March 15, 2023
Global Investment Strategy Team
Strain on banks persists — Investors’ top questions
- As the week progresses, financial stress and stability concerns have shifted from U.S. regional banks to European global banks.
- While we do not view these financial system strains as symptomatic of the entire industry, we have been saying for the past year that rising interest rates, falling money supply growth, and tighter liquidity conditions across the economy’s financial sector are all working to quell inflation, but at the cost of a slower pace of economic activity.
What it may mean for investors
- The Q&A that follows is our take on what we are watching and how we believe that a defensive approach to risk still fits in this market environment.
1. Do we see the events of the past week being systemic or a broader crisis?
As the week progresses, financial stress and stability concerns have shifted from U.S. regional banks to European global banks. The spotlight’s shift to Europe is reinforcing investor concern and continues the recent risk-off environment in capital markets. This is a powerful example of how rising interest rates can create similar stresses across those financial institutions that fail to manage their assets to allow for swings in customer demand for cash.
In fact, this week marks the one-year anniversary of the Federal Reserve’s (Fed’s) first interest rate hikes. The lagged effect of tightening financial conditions is pressuring economically sensitive sectors of the economy, and investors are responding by moving toward more traditionally conservative asset classes and sectors. We have been expecting rising interest rates to affect the economy and financial system, and for this reason have favored a defensive stance in managing portfolio exposures.
2. What downstream ripples would we expect for the economy?
Households’ confidence in executing their spending plans intuitively goes hand-in-hand with their sense of security in their incomes and financial resources. When one falters, so does the other. For most of the past year, we have watched the economy slow, and the increase in financial stress at some financial institutions likely adds downward pressure on economic growth.
To the extent that households worry, they may hoard cash and keep it in places they perceive to be safer, including short-term U.S. Treasuries. (Reflecting this demand, the 2-year U.S. Treasury note yield has fallen sharply, from 5.07% on March 8, to 3.80% intraday on March 15.) For their part, financial institutions are likely to become more stringent with how they use cash, and we expect tougher bank lending standards. Small businesses depend on retail spending for revenue and on banks for funding, and so may feel these shifts the most. As the economy slows more perceptibly, we expect to see faster disinflation, which historically has accompanied concerns about the financial system.
3. What indicators are you watching for potential improvement or further deterioration?
Stabilizing bank stock prices and falling stock and bond market volatility (measured by the CBOE VIX Index (VIX) and the moves in yields across the U.S. Treasury maturity spectrum) would indicate improving conditions, and conversely if bank stocks fall and VIX rises. Also, if the S&P 500 Index trades below the December low (3783), it would probably trigger another round of selling by trend-following and momentum-driven strategies, but if the Index holds those levels, it may help restore investor confidence.
4. What are the most important implications for equity markets and sectors?
Financials sector: We reiterate our neutral rating. We believe that the sharp declines in the Financials sector will lead to historically cheap valuations, and the sector has historically tended to do well once the yield curve started to steepen, as it has recently. Given these positives amidst the current sell-off, we reiterate our neutral rating, meaning that we favor holding this sector at close to its market weight.
Information Technology sector: We reiterate our favorable rating. While some of the hardest-hit banks tend to cater to smaller technology companies, it is worth noting that larger technology companies have much broader access to credit and should continue to outperform in this uncertain environment. We favor holding this sector above its market weight.
Health Care and Energy: We reiterate our favorable ratings. During times of stress, markets favor traditional defensive sectors like Health Care, which coincides with our favorable rating. Also, the structural undersupply of energy should continue to propel Energy’s ability to generate cash for investors.
Regionally, we continue to favor U.S. stocks over international markets, but we will continue to look for opportunities to rebalance our regional exposure.
5. What do the events of the week mean for central-bank policy? Does the drop in short-term rates mean an end to the Fed tightening cycle? Do we still favor short- and long-term investment-grade fixed income?
