Central Banks’ new conundrum 

 The March banking stress was a good test for the global economy: it proved the lack of viable channels of contagion which could have accelerated the downturn now faced by most economies in the late business cycle phase. US deposits are moving from failing banks into institutions with stronger balance sheets, thus further consolidating the sector with marginal impact on credit standards from large cap banks beyond the Fed’s own measures to restrict liquidity. In Europe, the euro area bank lending survey (BLS) indicated that, although the pace of financial tightening increased substantially, tightening conditions did not accelerate following the recent banking stress. And besides regulators’ resolve to deploy swift macro-prudential measures, the lack of systemic risk also finds roots in the sound balance sheet conditions of economic agents, underscoring the capacity of households and firms to weather stricter financial conditions. 

The financial sector undeniably bore the brunt of this confidence shock as investors offloaded highly detained positions such as banks and took refuge in defensive stocks and mega tech. And while real money investors might be restricted from deploying capital to the sector in the coming months due to the volatility shock, we still view banks as a source of outperformance within H2O AM’s equity sector arbitrages due to their deep undervaluation, a state which has prevailed long before the recent tightening of financial conditions. Overall, the investment team remains of the opinion that value stocks will gain ground during the end of the economic cycle, thus leading H2O AM to preserve its allocation to cyclical (EU) Autos and Banks, with marginal adjustments such as investments in energy and basic resources to diversify the basket of value securities. 

Macro Landscape 

The global economy is expected to cool-off in the second quarter. But the resilience of economic structures points toward a progressive and controlled contraction, consistent with a soft landing scenario. Core inflation remains elevated in the euro area on the back of ever-tight labour markets, real labour income advancements, and expanding Service industries. Even the US, which stands ahead in the economic cycle and experienced a local shock over its mid-sized banks, is on the path of moderate slowdown as labour conditions remain strong (April unemployment rate at 54-year low: 3.4%) while the economy is supported by exogenous factors: China’s reopening, Europe’s robustness, and higher purchasing power from lower energy prices (headline disinflation). In fact, these economies are still under the effect of measures undertaken in the aftermath of Covid and are yet to bear the brunt of rate increases despite cracks emerging in specific sectors. The situation thus warrants the need to remain data-dependent and adapt the central macro scenario should circumstances require it. 

At their current level of valuation, bonds hold no value in the absence of a global hard landing, which is not our central scenario. Investors seem very optimistic in pricing six cuts over one year in the Fed policy rate. However, the current market sentiment overlooks the likelihood of further rate hikes to come as Central Banks are met with renewed signs that inflation will remain structurally above-target. And even though our long-term view is that Central Banks will favour growth to inflation, we believe this is not yet the case as they are still concerned with their credibility. 

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