This isn't 2008: A current look at the markets for financial advisors

Beware the ides of March, indeed!

In recent years, capital markets faced unique events during March, each time leading many investors to search for shelter (literally and figuratively). March of 2020 brought COVID-19 lockdowns, March of 2022 brought the Russian invasion of Ukraine into focus, and this year March brought the events of the Silicon Valley Bank (SVB) failure.

Over the last few weeks, I have talked to dozens of our investment managers, clients, researchers and colleagues. This Global Investment Outlook focuses on the most important conversations and takeaways. I hope it helps make a bit of sense out of what just happened – and all the opportunities that lie ahead.

This is not a repeat of the 2008 global financial crisis (GFC). Today’s banking “crisis” is far less severe than 2008, and it’s not systemic. Indeed, the quality of overall bank assets and capital ratios are dramatically better. The central banks are now coordinating globally to offer banks daily access to the capital they need to operate smoothly. SVB failed because of a mismatch between its short-term depositors who were withdrawing assets and its longer-term assets, mostly US Treasuries, that had dropped in value as interest rates increased.

 

The banking system will almost certainly get more oversight and regulation. Much of this oversight will likely be focused on regional banks. We continue to see investment opportunities within regional banks, but each bank will need to be evaluated on a case-by-case basis, not as a group.

 

Cash deposits are moving from regional banks to money market funds. As clients look for higher returns on their investments, more deposits are leaving the banking system. Money market funds have been the biggest beneficiary; with over US$286 billion of inflows in March, this has brought money market balances to the highest level on record.¹ Bigger banks are also benefiting according to the Federal Deposit Insurance Corporation, as flows to the largest 25 banks increased by US$120 billion.²

 

Who are potential winners against this backdrop? We see opportunities in income, especially fixed-income and dividend-paying equity. We generally favor investment-grade and sovereign debt, while the outlook for emerging market local currency debt also looks promising. Non-US equity is apt to be attractive as China reopens and Europe shows more resilience than expected.

 

Private credit will likely be one of the beneficiaries. In the aftermath of the regional banking turmoil, private credit will likely replace some of the current regional bank loans. We believe the current market disruptions may present the most attractive investment opportunity for private debt since the GFC.

 

Crisis of confidence

 

Throughout the first three months of 2023, capital markets oscillated between euphoria and pessimism. Rapid changes in expectations for US Federal Reserve (Fed) policy driven by conflicting data on US growth and inflation, as well as hopes that China’s economic reopening will boost global growth this year, have driven shifting sentiment. Most recently, attention has focused on fears of financial stress—or worse— in the United States and Europe. All that is taking place against a backdrop of flagging corporate profits as rising costs are creating margin pressure.

 

The arrival of the banking turmoil is of particular importance. While the implosions of Silicon Valley Bank (SVB) and Credit Suisse have distinct “own goal” elements to them, they serve to remind us that systemic risks start as isolated cases, which then expose more profound vulnerabilities. And while bad loans were not the source of today’s banking turmoil, there are probably other banks that could be at risk if large losses result from securities holdings that need to be sold to satisfy large and rapid depositor withdrawals. However, given all the regulatory actions post the global financial crisis (GFC) to help de-risk banking business models in both the United States and Europe, this does not look to be a systemic situation at this stage. In the sections that follow, our investment teams weigh in further on reasons why the current turmoil is different from the GFC and the potential policy implications.

 

The rapid response of various government entities to provide liquidity in mid-March has reduced the tumult, but it still has not addressed the banking system’s fundamental sources of risk. US Treasury Secretary Janet Yellen’s frank admission about the absence of universal deposit insurance in her Senate testimony of March 22nd only underscores the fact that other banks could experience depositor runs in the event they are perceived to be poorly managed. Meanwhile, the Fed’s unrelenting campaign of interest-rate hikes only increases the risk of bank deposit intermediation by higher-yielding money market funds, a potential source of both liability pressures for banks and reduced credit funding for an already weakening economy.

 

As Fed Chair Jerome Powell noted in his most recent press conference, the US banking turmoil will act to slow lending, spending and growth in the economy.³ This may be particularly acute within the regional banking sector, which provides the lion’s share of lending to small and mid-sized businesses in the United States. While that may permit the Fed to raise rates more cautiously, it may also lead to a continued shift of banking toward non-bank private credit sources. In addition, all of this disintermediation serves to reinforce one of our existing 2023 themes – namely regional growth de-coupling.

 

China provides the clearest source of likely divergence, given its belated COVID-19 reopening supported by modest credit and fiscal easing. Notwithstanding the demise of Credit Suisse, the banking turmoil is likely to be economically less damaging in Europe, where stresses are less apparent, and banks operate in a more tightly regulated environment. Lower interest rates also suggest that both deposit disintermediation and securities losses are apt to be less problematic. The European Central Bank (ECB) increased its benchmark interest rate by 50 basis points (bps) at its March policy meeting, suggesting that it does not currently see US-style banking risks in the eurozone. That action gave financial markets a dose of confidence.

