The recent string of bank failures and wobbles in the US and Europe have understandably been met with a panicked response from investors; still scarred by the aftermath that followed the Lehman Brothers collapse in 2008. We have released written and video commentaries on the topic recently (please see our recent Special Statement, Ask Forstrong and Podcast), explaining why the current situation does not mirror the global financial crisis. However, the implications of stress in the banking system must be considered carefully.

For starters, one must be cognizant of other vulnerabilities. After well over a decade of ultra-accommodative monetary policy and rock bottom interest rates, it is not surprising to see companies get caught off guard by rapidly changing financial conditions. Leveraged and opaque business models are particularly at risk. We’re keeping a close eye on commercial real estate, speculative tech (including crypto) and private equity and credit to name a few. The good news is that systemic risk is limited by the fact that most of the riskiest exposures are (somewhat ironically) not held on bank balance sheets.     

Recession risk is undoubtedly higher following this episode. Bank lending standards will almost certainly be tightened aggressively, making it more difficult for companies to roll-over their liabilities and finance their operations. But “recession” is a catch-all term (with horrifically negative connotation), despite the fact that periods of falling economic growth come in all shapes and sizes. As always, investors need to be cognizant of what is already “priced into” financial assets. Here there are some conflicting signals: inverted yield curve vs. tight high yield bond spreads and sharply lower rest-of-world equity valuations vs. still-elevated US growth stock multiples. Our interpretation is that markets are expecting a modest US recession, but have been reluctant to let go of yesteryear’s winners. 

The role of central bankers has become much more difficult in recent weeks. Monetary policy decisions must now weigh stubbornly sticky inflationary pressure against financial sector stability. This added career risk plays to the advantage of investors. The combination of expedient policy responses to bolster confidence and liquidity in the banking sector and reduced appetite for interest rate hikes amongst central bankers is a net positive for risk assets looking forward. We do worry however that growing expectations of imminent rate cuts are likely to prove overly optimistic. 

As can be seen above, financial markets are presently experiencing considerable crosscurrents. At such times, volatility tends to stay elevated and portfolio diversification becomes all the more imperative. We outline our key investment strategy positioning and notable changes below.

Trimming equity exposure

• Global equity sentiment is likely to remain tense as investors gauge collateral damage from the banking sector and fret over other vulnerable pockets of financial markets. 

• However, we maintain that the banking troubles are a liquidity issue, not a solvency one, and ironically could provide a boon for stocks should central banks stop tightening policy earlier than expected. 

• Equity positioning has been decreased but remains modestly overweight in client portfolios.

Avoiding US growth stocks

• US growth stocks, particularly technology-themed companies, thrived during the ultra-low interest rate environment of the past 15 years.

• Despite the rapid change in monetary conditions, investors have been reluctant to let go of the former narrative. 

• Equity holdings continue to be oriented towards better valued and less interest rate sensitive segments of the market; primarily outside of North America.

Moving further underweight fixed income

• Central banks’ commitment to reining in inflation will be put to the test as banking sector confidence takes precedence.
• Bond markets appear to have discounted an economic contraction, but remain vulnerable to higher-for-longer price pressures.
• Fixed income exposure remains underweight and has been modestly decreased in client portfolios.

Remaining short duration

• Extending duration to hedge a wider range of potential economic outcomes would generally be a prudent strategy.

• However, with a deeply inverted yield curve in the US and other developed markets, the lower yield and higher volatility of long-term debt do not adequately compensate for the inherent risk.

• We are maintaining our overweight positioning in short-term and floating rate debt this quarter.

Initiating Taiwan and South Korea Equity Exposures

• An unusual dichotomy has opened up in the world economy, as Western nations slow, while a re-opening China accelerates.

• In addition to their outsized exposure to the Chinese business cycle, Taiwan and South Korea’s tech hardware export-centric economies stand to benefit from a bottoming in the semiconductor cycle.

• Positions in Taiwanese and South Korean equities have been initiated in balanced and growth-oriented strategies this quarter.

Liquidating US high yield bonds

• Our view of a more resilient than consensus US economy broadly aligns with an overweight high yield bond exposure.

• However, with high yield spreads below historical averages, the asset class does not adequately compensate investors for the elevated default risk in the current environment.

• US high yield bond exposure has been liquidated in income-oriented strategies this quarter.