April & May in summary

US, Eurozone, and UK Purchasing Managers Index (PMI) surveys all beat expectations, and China’s Q1 GDP print was also stronger than expected.

Equity markets continued their rally and have now broadly recovered from the tumult in March. While near-term recessionary risk seems to have receded somewhat, the closure of another US financial institution at the end of April highlights that the cumulative impact of central bank tightening has still not been fully felt by developed economies. This means that despite the recent improvement in the business surveys, portfolio diversification remains essential in the face of significant recession risk.

Digging deeper into the key factors behind markets movement in these months reveals the following:

After the collapse of SVB (Silicon Valley Bank) in March another three banks, Silvergate, Signature Bank and First Republic Bank, also failed. The last one became the biggest failure since 2008. First Republic is the 14th biggest bank in the U. S with about $200 billion in assets when it collapsed. As a result the bulk of its operations was sold to JPMorgan Chase in May.

This crisis differs from 2008 market turmoil due to its nonsystemic nature, in other words, the turmoil in the industry has centered on regional banks. Moreover, the crisis was driven by unique factors including large amounts of uninsured deposits and losses on banks' investments in government bonds relative to the size of their capital base, not using some obscure products. So instead of being "too big to fail" in 2008 crisis, now banks are meant to be "too small to thrive".

The banks that failed recently all invested in long-term Treasuries, as a safe haven, but as the Fed embarked on an aggressive rate hiking cycle, the value of these investments fell. When the banks experienced bank runs, they were forced to sell the investments at a loss, leaving them without adequate cash to back depositors' funds. Bank accounts also exceeded the federally insured limit of $250,000, making their deposit bases more vulnerable to flight with any signs of stress.

But investors are fearful that there are more dominoes to fall. One of those dominoes could be PacWest Bancorp. Shares of the bank were down as much as 30% on May after it reported customers recently withdrew 9.5% of its total deposits.

Deposits at U.S. commercial banks year-to-date through April 26 are down 3%, or $494 billion, to $16 trillion, with outflows led by small banks.

Since March 2022, the Fed has hiked interest rates on ten consecutive occasions, to combat inflation. US interest rates have gone from 0.25% to 5−5.25% and it’s one of the fastest monetary policy tightening cycles in 40 years. ECB also enacted its seventh rate hike in less than a year. Its deposit facility rate is now 3.25% - 375 bps above its level before the ECB initiated its inflation-fighting campaign in 2022. The Bank of England hiked policy rates to 4.5% as it carries on with its fight against stubborn inflation while growth stagnates.

Central banks are deliberately causing recessions by hiking interest rates to try to rein in inflation. Despite recent banking instability, the Fed continues to be more worried about not doing enough to get inflation under control than it is about tightening too much.
April CPI data showed that core goods prices surged and core services inflation excluding shelter stayed sticky through the last three months. That means annual core inflation is running close to 5% in the three months to April — too high for the Fed. Core services inflation excluding shelter did decline in April — but it is nedded to see that decline extend over a longer period to prove that underlying inflationary pressures are easing.

The effects of higher interest rates and tightening financial conditions are hitting the economy. It’s obviously not a repeat of 2008’s financial crisis, yet the bank tumult has reinforced our recessions views.

Digging deeper into the key factors behind markets movement in these months reveals the following:

Despite growing concerns with U.S. regional banks, a debt ceiling debate standoff, another interest rate hike this week, and signs that the U.S. economy might be finally cooling down, a better-than-expected Q1 earnings season has kept investors in the market—at least from a performance point of view

To date, 92% of the companies in the S&P 500 have reported earnings for the first quarter. Of these companies, 78% have reported actual EPS above the mean EPS estimate, which is above the 10-year average of 73%. In aggregate, earnings have exceeded estimates by 6.5%, which is above the 10-year average of 6.4%. It is also the highest surprise percentage reported by S&P 500 companies since Q4 2021 (8.1%).

In terms of earnings guidance, 57% of the S&P 500 companies (50 out of 87) that have issued EPS guidance for Q2 2023 have issued negative guidance. This percentage is below the 5-year average of 59% and below the 10-year average of 67%. In terms of revisions to EPS estimates, analysts lowered EPS estimates for Q2 2023 for S&P 500 companies by 0.8% in aggregate during the month of April, which was much smaller than the 5-year average of -1.9% and the 10-year average of -1.8% for the first month of a quarter.

Of course there’s plenty to worry about for the rest of the year, including the potential for recession, tightening financial conditions and debt limit drama. But after earnings season is over the risk of an additional sharp contraction in profit margins has come way down.

