US equities had a particularly poor week, as investors absorbed more tough talk from Federal Reserve Chair Jerome Powell and signs that he and his fellow policymakers still had work to do in cooling inflation and the hot labour market. The Dow Jones, S&P 500 and Nasdaq were down -4.44%, -4.55% and -4.71% respectively. Financials led the declines within the S&P 500 and contributed to the pronounced weakness in value stocks. Concerns grew throughout the week about the health of Silicon Valley Bank (SVB), as customers pulled deposits after the technology-oriented regional bank was forced to sell and realize losses in securities held on its balance sheet to meet capital requirements—marking the second-biggest bank failure in US history. Stocks in other regional banks fell in response, although only moderately, suggesting that investors concluded that SVB’s risk exposure was exceptional.
Equities in Europe fell amid worries about stress in the banking system and the potential effects of a prolonged period of elevated interest rates. The pan-European STOXX Europe 600 Index ended -2.26% lower, Germany’s DAX Index weakened -0.97%, France’s CAC 40 Index declined -1.73%, with Italy’s FTSE MIB Index dropping -1.95%. The UK’s FTSE 100 Index lost -2.50%.
Within fixed income, the market believed that the collapse of SVP might cause the Fed to dial back its interest rate hikes to prevent further stresses in the financial system, which saw the two-year US Treasury yield fall from 4.9% to just above 4.6%, while markets began pricing in a quarter-point hike at the next Fed meeting instead of a half-point hike. This flight to safety resulted in the yield on the benchmark 10-year US Treasury note rallying more than 25 basis points (bp) for the week, while credit spreads, especially in high yield, widened dramatically, with US high yield selling off more than 60bps to 450bps.
Jobs data was somewhat mixed over the course of last week. Friday’s US payrolls report, which showed an increase of 311,000 nonfarm jobs in February, well above consensus expectations of around 200,000, while the unemployment rate rose unexpectedly from a January five-decade low of 3.4% to 3.6%. Average hourly earnings also rose a bit less than expected, by 0.2%, which may have been due to many new jobs coming in relatively low-paying sectors.
The UK economy rebounded by more than expected in January, driven by growth in the services sector. Gross domestic product rose 0.3% sequentially, after contracting in December, while Eurozone economic growth in the fourth quarter was revised down to 0% from an initial estimate of 0.1%.
On Tuesday in the US, Fed Chair Jerome Powell testified before Congress that policymakers were prepared to speed up the pace of tightening and raise rates higher than anticipated if inflation maintains its current trajectory. He noted that the process of getting inflation down to the Fed’s long-term 2% target will likely be bumpy, referring to a broad reversal of the disinflationary trend in January, while adding that stronger recent economic data suggest the ultimate level of interest rates may be higher than expected. The US 2-year Treasury reacted to the hawkish tone of the testimony, and initially sold off to over 5%, before rallying to just under 4.6% as hints of labour-market weakness and a flight to safety set off by a retreat in financial company shares sent investors piling back into the same government securities they spent much of the first half of this week selling.
Silicon Valley Bank saw its share price collapse on Thursday as rising US interest rates resulted in a combination of losses on fixed income security holdings, an increasing short-end funding costs, and a high exposure to the weakening tech/start-up space. SVB said on Wednesday it had lost roughly $1.8bn on the sale of about $21bn of securities, which represented about 80 %of its securities portfolio marked as available for sale. The decline sparked contagion among financial stocks more broadly, drawing attention to the potential effect that rising interest rates could have on net interest income at other banks. Stocks in other regional banks also fell, however, declines were relatively moderate because of stricter banking regulations, which required them to previously mark down the value of some securities, suggesting that SVB’s risk exposure was exceptional. While credit risks should not be dismissed as economic conditions soften, SVB is a very small institution with specialised lending practices. While additional isolated disruptions among some higher-risk or smaller institutions may transpire, the overall US banking system remains very well capitalised, limiting the potential for a more systemic banking-system problem that would pose a larger risk to the economy and financial markets.
In the US, strong non-farm payrolls data showed that the economy is still going strong, despite an increase in initial and continuing jobless claims (more on that below). Industrial production and manufacturing weakness is still a concern, and a recession is still likely as Fed hikes flow through the economy. In the UK, there was a slight growth rebound in January with monthly GDP coming in at 0.3% against a previous reading of -0.5%. While industrial production and manufacturing continue to show weakness, -0.3% and -0.4% month-on-month (m/m) respectively, services dragged growth up coming in at 0.5% m/m above analyst expectations of 0.3%. A cause for concern is construction output which has cratered compared to previous readings coming in at -1.7% m/m and 0.6% year-on-year (y/y) against expectations of 0% and 2.5% respectively. The growth outlook remains unclear for the UK, with all eyes on the Chancellor’s budget statement this week.
US employment data painted a muddled picture of the direction of inflationary pressure in the economy. On the one hand, initial jobless claims came in at 211k, much higher than the consensus estimate of 195k and a marked increase from the previous week’s reading of 190k, indicating some weakening in the labour market coming through. While tech sector is still the leader in layoffs, claims are now broader based across sectors. On the other hand, non-farm payrolls data came in much hotter than expected, at 311k added against expected 225k. While it is a decrease from January’s revised figure of 504k it showed continued tightness in the labour market which will make the Fed uneasy. Important to note that despite the strong overall outlook, manufacturing payrolls have contracted slightly in line with other indicators showing weakening of industrial production and manufacturing ahead. The picture is further complicated by an increase in unemployment to 3.6% from 3.4% but that is mostly down to labour supply growth outstripping job creation as seen from the participation figure rising to 62.5%. Finally, average hourly earnings slowed slightly to 0.2% m/m / 4.6% y/y from 0.3% and 4.7% respectively and average weekly hours worked to 34.5 from 34.7. Mixed signals from the labour market mean that Wednesday’s CPI print will be a key data point that guides the Fed’s decision at next week’s rate-setting FOMC. Elsewhere, German inflation came in as expected at 8.7% and Japan’s PPI eased to -0.4% m/m / 8.2% y/y from 0% and 9.5% respectively.
This last week highlights how volatile the market can be, and how quickly markets can turn. Continued high inflation and hawkish central banks caused investors to believe that higher terminal rates were on the horizon. However, with the collapse of SVB, expectations have done an about turn. We continue to reiterate our view duration should be added back to portfolios, and this past week’s risk-off rally in 10-year US Treasuries highlights this view – fixed income diversification is back. While the short end of the yield curve is higher than the long end, economic data and market speculation has caused short-end yields to be extremely volatile. Portfolios should be positioned for continued volatility going forward. We recommend taking advantage of the negative stock-bond correlation by adding duration through government bonds, while having exposure to high quality short duration corporate credit which offer attractive all-in yields. We reiterate our view on being up in quality and highlight the continuing diminishing equity-risk premium as parts of the bond market offer decade-high yields.
The week ahead
- Monday: Japan GDP
- Tuesday: US CPI
- Wednesday: US Retail Sales and US Industrial Production and UK CPI
- Thursday: US PPI, US Housing Stats, US Initial Jobless Claims
- Friday: France CPI
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