize home builders without the access to capital markets for funding that is available to the big publicly traded builders.
Weaker credit will also be a headwind to consumer spending, albeit less so, and more indirectly through a softer job market and any impact on consumer confidence.
Central banks – inflation down
Slower sub potential growth will help further rein in inflation, which looks increasingly on script to return to the Fed’s target by mid2024.
More explicit in accordance with Moodys Analytics, consumer price inflation, which peaked at 9% on a year over year basis in June and has since moderated to 5% in March, is expected to be just over 3% by year end 2023 and closing in on the Fed’s 2.5% implicit CPI target by June 2024.
Rents
Rents surged when the economy reopened and many renter households were forming, but pandemic related supply chain and labor supply problems limited new supply.
In recent months rents have gone flat to down as rental supply has picked up with normalizing supply chains and labor supply.
Central banks – federal reserve pauses
With inflation headed back to the (Central Banks) Fed’s target with increasing certainty, the easing job market, and the fragile banking system, the Fed should soon pause its rate hikes.
The Treasury bond and federal funds futures markets are even pricing in a significant easing in monetary policy beginning sometime this summer.
It probably will not kill the economy if the Fed increases rates by another 0.25 percentage point. But why take that risk? The risk of inflation remaining too high appears meaningfully lower than the risk of a recession.
The Fed misjudged and waited too long before normalizing interest rates coming out of the pandemic. The result was runaway inflation.
Where are we going? (9 must critical points)
For OCBC Bank 2023 economic slowdown is concentrated in advanced economies, especially the euro area and the United Kingdom.
The US near term policy rate expectations were repriced significantly, with the magnitude and scale comparable to that of Black Monday in 1987.
Default rates – central banks
For firms, default rates have remained low, as the sector’s substantial cash buffers built during the pandemic have provided financial cushioning.
However, declining corporate earnings and tighter funding conditions have started to erode these buffers and could lead to repayment difficulties down the road and expose firms to defaults, especially for small firms, which lacks alternative financing methods.
China stronger than expected growth
The much stronger than expected export in March was attributable to the rebound of demand from EU and strong demand from ASEAN and other emerging markets although demand from US and Japan remained soft.
ASEAN further consolidated its position as China’s largest trading partner with the share of total trade rose to a record high of 15.8% in March.
Central banks financial condition index
In accordance to OCBC Bank the financial condition in the US and the UK have eased after the banking stress in March, while in the Eurozone, the financial condition remains tightened.
It does not capture the tightened lending condition after the banking sector turmoil and the actual financial condition could be tighter than what the index has suggested.
Central banks – what the market are pricing in? (8 must updates)
For UBS Wealth Management the market is pricing in a high probability of a near perfect landing for the US economy.
Warren Buffett has said that he still expects some other banks may fail, and it stands to reason that smaller regional US banks, which have not been held to the same capital requirements as the large systemically important banks, carry higher risk in a period of rising rates and a slowing economy.
The likelihood of tighter credit and lower growth is not adequately reflected in equity market pricing today.
Central banks – s&p 500
The S&P 500 forward price to earnings (P/E) of 18x is near its highest in about a year and higher than pre pandemic levels.
Historically, when the S&P 500 has traded above 18x, consensus earnings growth expectations are robust (14% on average) or the 10year Treasury yield is less than 2%.
Today, UBS Wealth Management expects S&P 500 earnings to contract 5% in 2023, and the 10year Treasury yield is 3.6%.
Inflation
In the previous eight episodes when US CPI has risen above 5% since 1960, it took an average of three years before inflation fell back below 3%.
So, while it is possible that optimism on inflation may eventually be proven right, UBS Wealth Management thinks it unlikely that disinflation will happen in the kind of straight line that equity markets appear to be pricing.
China will meet or even exceed 5% real (gdp) – corporate earnings
Underlying the 5% official GDP growth estimate this year is strong corporate earnings growth estimates within the MSCI China Index (20.7%) and Shanghai Composite Index (26.8%).
Recession risk
A final point about recession risk is that a major global economic shock will trigger the Chinese government to implement a strong fiscal policy response to support aggregate demand.
This brings us back to the consumption trinity and the importance of bolstering domestic demand to a position of reasonable strength as global growth looks set to head into a chilly winter.