Concerns over U.S. and European banks may complicate central-bank tactics, but we do not think they will mean an immediate end to the tightening cycle. We still expect the Fed to raise rates by 25 basis points (a basis point is 1/100 of a percent) next week and likely another two times before a possible pause — that is, we maintain our year-end 2023 target of 5.25% – 5.50% for the federal funds rate. Any lingering banking concerns may slow the pace of rate increases, but we believe the Fed will not signal a peak in rates until inflation is much closer to its 2% target. Similarly, the European Central Bank could slow its rate hike trajectory from the previous 50-basis-point increases that it previously signaled, but we do not believe it will pause or reverse its rate rises at this point.
Notwithstanding their recent, sharp decline, we expect short-term interest rates to rebound, as investors refocus on the rate hikes that central banks still intend to make. Thus, a barbell strategy of short- and longer-term fixed-income exposures still makes sense to us, as rates on short-term bonds and bills are already relatively high and somewhat protected from the volatility of other riskier assets such as credit and equities. Longer-term bonds are subject to duration risk (duration is a measure of a bond’s interest rate sensitivity), but yields may already have seen, or be close to peaks, and should fall further in the context of the recession that we expect. In addition, we reiterate our preference for investment-grade fixed income and recently upgraded our rating to favorable for U.S. Treasury securities.
6. What does it mean for our favorable view on commodity prices?
We remain favorable on a broad basket of commodities in 2023, especially relative to other major assets. While the current financial environment is not ideal for economic growth, structural global supply issues should continue to support commodity price gains. We favor treating any commodity price weakness that may emerge from the developing economic slowdown or the current financial environment as a buying opportunity.
7. Are we concerned about a spillover that weakens real estate markets, especially commercial real estate?
Yes, we have concerns about commercial real estate prices. Real estate markets were already seeing cracks from higher interest rates, but now have tightening lending standards to contend with. According to the Fed’s senior loan officers survey, lending standards for commercial real estate loans continued to tighten in the first quarter of 2023. Since commercial real estate relies heavily on debt to finance new projects, tighter lending conditions will likely lead to a slowdown in real estate markets. Therefore, we reiterate our unfavorable view on real estate, and our recent downgrade to neutral of commercial mortgage-backed securities (CMBS).
8. What are the potential spillovers into Private Capital, especially Private Equity? Are there now opportunities in Distressed Debt?
We maintain our neutral rating on Private Equity. Although the government backstop of bank deposits saved many start-up companies, their investors, and many small-to-mid-sized banks from significant losses, further bank failures may continue to impact venture capital markets. Ongoing economic uncertainty, stubborn inflation, and higher interest rates will likely impede fundraising activity in the near-to-intermediate term. We expect fundraising activity to remain subdued in the current environment. However, a decline in valuations and capital availability should bode well for the opportunity set and create a more investor-friendly market for venture capital funds set to launch during the downturn. We favor patience and maintain our neutral rating.
A mix of factors also leaves in place our neutral rating on Distressed Credit. We anticipate a wide range of Distressed Credit managers will be involved in reviewing and underwriting the remaining assets of the failed banks. In addition, private lenders are evaluating the loan books of the failed banks. Private lenders are likely candidates to replace the capital available to venture-backed companies. Even so, the lack of supply in today’s environment implies higher costs of capital. We believe it is too early to turn favorable on this strategy.
9. Does the recent spread widening create opportunities in credit?
At some point we believe these opportunities will arise, but it is still too early to abandon our more defensive stance or to upgrade our view from unfavorable. High-yield spreads have widened from below 400 basis points over U.S. Treasuries of comparable maturity, to around 500 basis points on the current bout of instability. However, previous periods of spread widening reached above 800 basis points in 2011 and 2016. As the economy slows further, we expect additional spread widening.
10. What do we want investors to do?
While we do not view these financial system strains as symptomatic of the entire industry, we have been saying for the past year that rising interest rates, falling money supply growth, and tighter liquidity conditions across the economy’s financial sector are all working to quell inflation, but at the cost of a slower pace of economic activity.
