Where to hide in a volatile market?

Cross Asset Strategy

Global equities gained on the week. Risk sentiment improved on the stabilization of the banking sector in light of First Citizens’ takeover of Silicon Valley Bank (SVB). Looking more closely at the deal, First Citizens will take on SVB’s $72 billion in loans (bought at a $16.5 billion discount) and $56 billion in deposits. To help backstop the deal, the Federal Deposit Insurance Corporation (FDIC) agreed to cover a portion of potential losses on loans for the next few years and offered additional funding to First Citizens if it’s needed. The FDIC will also retain the remaining $90 billion of SVB’s securities and other assets for now. From here – of the U.S. banks that catalyzed the turmoil – that leaves First Republic as the largest outstanding question mark. Some reports suggest U.S. authorities are considering ways to expand its emergency lending facility and give First Republic some more time to strengthen its balance sheet.

The S&P 500 rallied back above 4,000, and equities in Europe and Asia followed the course with a risk-on rally. Bond yields reversed some of the decline over the past few weeks with the 10-year Treasury trading around 3.5%. Gold stood out over the recent weeks as one of the best performing assets year-to-date (+8%). The yellow metal has been responsive to the recent instability in the banking sector as a storage of value, demonstrating its typical safe haven characteristics. On the other hand, crude oil fell -9% on rising recession concerns and a smaller-than-expected boost from China’s reopening. While we believe regulators have the tool to manage financial stability risks, credit tightening from banks will likely lead to more cracks in the economy. Amid this high level of uncertainty, where can investors hide as macro risks rise? Read on for our latest thoughts on how investors can allocate their assets today.

Strategy Question: Where to hide in a volatile market?

Over the past month, three U.S. banks have failed and Credit Suisse has merged with UBS. Remarkably, while yields have declined, global equities have been little changed (outside of bank stocks). Price volatility in U.S. interest rates and bank stocks is back to Global Financial Crisis (GFC) levels, while the VIX is near its average level over the past five years. The U.S. equity risk premium (ERP), which compares the expected yield in stocks to Treasury bonds, increased by over 50bps, driven almost entirely by a decline in interest rates; the ERP is still below its 25 year median, but over the course of the month bonds became less attractive relative to equities. If you substitute investment grade bonds for Treasuries in the ERP, the two expected yields are near parity despite equities being higher risk. As growth is the real economy is looking more challenged, high quality growth stocks continue to look attractive.

Market vulnerability proxies are flashing red – Treasury market functioning deteriorated and market depth is back to March 2020 levels¹; it’s hard to price any asset with this much volatility/instability in the world’s reference rate. Measures of dollar funding stress, both onshore U.S. and offshore, have surged – but that said, they are still below the COVID highs.

The tightening in financial conditions looks set to continue, with the Fed passing the baton to banks. Credit growth fuels economic growth. When credit is expanding, consumers and businesses can borrow, spend, and invest more. Bank loan growth has historically run a bit more than double that of real GDP. When credit spigots turn off, growth declines; a negative shock of 2% to loan growth slows GDP by a bit less than 1%². Unfortunately, small banks accounted for 90% of loan growth over the last six months and recent bank failures are likely to decrease their ability and willingness to deploy a loan.

1. Ability: Small banks just realized that their deposit base may not be as stable as previously expected. To boost liquidity they are likely to raise deposit betas – the percentage of change in fed funds passed on to depositors - quickly towards prior business cycle highs. As deposit betas rise, profitability wanes and restricts the ability to lend.
2. Willingness: Even with higher deposit rates, small bank confidence is dented and deposit flight may pick back up. With such uncertainty, small banks may hesitate to lend or at least require a higher rate of return to deploy a loan – and credit growth slows in turn. Small banks are outsized lenders to commercial real estate and small businesses. According to a 2017 FDIC snapshot, small banks make twice as many loans to small businesses than large banks ($362bn vs. $190bn respectively, proxied by business loans <$1mn).