 

In Asia, central banks may be inclined to implement accommodative and growth-supportive policies to cushion any liquidity stresses, creating a more constructive environment for the region. Most banks in Asia have been maintaining both strong capital buffers and prudent leverage following Russia’s invasion of Ukraine, even as the Fed embarked on a monetary policy tightening path. Given this divergent growth backdrop, we see opportunities as follows.

Focus on income

 

The stability of a regular stream of cash flow can provide a stable source of return in periods of increased volatility. Historically, yield offers the largest component of return within fixed income, and we believe current levels create a more attractive forward total return profile.

 

Focusing on higher credit quality leads us to favor investment-grade and sovereign debt. With the consensus view for 2023 expecting US growth to come in below that of Japan, as well as China and many other emerging markets, the outlook for emerging market local-currency debt also looks promising. Opportunities are evident in Europe, where the eurozone economy is doing better than many had forecasted, underpinning credit fundamentals.

 

Eventually, we believe one of the biggest fixed income opportunities for 2023 will be to position for a flattening and then a steepening of the US Treasury yield curve. While it is premature to position for yield-curve normalization, the unwinding of the currently inverted yield curve is likely to have significant investment implications, in our view. The way the yield curve normalizes is of crucial importance. If short rates fall relative to long rates on fears of a deep or prolonged recession, then yield curve normalization is likely to lead to significant weakness in equity and credit markets.

 

If, on the other hand, yield curve normalization reflects the restoration of low inflation amid an ongoing expansion (a “soft landing”), it bodes well for corporate profits and hence equity and credit returns. For instance, in periods since 1962 when inflation peaked and started to decline, US Treasuries generated an average of 14% returns and the S&P 500 Index an average of 10% returns in the 12 months after peak inflation.⁴

 

Discerning between those two yield-curve normalization possibilities is a key focus for the Institute throughout 2023. For now, however, our focus within equities is a “barbell,” composed of more exposure to countries, regions and sectors likely to benefit from China’s reopening, complemented by higher-quality, dividend-yielding equity holdings in the United States. Importantly, during periods of elevated inflation, returns from dividends become more significant.

From 2000–2022, for instance, when inflation exceeded 2.5%, the MSCI US High Dividend Index outperformed the MSCI US Index by 11.5%.⁵ The same is true during episodes of Fed rate hikes, when the MSCI US High Dividend Index generated higher returns than the MSCI US Index 78% of the time.⁶

Equally, during periods of financial stress, income-focused equity allocations have provided more resilient return profiles. During the 1970s and 1980s, for example, high inflation and interest rates created a challenging environment for stocks, and equity income indexes outperformed broad equity indexes. The same is true when the technology bubble burst in 2001, as equity income indexes, which were less exposed to the technology sector, outperformed the broad market. Finally, during the 2008 financial crisis, equity income indexes also outperformed broad equity indexes as investors sought out more stable and reliable sources of income.

Increase quality through shifting sector and global allocations

Another big equity story for the rest of 2023 is apt to be the attractiveness of non-US stocks, reversing a significant trend lasting more than a decade. One of the reasons is China’s re-emergence from COVID-19 lockdowns, supported by a policy easing – most recently evidenced by a cut in banks’ required reserve ratio.

The other reason is a theme of resilience in Europe, which has held up and adapted better, and faster, than expected to the challenges posed by the Russia-Ukraine war. Those factors offer opportunities for investors. Equity markets outside the United States – in China, the emerging markets complex, and Europe – command lower valuations than the United States. Should growth and earnings prospects improve in those regions as China pivots, then more favorable absolute and relative valuations in non-US equity markets could provide a springboard for performance potential.

Lastly, we continue to underscore other secular trends as opportunities for long-term investors. Dislocations due to high inflation and interest rates have, if anything, created more favorable entry points in sectors such as biotechnology, alternative energy or the digital ecosystem—all areas we believe have excellent long-term growth prospects.

Finding selective opportunities

In sum, the continuing message for 2023 is one of selective opportunities. Differences in growth rates, macro policies and valuations will create differentiated outcomes in the year ahead. We believe investors are likely to be rewarded in higher-quality fixed-income and dividend yield allocations, and on the equity side, looking across the globe—with an eye on emerging markets—makes sense to us. As a result of recent dislocations, areas such as private equity, private credit and commercial real estate also might be viewed with a new lens. Using episodes of market weakness to build positions in the industries of tomorrow is, as always, a prudent strategy for long-term investors.

Sources:
1. Masters, B, Harriet C, and K. Duguid. “Money market funds swell by more than $286bn amid deposit flight,” Financial Times, March 26, 2023.
2. Stone, B. “How You Can Monitor The Severity Of The U.S. Banking Crisis,” Forbes, March 26, 2023.
3. Transcript of Chair Powell’s Press Conference, March 22, 2023.
4. Analysis by Franklin Templeton Institute, SPDJI, US Department of Treasury, Macrobond. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
5. Analysis by Franklin Templeton Institute, MSCI Indices, Macrobond. Notes: Rising interest rate means an increase in US policy rate over the calendar year. Higher inflation means more than 2.5% inflation for the calendar year in the United States. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results. MSCI makes no warranties and shall have no liability with respect to any MSCI data reproduced herein. No further redistribution or use is permitted. This report is not prepared or endorsed by MSCI.
6. Ibid.