Equities were broadly weaker in February. In the US, the S&P 500 fell -2.6%, the Nasdaq was down -1.1%, whilst in the UK, the FTSE 100 outperformed, rising +1.4%. In Australia, the ASX All Ordinaries Accumulation Index fell -2.5%. Defensive sectors such as Utilities and Insurance outperformed whilst Mining was the worst performer due to concerns around the state of the Chinese economy and strength in the US dollar, which typically is a headwind for commodity prices. Growth stocks outperformed value stocks in the month.

In bond markets, the US 10 year bond yield increased +43 basis points to close at 3.95%, whilst its Australian counterpart rose +30bp to finish at 3.86%. The driver of higher bond rates was continued data showing inflation around the world remains stubbornly high, which in turn is leading to expectations that central banks will have to continue to further increase interest rates in order to bring inflation back to acceptable levels. During the month, the RBA increased interest rates by 25bp to 3.35%. The RBA has now increased the cash rate by +325bp over the last 12 months. Whilst the timing is uncertain, we remain of the view that at some point this year, we will see the domestic economy begin to cool given the impact of the rate rises, which in turn should see the current pace of rate rises moderate. 

Commodities were generally weaker in February. Thermal coal continued to slide, falling -26%, iron ore -2%, copper -3%, gold -5%, whilst brent crude oil declined -1%. The A$/US$ fell -5% to US$0.67.

Kapstream's Portfolio Manager, Dan Siluk, explains why the Federal Reserve (Fed) opted to raise rates and highlights the threat posed by persistently high inflation despite recent upheaval in the banking sector.

Key takeaways:

• While acknowledging the recent developments in the banking sector, Fed Chairman Jerome Powell emphasized that the central bank's primary focus continues to be guiding inflation toward its 2.0% target.
• Although relatively hawkish, the Fed's move was likely tempered by tightening credit conditions weighing on consumers' and businesses' ability to borrow, which could act as an economic headwind.
• A bullish pivot likely doesn't await investors, but by delivering a 25 basis point (bps) rate hike, the Fed may have decreased the chance of a policy error that could send bond yields markedly higher.

After nearly two weeks of speculation, with a few pointed sentences Federal Reserve (Fed) Chairman Jerome Powell reaffirmed that the Federal Open Market Committee's (FOMC) highest priority remains price stability, while also acknowledging that recent banking sector upheaval and its impact on credit availability are developments they cannot dismiss. By shifting the focus back to inflation and a tight labour market despite indications of a slowing economy, Chairman Powell provided the context for the FOMC's 25 bps rate hike to a range of 4.75% to 5.00%.

Even with the focus squarely on inflation, we believe the impact of the banking turmoil was already evident in Chairman Powell's statement. In his Congressional testimony only a few weeks ago, he hinted that rates would likely have to rise higher than the market anticipated. Taking him at his word, futures prices responded by implying the terminal rate would climb as high as 5.75% in mid-2023. Fast forward to Wednesday and his message morphed to a less certain "some additional policy firming may be appropriate."

All eyes on the mandate

Citing "robust" job gains keeping stickier drivers of inflation - e.g., wages - elevated, Chairman Powell emphasized that there is much work to be done in achieving the Fed's objective of 2.0% inflation. This meeting's update to the Summary of Economic Projections reflected the Fed's modestly hawkish thinking. Estimates for 2023 headline and core inflation were revised upward to 3.3% and 3.6%, respectively. The challenge facing the Fed is acutely illustrated in the incongruity of paltry 2023 gross domestic product growth of 0.4% and the year's unemployment rate being revised down to 4.5%.

While banking sector turbulence has sent 2-year Treasury yields lower, sticky inflation could reverse that trend
 
Source: Bloomberg, as of 22 March 2023.

