The fastest central bank rate hikes since the early 1980s heralded the specter of recessions and financial system cracks. An important crack emerged this weekend with the collapse of two U.S. regional banks.
U.S. authorities have acted quickly to help prevent wider contagion by protecting depositors from the bank failures. The U.S. Treasury and Federal Reserve moved to ensure that depositors affected by the regional banks have access to their cash today. The Fed also announced a new lending facility for banks providing one-year loans against their bond portfolios: a decisive move, in our view.
Unlike in 2008, this is not about assets with opaque valuations clogging bank balance sheets. The assets at the heart of the current bank troubles, such as U.S. Treasuries, are among the most liquid and transparent – and losses can be easily assessed. That helps the effectiveness of these combined measures.
Yet this is bad news for U.S. bank shareholders. First, the policy toolkit is now equipped to protect depositors – but at the expense of shareholders. Second, the banking sector as a whole is responsible for any shortfall in deposit insurance funds stemming from protecting uninsured deposits. Third, this event likely means greater regulation of U.S. regional banks that had avoided stricter global guidelines.
We see knock-on effects for the economy – reinforcing our expectation of recession. We see financial conditions and credit supply tightening, especially to sectors such as tech. These developments are also likely to hurt confidence and increase risk aversion. Moreover, we don’t see these developments allowing the Fed to halt its rate hike campaign – this is a very different environment from 2008 when all monetary policy levers were used to support the economy. Instead, by shoring up the banking system, the Fed can focus monetary policy on bringing inflation down to its 2% target.
The bottom line: We have been underweight developed market (DM) equities because they were not pricing in the damage, in our view. Markets will likely cheer the decisive policy measures at first, but the damage is only starting to be priced in. We keep a relative preference for emerging market stocks over DM. We recently trimmed our overweight to investment grade credit and are reassessing our view due to tightening financial conditions. We prefer short-term government bonds for income, even with the sharp yield drop in recent days. The yield slide could quickly reverse as investors see the Fed pressing on with rate hikes. We also prefer inflation-linked bonds amid persistently higher inflation.
This post originally appeared on the iShares Market Insights.