Negotiations to lift the U.S. debt ceiling are heating up. The Treasury hit the $31.4 trillion “ceiling,” or cap on how much debt it can issue, in January. It may be unable to pay its bills in early June. Even if a deal is struck before then, the debt showdown can stoke additional market volatility.

After investors poured into money market funds in March, their appetite subsided in April. Money market funds collected just $7.8 billion during April compared with the $362.2 billion the month before—and experienced their largest week of outflows since 2020.

That flood of cash was the product of two factors: higher yields on money market funds as a result of the Federal Reserve’s aggressive interest-rate increases, and worries about the safety of bank deposits following the recent failures of several regional banks. Investors receive 4.7% on an annualized basis in a Fidelity government money market fund for putting their cash in a money market fund today. Interest rates on savings deposits generally rise at a much slower pace.

Investors have pulled $632 billion in deposits from commercial banks since the start of the year through April 26. The failure of another major regional bank in May, First Republic, did not generate a panic and a move to money market funds the way the initial bank failure did.

In May, money market fund assets jumped to a record $​5.​685 trillion, with a surge of inflows since the collapse of Silicon Valley Bank and Signature Bank in March.

But now there is one potential problem for money market funds. This is the uncertainty around the debt ceiling in the US. While experts deem a default unlikely, if the U.S. did run out of money, one result would be a failure to pay interest and principal on its debt, which could include the kinds of short-term Treasury securities held by money market funds.

Still, concerns about disruptions from the U.S. government hitting the debt ceiling are showing up in the bond market, where short-term Treasury yields have spiked recently. But money-market funds have a layer of protection through so called "breaking the buck" rule. The funds always keep their net asset value at around $1. At that point, the U.S. could default, meaning it wouldn’t pay the full principal it owes on liabilities such as one-month Treasury debt, which many money-market funds hold. That is why the price of one-month Treasury debt has dropped recently. One-month Treasury yields have risen to 5.5% as of May 10—up from 4.7% at the end of March.

We suspect money market fund flows may remain strong until the US debt ceiling showdown is resolved, confidence in regional bank stability returns and uncertainty regarding a possible US recession and downward earnings revisions is reduced.

Global equity funds witnessed a fourth successive weekly outflow in the week ended May 10, hit by deadlock over the U.S. debt ceiling and lingering worries over an economic slowdown. Among sector funds, financials led with biggest outflows. If the standoff actually triggers a debt default, it could wipe out billions worth of money from equities.

US bond yields fell in April as fixed income markets changed its expectations about the peak of Fed rate. Now market expects that the Federal Reserve will not make any hikes in the coming months before cutting rates at the back end of 2023. At the last meeting in early May, the Federal Open Market Committee voted for a 25bp interest rate increase, taking the Fed funds target range to 5−5,25%. The regulator’s statements have become softer: no longer plans to tighten policy. Investors also received positive news on inflation. US inflation eases to 4,9% in April, which is slightly weaker than forecast. Core inflation stayed at 5,5% year on year in April, though leading indicators continued to suggest that it should start to moderate in the coming months. However, there were no signs of cooling from the labour market. As the unemployment rate fell to 3,4% in April and non-farm payrolls grew by 253,000, wage growth increased to 4,4% year on year from 4,2% in march.

The recent banking sector turmoil in the US has somewhat fuelled market expectations for the Fed to cut rates in 2H23. The Fed still remains highly attentive on inflation risk as the US labour market continues to be strong. Consequently, the UST market may continue to fluctuate over the near term as investors monitor incoming economic data and any contagion effects from the banking crisis.

ECB increased its main policy interest rates by 25bp, bringing the deposit rate to 3.25%. It is the smallest in the current cycle, suggesting that the ECB has entered the final stage of this tightening cycle. Eurozone headline inflation fell sharply as base effects in energy started to drag. The consumer price index fell from 8,5% year on year in March to 6,9% in April. Core inflation, however, increased by 0,1 percentage points to 5,7% year on year. We expect the ECB to continue raising rates at the upcoming meeting, as inflation in the region is still at elevated levels and shows no consistent signs of slowing down. Against this background, volatility in the European market is likely to continue in the coming months.

After a strong run up in March (+9,3%), gold prices returned just around 0,2% in April. Nevertheless, gold was trading above $2000/oz last month. This is near an all-time high amid a decline in US bond yields and the dollar following indications from the US Federal Reserve that it might pause its rate hiking cycle. We expect that gold will be above $2200/oz at the end of the year, as nervousness over the banking system, along with the weakening of the US dollar and falling Treasury yields will support gold prices.