Given the recent developments in the banking sector, we had suspected that the Fed could have considered a 2023 pivot as lenders' health can materially impact financial conditions. Chairman Powell, however, dismissed that scenario, noting that the FOMC does not see a rate cut occurring this year. In fact, the Fed's much ballyhooed DOTS survey revealed that respondents see the fed funds rate finishing 2024 at 4.3% - slightly higher than the 4.1% suggested in its December survey. We interpret this as the Fed being willing to leave rates at their cycle high for longer than what the market is currently pricing in. Such a pause would give the central bank time to assess the impact of previous rate hikes and other tightening initiatives.

We believe the Fed was correct in shifting the conversation back toward its battle with inflation. Even before most people had ever heard of Silicon Valley Bank (SVB), the Fed was faced with striking a delicate balance between reducing inflation and inflicting as little harm as possible on the economy. That battle has not gone away.

Breaking something

Arguably, the genesis of the current banking turmoil was last year's rise in interest rates, which led to the mismatch between SVB's assets and liabilities and resulted in the run on the bank. We often state that the purpose of monetary tightening is to break something. Typically, what gets broken first are the weaker business models and pockets of the economy that are dependent upon low rates. While regional banks with narrow customer bases may be the first segment to give way, they may not be the last, and investors must be wary of what else higher rates could expose.

In his statement, Chairman Powell emphasized that the U.S. banking sector was "sound and resilient." This is due, in part, to the action taken by the Fed in concert with the U.S. Treasury to shore up banks' access to funding. Thanks to the alphabet soup of policy prescriptions created during the Global Financial Crisis, the Fed has a full cupboard of facilities well-suited to addressing financial stability. This leaves the fed funds rate available for the task at which it's effective: addressing inflation.

Bringing this full circle, the stress to regional banks that initially caused a historic rise in rates may, in the end, assist the Fed in tightening financial conditions. Mr. Powell made a point to highlight that households and businesses are likely to face tighter credit conditions. This is in addition to higher rates already negatively impacting the housing market and business investment.

Narrowing rates' range of outcomes?

We think recent developments - and the Fed's decision - leaves much for investors to digest. In one respect, the added headwind of tightening credit conditions means that the near-term ceiling for interest rates may be lower than it was in early March. This could lead to lower volatility in shorter-dated bonds. Still, we see a disconnect between the yield on the 2-year U.S. Treasury of roughly 4.0% and the end-of-2023 DOTS projection of 5.1% for the fed funds rate. This disparity may reflect the Fed's concern that it's too soon to declare victory in its battle against inflation.

In contrast to the Fed's expectations for its benchmark rate, the futures market believes a dovish pivot is in the cards by the end of 2023
 
Source: Bloomberg, as of 22 March 2023.

Recent market and economic developments have no doubt tested the Fed. We appreciate that its focus remains on price stability, as imbedded inflation expectations can lead to long-lasting price distortions across the economy. By recognizing that it has the facilities at its disposal to address financial stability, the Fed can keep another 25 bps rate hike on the table should consumer prices remain uncomfortably hot and the labour market tight.
In choosing a circumspect hike rather than the pause many had called for, the Powell Fed, in our view, has passed the initial test of not blinking at the first sign of something breaking, which - as history has shown - only results in more difficult battles down the road in containing inflation and longer-term rates. 

Basis point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%.
The Federal Open Market Committee (FOMC) is the body of the Federal Reserve System that sets national monetary policy.
The FOMC dot plot is a chart that summarizes the FOMC's outlook for the federal funds rate.

The latest RBA statement highlights the problem of high inflation and that the path to a soft landing is a narrow one. It reiterates the RBA's commitment to pursuing a 2 - 3 % inflation target, a target which notably the current RBA leadership has never sustainably achieved. It flags further interest rate increases too, as has the Federal Reserve. Markets think a further two rate increases in Australia are needed bringing the cash rate to circa 4% and, more importantly, home loan rates beyond 6%.

Home loan rates of over 6% will cause much pain to the average Australian mortgagee rolling off a fixed rate mortgage this year and make a meaningful impact on consumer discretionary spending. As such, we have already seen building approvals fall off in January and much anticipation that Australia will be heading in later 2023 for its first real housing-associated recession since the early 1990s. Much of the global economy is battling similar issues, and housing price falls.