As we wrote on March 2, the equity markets are likely to trade in a range.1 In fact, the S&P 500 Index has traded in a wide band since April 2022 and, similarly, the 10-year U.S. Treasury note yield has traded in a range since September 2022. As risk aversion increases and the S&P 500 Index heads toward the bottom end of its recent range, we favor adding to positions to our asset classes, as detailed below. As risk aversion eases, and the Index moves toward the top of the recent range, we would slow or pause new allocations. We do expect a sustained economic recovery to begin by year-end and extend into 2024, with much lower inflation, and then lower rates as 2024 progresses. Our specific preferences include the following:
- In fixed income, we favor a “barbell strategy”, that is, overweighting positioning in short- and long-term maturities. A barbell should take advantage of high short-term rates and attractive long-term yields that we have not seen in multiple decades.
- Fixed-income sector positioning should be more defensive, and we favor moving up in credit quality. We remain unfavorable on High Yield Fixed Income and neutral on CMBS.
- Looking through near-term volatility, we do think the international environment is improving for international fixed income, and international equity opportunities could arise as 2023 progresses.
- Several highly cyclical areas of the market found their footing early in the year, but we believe that declining earnings have not been fully priced in the majority of cyclically oriented sectors. Thus, we still prefer to buy quality sectors (Information Technology, Health Care, and Energy) when their risk-reward balance becomes more attractive, at or near the lower end of their trading ranges.
- Commodity prices are below their 2022 highs, but we expect gains from current levels, as the economic recovery gains momentum. And, especially for long-term investors, the supplies of raw materials are likely to lag strong demand growth, while countries around the world replace and improve infrastructure. Upward pressure on commodity prices should continue beyond 2023, and we favor building exposure into a multi-year position in portfolios that may still be underexposed.
Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. Although Treasuries are considered free from credit risk they are subject to other types of risks. These risks include interest rate risk, which may cause the underlying value of the bond to fluctuate. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions. Commercial Mortgage Backed Securities (CMBS) are a type of mortgage-backed security backed by commercial mortgages rather than residential real estate. CMBS tend to be more complex and volatile than residential mortgage-backed securities due to the unique nature of the underlying property assets.
Sector investing can be more volatile than investments that are broadly diversified over numerous sectors of the economy and will increase a portfolio’s vulnerability to any single economic, political, or regulatory development affecting the sector. This can result in greater price volatility. The Energy sector may be adversely affected by changes in worldwide energy prices, exploration, production spending, government regulation, and changes in exchange rates, depletion of natural resources, and risks that arise from extreme weather conditions. Some of the risks associated with investment in the Health Care sector include competition on branded products, sales erosion due to cheaper alternatives, research and development risk, government regulations and government approval of products anticipated to enter the market Risks associated with the Technology sector include increased competition from domestic and international companies, unexpected changes in demand, regulatory actions, technical problems with key products, and the departure of key members of management. Technology and Internet-related stocks, especially smaller, less-seasoned companies, tend to be more volatile than the overall market.
Alternative investments, such as hedge funds, private equity/private debt and private real estate funds, are speculative and involve a high degree of risk that is suitable only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. They entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification, absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds. Hedge fund, private equity, private debt and private real estate fund investing involves other material risks including capital loss and the loss of the entire amount invested. A fund's offering documents should be carefully reviewed prior to investing.
Investing in distressed companies is speculative and subject to greater levels of credit, issuer and liquidity risk. In addition, the repayment of default obligations contains significant uncertainties.
Hedge fund strategies, such as Equity Hedge, Event Driven, Macro and Relative Value, may expose investors to the risks associated with the use of short selling, leverage, derivatives and arbitrage methodologies. Short sales involve leverage and theoretically unlimited loss potential since the market price of securities sold short may continuously increase. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty and management risks. Arbitrage strategies expose a fund to the risk that the anticipated arbitrage opportunities will not develop as anticipated, resulting in potentially reduced returns or losses to the fund.
A barbell strategy is when a fixed-income portfolio strategy invests half of the holdings in short-term instruments and the other half in long-term holdings.
An index is unmanaged and not available for direct investment.
Chicago Board Options Exchange Volatility Index (VIX) reflects a market estimate of future volatility, based on the weighted average of the implied volatilities for a wide range of strikes.
S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the US stock market.
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