BlackRock Commentary: Financial cracks show: What to do now

Jean Bovin – Head of BlackRock investment institute, together with Wei Li – Global Chief Investment Strategist, Wei Li – Global Chief Investment Strategist, Alex Brazier – Deputy Head, and Vivek Paul – Head of Portfolio Research all forming part of the BlackRock Investment Institute, share their insights on global economy, markets and geopolitics. Their views are theirs alone and are not intended to be construed as investment advice.

Key Points

Financial cracks: More financial cracks from rapid rate hikes are emerging. We stay underweight equities, downgrade credit and prefer short-term government bonds for income.

Market backdrop: Bank troubles on both sides of the Atlantic hit the sector’s shares last week. Short-term bond yields plunged on hopes for sharp central bank rate cuts.

Week ahead: We don’t see central banks coming to the rescue with rate cuts but using other tools to ensure financial stability. The Federal Reserve is set to hike this week.

The U.S and European bank tumult is the latest sign rapid rate hikes are causing financial cracks, reinforcing our recession view. We expect central banks to keep hiking to fight higher inflation – not come to the rescue. We stay risk-off: underweight developed market (DM) stocks and trim credit to neutral. But we are ready to seize opportunities as macro damage gets priced in. We overweight very short-term government paper for income and prefer emerging markets.

Banking troubles on both sides of the Atlantic were roiling markets last week. That’s the latest fallout from the most rapid rate hikes since the early 1980s. We have argued that bringing inflation down would be costly, creating economic damage and cracks in the financial system. This week’s events will crimp bank lending, reinforcing our recession view. As the cracks emerged, market expectations for peak rates plummeted, as the pink line in the chart shows. The reason: hopes that central banks will come to the rescue and cut rates, as they did in the past. That’s the old playbook – and it no longer works. Central banks are set to keep fighting stubbornly higher inflation, and use other tools to safeguard financial stability. Case in point: The European Central Bank raised rates by 0.5% last week. And we see the Fed raising rates this week. Our conclusion: Investors need a new investment playbook and to stay nimble in this new market regime.

The banking stresses that are roiling markets are very different – but what they have in common is that markets are now scrutinizing bank vulnerabilities through a lens of high interest rates. We don’t see a repeat of the 2008 global financial crisis. Some of the troubles that emerged recently were longstanding and well-known, and banking regulations are much stricter now. Instead, this is about a recession foretold. Why? The only way central banks could bring inflation down was to hike rates high enough to cause economic damage. The latest financial cracks are likely to tighten credit, dent confidence – and eventually hurt growth. What does this mean for investing? We see three clear takeaways:

Three takeaways

First, we stay underweight equities and downgrade credit to neutral. We believe risk assets are not pricing the coming recession. This is why we stay underweight DM equities on a tactical horizon of six- to 12-months. We expect reduced bank lending in the wake of the sector’s troubles. The recession is likely to see more credit tightening now. We downgrade our overall credit view to neutral as a result, trimming investment grade (IG) credit to neutral and high yield to underweight. We have a relative preference for European IG because of more attractive valuations versus U.S. peers.

Second, we overweight short-term government bonds. We think this recession will be different. Central banks will not try to resuscitate growth by cutting rates. The reason: persistent inflation. We think major central banks will distinguish their inflation fights from any actions taken to shore up the banking system. The ECB did so last week by hiking rates as it originally telegraphed – even as markets had started to doubt its resolve. We expect the Fed to take a similar approach when it hikes rates this week. The U.S. CPI last week confirmed core inflation is not on track to fall to the Fed’s target. That’s why we could see a reversal of the recent sharp drop in two-year and other short-term government bond yields. As a result, we now prefer even shorter maturities for income in this asset class. We stay underweight long-term government bonds and upgrade inflation-linked bonds given our view inflation is likely to stay well above current market pricing.

Third, we prefer emerging market (EM) assets. Markets have focused on the mayhem in the developed world. Under the radar has been confirmation that the economic restart in Asia from Covid restrictions is powerful. In addition, China’s monetary policy is supportive as the country has low inflation compared with DM. This should benefit EM assets, in our view. As a result, we keep our relative preference for EM stocks. We also go overweight on EM local-currency debt as EM central banks near the end of their hiking cycles and possibly cut rates.

Market backdrop

Short-term government bond yields plunged as the emergence of financial cracks spurred the market’s hopes for sharp rate cuts. Bank shares led losses in Europe and were a drag in the U.S. after the troubles at U.S. medium-sized banks and concerns over a large Swiss financial institution. We think central banks will keep hiking as they both seek to bolster banking systems but distinguish those efforts from the need to keep fighting inflation.