Somewhat perplexingly, equities have held up in 2023 despite belated recognition from bonds that the interest rate pressures aren't over and despite earnings margin deterioration and higher discount rates. Surely equities should have realised by now that we are heading for recession and that the cost of money has risen, so why are they so slow to get the memo?

The answer to this question is critical to the path forward. So, let's consider it.

There are a few potential reasons for high valuations and equity market intransigence, led by the US:

(1) Corporations are still awash with cash because of the massive post-covid government stimulus and are still engaging in aggressive buybacks globally. These corporations feel the need to do something with their cash and prefer to spend it buying their stock regardless of price.

(2) The price-independent "passive investor" or buyer has become dominant in markets. Passive managers don't value anything before they buy it and are price and outlook insensitive. This tends to boost market prices.

(3) The amount of speculation in markets remains incredibly high. Options markets now trade over $1 trillion in notional value daily, which is greater than physical buying. Much of these are one-day or less options capable of easily moving market pricing in the short-term due to its sheer leverage and dominance!

Equity markets have hence never been more casino-like and vulnerable to speculative flows. No wonder price movements defy belief in recent times and over short periods. Much of the market doesn't care whether we are in a recession in late 2023 because it's either price insensitive or only concerned with the current day's price movements. How we got to this ridiculous scenario is another story.

So, it is indeed different in a meaningful way this time because of the character of market participants, but will it be different when we enter recession and earnings, and earnings margins take a more significant hit? This depends on the provision of one key factor, the actual amount of liquidity provided by central banks, commercial banks, and governments to the market.

Commercial banks are and will likely be less willing to lend money to the less creditworthy when the outlook is poor, but what about governments and central banks?

Governments, on the other hand, have become more fiscally irresponsible and dominant globally. They are likely to continue stimulating no matter what, given recent trends for greater government, the need for massive stimulus programs for infrastructure, climate change and increased military spending, and worsening dependency ratios and inequality.

The swing factor is central banks. Suppose central banks are true to their words and are committed to getting inflation down sustainably. In that case interest rates will increase further and potentially stay higher for longer in the face of economic weakness. Quantitative tightening will suck liquidity out of the market.

Given the above, the equity market is still likely to suffer and behave as it has in every other recession (assuming we get a recession, which leading indicators suggest is highly probable).

The challenge for the outlook is that markets don't trust central banks to do what they say, and they have legitimate reason to be sceptical. Central banks could easily give up on tightening measures and reverse course in the face of weakening economies and rising unemployment. Equally, there is a solid case to be made given the sheer amount of debt in the global economy there isn't a realistic option for central banks to become fully responsible now. It is simply too late as the economy has been overly financialised, and without ongoing stimulus, a deflationary bust will ensue which politicised central banks can't tolerate. In other words, financial repression is needed whereby interest rates are kept artificially low to stimulate higher structural inflation to wear away high debt levels over time. This provides a potential path for equity markets to hold up and explains how it could be different this time.

In our view, both the bears and bulls will be wrong and right. Central banks are first likely to cause a market accident or hard landing particularly given the nature of market participants and speculation in today's equity market, yet ultimately will be forced into a path of financial repression. It's a matter of timing. So, while cash looks attractive today, its attractiveness is likely to be somewhat fleeting. Equally equities are unattractive today but will likely provide a great buying opportunity at some point later this year.

History has convincingly demonstrated that in every market sell-off investors don't buy at the bottom and become afraid to become invested. Investors hence need to be invested, but just prudently at this point in time to avoid the risks of a hard landing in the short-term while still capture the likely benefits of financial repression over time. This means being invested with truly active and dynamic management that will buy into economic and equity market weakness when it arises but is investing cautiously with low equity market exposure for now, patiently waiting for the opportunity to strike. This management style will look to take advantage of an opportunity that we know investors are not structured to achieve and will otherwise miss. You need to be in it to win it, but equally you need to ensure the journey is tolerable too.