The Fed is signaling recession, which is yet another reason to consider owning core duration. Some suggested Chair Powell was optimistic about the economic outlook at the March FOMC meeting, but we disagree. In their projections, the Fed downgraded their growth assumption for 2023 to 0.4% (vs. 0.5% prior) – without raising the expected terminal fed funds rate (they too think the baton has been passed to the banks). Q1 2023 is nearly over and real GDP growth is tracking at a 2+% rate. For growth to average 0.4% this year, at least one quarter may have to be negative. We continue to expect one more 25bps rate hike, but more importantly we continue to expect the Fed to be cutting towards the end for the year (and so does the bond market).

Since March 8th (the Silicon Valley Bank woes), 2-year Treasury yields have declined ~1.5% – and this is what reinvestment risk looks like. Over the same horizon, 10-year Treasury yields have declined 65bps. Certainly rates have come down, but we continue to expect 10-year Treasury yields to end the year at 2.85% (below consensus). Investment grade bonds still offer 5+% yields, with near zero default risk. At this moment, 10 year and shorter investment grade bonds look more attractive.

We’re still defensive in U.S. equities, so in the search for offense we suggest considering high-quality growth. Our base case remains for the S&P 500 to be range-bound from here with continued volatility. For broad equity exposure we prefer to monetize that volatility via structured products; investors move up in the capital structure (with the aim of gaining) attractive returns with downside protection. To play defense at the sector level we still like healthcare (an undervalued defense), and reasonably-priced Tech and Industrials (given backlog and margins). For those looking to play offense, consider adding growth. Growth, as an equity factor, has screened attractive relative to the economy for months, and now the end of the likely in sight. The Fed anticipates one more 25bps rate hike, while the bond market says the next move is a cut. 

In FX, we have long believed that in 2023 the U.S. dollar would unwind the excessive overvaluation that built up last year. The weaker USD thesis is that U.S. growth and yields “catch down” to the rest of the world over the course of the year (provided USD funding markets remain well-behaved). At present, we see recent turmoil in the banking sector as likely to have a larger negative growth impact on the U.S. than the rest of the world, which will likely elicit a relatively easier path of monetary policy and thus mean interest rate differentials continue to move against the USD. Meanwhile, signs of offshore USD funding pressures look minimal amid expanded USD liquidity facilities from the Fed. Still, weak risk sentiment limits where one can express a weaker USD view with the right risk/reward to alternative reserve currencies (i.e. EUR, JPY and CHF). We continue to favor gold as a safe haven play. The yellow metal has been very responsive to the instability in the banking sector demonstrating alternative stores of value benefit. In addition, a reduced chance of dollar strength and lower expectations of real rates will likely continue to provide support.

¹5-day moving average of bid/ask spread on 2y, 5y, 10y, 30y UST

²Calomiris and Mason (2003)

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• Structured products involve derivatives and risks that may not be suitable for all investors. The most common risks include, but are not limited to, risk of adverse or unanticipated market developments, issuer credit quality risk, risk of lack of uniform standard pricing, risk of adverse events involving any underlying reference obligations, risk of high volatility, risk of illiquidity/little to no secondary market, and conflicts of interest. Before investing in a structured product, investors should review the accompanying offering document, prospectus or prospectus supplement to understand the actual terms and key risks associated with the each individual structured product. Any payments on a structured product are subject to the credit risk of the issuer and/or guarantor. Investors may lose their entire investment, i.e., incur an unlimited loss. The risks listed above are not complete. For a more comprehensive list of the risks involved with this particular product, please speak to your J.P. Morgan team.
  
• Investments in commodities may have greater volatility than investments in traditional securities. The value of commodities may be affected by changes in overall market movements, commodity index volatility, changes in interest rates, or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Investing in commodities creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.​Past performance is not indicative of future results. You may not invest directly in an index. 
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Index definitions

KBW Bank Index (BKX Index) is a modified cap-weighted index consisting of 24 exchange-listed National Market System stocks, representing national money center banks and leading regional institutions.

Standard and Poor’s 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The index was developed with a base level of 10 for the 1941–43 base period.

The CBOE Volatility Index (VIX) is a benchmark index to measure the market’s expectation of future volatility, based on options of the S&P 500 Index.

The ICE BofA MOVE Index (MOVE) is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options. It is the weighted average of volatilities on the CT2, CT5, CT10, and CT30 (weighted average of 1m2y, 1m5y, 1m10y and 1m30y Treasury implied vols with weights 0.2/0.2/0.4/0.2, respectively).