We expect the Fed to press ahead with another rate hike, as the ECB did last week. The Fed’s updated forecasts may prompt markets to price back in rate hikes after the February CPI data showed sticky core inflation. But the Bank of England could pause hikes next week. Global PMIs will help gauge how much rate hikes are denting economic activity.

Week Ahead

Mar 21: U.S. existing home sales

Mar 22: Fed policy decision; UK CPI

Mar 23: U.S. jobless claims; Bank of England policy decision

Mar 24: Global flash PMIs; Japan CPI


BlackRock’s Key risks & Disclaimers:

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of 20th March, 2023 and may change. The information and opinions are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This material may contain ’forward looking’ information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.

The information provided here is neither tax nor legal advice. Investors should speak to their tax professional for specific information regarding their tax situation. Investment involves risk including possible loss of principal. International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation, and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are often heightened for investments in emerging/developing markets or smaller capital markets.

Issued by BlackRock Investment Management (UK) Limited, authorized and regulated by the Financial Conduct Authority. Registered office: 12 Throgmorton Avenue, London, EC2N 2DL.


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Franklin Templeton Thoughts: A multi-asset perspective on recent bank turmoil – Don’t lose sight of the macro story

Franklin Templeton Investment Solutions explores the shared macro concerns that set the stage for the recent banking crisis, its ripple effects on the broader economy and implications for multi-asset investing.

Our key takeaways are as follows:

  • The recent events at SVB and other global banks occurred due to a mixture of idiosyncratic problems at these institutions as well as macroeconomic forces that are a cause for broader concern.

  • Our macroeconomic outlook remains bearish as we expect global growth to further weaken and policy to remain tight.

  • We believe that valuations of risk assets are broadly expensive given our bearish macro outlook, which doesn’t appear to be priced in.

What happened? Don’t let the micro details hide the macro story

Idiosyncratic factors certainly played a role in SVB’s failure and the recent turmoil we’re seeing in US regional banks as well as overseas at Credit Suisse (CS). SVB had a glut of corporate customers that were tech startups (that have been drawing down their deposits), as well as a mismanaged asset and liability mix, particularly in an environment of rising interest rates (fixed-rate assets and floating-rate liabilities). CS has been engulfed in scandal over the last few months and has seen outflows and a steady decline in assets under management since this past October. However, we believe that even many of the micro stories of the last two weeks are not fully isolated from one another.

Fiscal and monetary stimulus following the onset of the COVID-19 pandemic in the United States and abroad spurred a hot global economy. With low financing costs, animal spirits were unleashed—booming private markets, unprofitable growth startups, digital assets and Reddit-fueled stocks like AMC and Gamestop saw their valuations soar. Animal spirits help produce strong growth, but they can also produce excesses in the economy that are concealed until policy tightens.

Witnessing a surge in inflation, global central banks embarked on the most rapid tightening cycle in decades. In the United States, Federal Reserve (Fed) policy rates have risen 450 basis points (bps) since the hiking cycle kicked off; 2022 alone saw the most bps of Fed rate hikes ever in a single calendar year. These rate hikes can take time to flow through the economy, and we are seeing the first few dominoes to fall with SVB, Signature Bank, and more recently, volatility at CS.

As a result of central bank liftoff, we saw yield curves around the world invert, which can hurt bank profitability. Banks invest customer deposits, fed funds and short-term instruments into longer-term loans, which under normal circumstances yields them a profit (assuming the loans they make do not default). However, when interest rates rise, the price of longer-dated securities falls in value. Further, when the yield curve inverts, new longer-dated loans are no longer higher yielding than short-term loans. While SVB in particular suffered from underwater carry trades, they’re not alone—banks  are currently sitting on around US $620 billion of unrealized losses.

Economic outlook

Bank lending standards across the United States and Europe were tightening before SVB’s collapse, and will likely only continue to tighten. These standards are important to watch, as they provide a reliable leading indicator to gross domestic product (GDP) growth and high-yield corporate credit default rates. Additionally, consumers are broadly still concerned about the safety of their deposits and the magnitude of the Fed’s backstop. Blue-chip, “too big to fail” banks like Bank of America and JP Morgan have seen billions of dollars in deposit flows over the last couple of days. The strain on small, regional banks may have a significant impact on economic growth. Loan growth has been shown to be a reliable leading indicator of economic activity, and when it slows, so too does the economy (Exhibit 1).

Exhibit 1: When bank loan growth slows, GDP usually follows

Unfortunately for central banks, a weak growth outlook is likely to take place alongside elevated levels of core inflation. The Fed, European Central Bank (ECB), and other developed market central banks are in a precarious position as there is now tension between their dual objectives of ensuring financial stability and reining in inflation. We wrote a series of papers last year cautioning that the Fed is walking a tightrope between hiking too much, risking recession, and hiking too little, allowing inflation to run too hot. Our concern was that with the Fed behind the curve, they might overdo it, and something would break. It is possible that moment is upon us, and the proverbial tightrope has been cut out from under them.

