2023 started with three important themes: An aggressive Federal Reserve (Fed) tightening cycle, inflation still above target, and economic releases showing resiliency. With that backdrop, markets were contemplating a range of economic outcomes, from a soft landing to a hard landing to no landing.  But in March, things got even more “interesting.”

There is a saying, “The Fed hikes until something breaks,” and last month, something broke as Silicon Valley Bank (SVB) and Signature Bank (SBNY) failed and the Swiss government had to force a takeover of Credit Suisse by UBS. The implications of these events will be important to what plays out in the markets and economy in the months ahead.

While the final impact of these events is yet to be seen, our main takeaway is that we think the chances of a recession have increased, and the timing thereof might be pulled forward. In our view, this impacts how investors should be positioned for the evolving environment.

Bonds are back as the ballast

The recent turmoil in the banking sector came as a surprise to markets, as most participants viewed the sector as high quality after it spent the past 15 years building up robust capital positions following government regulation in the aftermath of the Global Financial Crisis. Difficulties in the banking sector can have a significant impact on expectations for the economy, the central bank tightening cycle, and market returns.

In our view, at times like these, high-quality fixed income can bring much-needed defensive characteristics to a portfolio. As shown in Figure 1, as equities sold off amid the banking sector stress in March, core fixed income largely moved inversely and provided the ballast investors have come to expect from their bond allocation.

Coming into 2023, we believed high-quality fixed income’s key characteristics of income and diversification had returned after the great reset in rates in 2022, and we felt investors would once again be well served by a core bond allocation. While we did not envision large bank failures, we did feel strongly that fixed income was a necessary portfolio construction tool, as the Fed’s tightening cycle to slow the economy and bring down inflation could create risks. In March, we saw fixed income deliver on what clients needed from their bond allocation.

Bank failures: Idiosyncratic events or systemic crisis?

While investors can appreciate the diversification benefits exhibited by bonds in recent weeks, the pressing question is whether recent bank failures are idiosyncratic events that will be contained or the early signs of a systemic banking crisis? We believe it is still too early to tell for sure, but for now they appear idiosyncratic, as the banks that failed had risks and challenges that were quite distinct from the broader banking sector.

That said, we do think that idiosyncratic events have the potential to become more systemic, particularly if investors and depositors continue to look for the weakest lamb in the flock, so to speak. Irrespective of whether it’s based on truth or rumor, the loss of faith in an institution can swiftly bring about its demise if it results in a run on the bank.

Importantly, banks are also facing a challenging interest rate environment, as short-term interest rates are high and the yield curve is inverted. In a normal interest rate environment, where long-term rates are above short-term rates, banks make money by taking in short-term deposits and lending those deposits at higher rates for longer terms. But when the yield curve inverts, their ability to lend at much higher rates than the rates they pay on deposits becomes more difficult.

Further, as short-term rates have risen, banks are facing stiff competition for new deposits from higher-yielding money market and bond funds. As shown in Figure 2, U.S. banks have been experiencing a steady stream of deposit outflows since the Fed began raising rates in 2022. This will ultimately limit their capacity to make new loans, while also driving up rates on the loans they make as their funding costs rise.

Credit creation is a key driver of economic growth. Inasmuch as new deposits lead to new credit extension, the inverse also holds true: deposit outflows result in shrinking credit creation. If banks continue to see deposit outflows, we think this will place additional tightening on the economy. Banks will be forced to hold onto liquidity and tighten lending standards by making fewer, less risky, and more expensive loans, ultimately facilitating a slowdown in economic activity.

As shown in Figure 3, recent bank failures had a dramatic impact on tightening financial conditions after they’d started to ease early in 2023.

Portfolio positioning is key

Whether or not we experience a systemic banking crisis, we do think the Fed is in an even tougher spot now as it tries to stave off bank failures while still working to rein in inflation. We believe this is a material negative for the economy and increases the chances of recession. In addition, we think the Fed is much closer to pausing following its 0.25% hike in March, as it considers the effects on the economy of tighter financial conditions and impending slower loan growth from banks.

As investors contemplate how to position their portfolios going forward, we highlight three key points to consider in navigating the current environment:

1. Be more comfortable with some interest-rate risk (duration). In light of banking sector stress, the increased likelihood of recession, and our sense that the Fed is done – or very close to being done – raising rates, we think the likelihood that interest rates rise substantially from here is low. In addition, we think adding duration at current levels may provide much-needed defensive characteristics for portfolios.
2. Exercise caution around spread risk. Due to the heightened risks recently witnessed, we would advocate for a more defensive stance within allocations to bonds of lower credit quality. We would also eschew more cyclically sensitive industries, especially those most sensitive to tighter lending conditions. We believe a research-driven approach is more important than ever in the current environment, and investors should know what they own and the risks their portfolios are exposed to.
3. Be flexible and active. As the economic environment becomes more challenging, we think the likelihood of the divergence of clear winners and losers has also increased, and that the potential for certain sectors, industries, and individual issuers to out- or under-perform has grown. In our view, a nimble and flexible approach might better take advantage of opportunities that present themselves throughout the rest of the year, potentially resulting in better risk-adjusted returns.

Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.