Market pricing for central banks’ policy rates have fluctuated dramatically over the first couple weeks of March. On March 8, market participants were expecting the Fed to hike rates to 5.70% before pausing. As of March 16, the market is pricing in rates at just 4.93%. What this tells us is that investors believe that the Fed may have been too aggressive, recession risk has crept up, and the central bank may need to reverse course sooner than expected. While these expectations may end up coming true, the repricing is noteworthy; this highlights the tension between inflation and financial stability.

We continue to expect the Fed to hike rates by 25 bps at its upcoming March 21-22 policy meeting, although this is a highly fluid situation. Likewise, we are not surprised that the ECB increased policy rates by 50 bps as it focuses its interest rate policy on inflation.

Exhibit 2: Have central banks been too aggressive?

The mixture of a weak growth outlook, challenging inflation and tightening policy keeps our recession risk high, particularly in the United States and Europe where financial conditions have tightened. It also supports our regional preference for Asia, where inflation is a lesser issue and some economies are geared to China’s reopening.

Tail risk

CS is a much larger and more economically critical bank than SVB, with significant liquid assets and access to Swiss National Bank (SNB) credit lines to call upon in the event of rapid deposit withdrawals. The SNB backstop is a crucial development. While we continue to have some concerns, a full-scale SVB-like collapse in Europe, Japan, and other developed markets is unlikely given stricter liquidity and capital requirements than seen in the United States. We are monitoring these developments closely.

Multi-asset implications

Asset valuations are not reflecting our weak macro outlook. Equity risk premia and credit spreads are a far cry from levels we’ve seen in prior recessions (see Exhibits 3A and 3B). Similarly, corporate earnings expectations still appear too high, especially as profit margin pressures continue. To us, risky assets are not appropriately pricing in current macro fundamentals or recession possibility. Furthermore, if the Fed stays its hawkish course—against investor expectations—risk assets could suffer.

Exhibit 3A: Stocks valuations are not reflecting imminent recession 

Exhibit 3B: Yields are not mimicking past crises

At this point, we remain defensively positioned. We favor fixed income over equity, with a preference for government bonds over credit. Even with the strong repricing in government bond yields, elevated concerns around a recession still support duration at these levels as they can provide material downside protection.

Finally, as mentioned above, we are tilting away from developed markets, where inflation remains highest and bank concerns are having the most material impact on confidence. These issues are less apparent in Asia, which is also buoyed by the growth impetus stemming from China’s reopening. This supports our preferencing for Chinese equities and Asia Pacific emerging market local debt.


Franklin Templeton Disclaimer:

All investments involve risks, including the possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. The positioning of a specific portfolio may differ from the information presented herein due to various factors, including, but not limited to, allocations from the core portfolio and specific investment objectives, guidelines, strategy and restrictions of a portfolio.

Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions.

Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Investments in lower-rated bonds include higher risk of default and loss of principal. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. In general, an investor is paid a higher yield to assume a greater degree of credit risk. The risks associated with higher-yielding, lower-rated debt securities include higher risk of default and loss of principal. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments.

Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments.

Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio.

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MeDirect Disclaimers:

This information has been accurately reproduced, as received from Franklin Templeton Investment Management Limited (FTIML). No information has been omitted which would render the reproduced information inaccurate or misleading. This information is being distributed by MeDirect Bank (Malta) plc to its customers. The information contained in this document is for general information purposes only and is not intended to provide legal or other professional advice nor does it commit MeDirect Bank (Malta) plc to any obligation whatsoever. The information available in this document is not intended to be a suggestion, recommendation or solicitation to buy, hold or sell, any securities and is not guaranteed as to accuracy or completeness.

The financial instruments discussed in the document may not be suitable for all investors and investors must make their own informed decisions and seek their own advice regarding the appropriateness of investing in financial instruments or implementing strategies discussed herein.

If you invest in this product you may lose some or all of the money you invest. The value of your investment may go down as well as up. A commission or sales fee may be charged at the time of the initial purchase for an investment. Any income you get from this investment may go down as well as up. This product may be affected by changes in currency exchange rate movements thereby affecting your investment return therefrom. The performance figures quoted refer to the past and past performance is not a guarantee of future performance or a reliable guide to future performance. Any decision to invest in a mutual fund should always be based upon the details contained in the Prospectus and Key Information Document (KID), which may be obtained from MeDirect Bank (Malta) plc.

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