The turbulence among smaller banks in the U.S. is set to slow the economy, raising the likelihood of a recession. But stock and bond markets were offering different signals about whether the U.S. is headed for a hard landing earlier this week, according to Brett Nelson, head of tactical asset allocation for the Asset & Wealth Management Investment Strategy Group (ISG) at Goldman Sachs.
Based on the S&P 500 Index’s declines, a rough calculation suggests stock investors are pricing in about even odds of U.S. recession, which Nelson says isn’t far off from ISG’s estimate of 45 to 55% odds of recession in the next year. “We see the arguments in favor of a recession being about as compelling as those against one,” he said. (ISG’s forecasts may differ from those of other groups at Goldman Sachs). Short-term U.S. government bonds seemed more pessimistic: The recent decline in yields at their worst point suggested those investors think the Federal Reserve will cut interest rates later this year in response to coming weakness in economic growth, he says.
We spoke to Nelson about how much of the turbulence in the U.S. banking sector has played out, ISG’s expectations for recession and how clients should consider investing as the tightening in banking standards filters through the economy.
How much of the turmoil among smaller banks in the U.S. is already showing up in the economy?
In the Investment Strategy Group, we publish an annual outlook for the high-net-worth clients of the firm, and we always have a theme for that. This year the theme was ‘caution, heavy fog,’ given the tremendous uncertainty obviously facing investors on all sorts of things, including the trajectory of the economy, inflation, monetary policy and geopolitics.
I would say the events of the past weeks have definitely thickened that fog. Although we’ve probably seen the first-order effects of tighter financial conditions play out in higher risk premiums across a variety of different asset classes, the impact on the real economy — which will ultimately feed through via bank lending, economic growth and consumer confidence — has yet to play out.
Now keep in mind that these impacted small- and mid-sized banks are pretty vital to credit formation in the U.S. These banks collectively represent about half of U.S. commercial and industrial lending, about 60% of residential real estate lending, 80% of commercial real estate lending and 45% of consumer lending.
So it seems very likely, given the events of the past week, that we are going to see a tightening in the lending standards of these institutions, and that will obviously be a drag on growth, given the statistics that I just gave you. At this stage it’s very difficult to dimension what that tightening in lending standards will mean. But our colleagues in Global Investment Research have taken a stab at this, and they’ve estimated that as these banks tighten their lending standards, that could represent something on the order of a half a percentage point drag on GDP growth this year, and the equivalent of about 25 to 50 basis points of Fed hikes.
So it’s material, but it’s not so large a drag on growth that we think it would tip the economy into a recession, especially if things stabilize in the next few days.
How do you position a portfolio at a time like this?
As investors, we dislike uncertainty and we prefer environments where we can have high conviction in the outcome, and therefore know exactly how to optimize our portfolio positioning. But candidly, we do not think we’re in one of those environments.
As I mentioned earlier, we see the arguments in favor of a recession being about as compelling as those against one. And so what we’ve been telling our clients, given this fog of uncertainty, that they shouldn’t position their portfolio for any one of those outcomes exclusively. Instead, our advice has been to stay invested at one strategic asset allocation, which is broadly diversified by design.
In terms of the market reaction, do you think it’s roughly in line with where you would expect that to be?
It’s always difficult to know what markets are discounting at any given time. As investors, we’re always trying to figure that out to find out if there’s an opportunity to lean against where the markets are positioned. Our general sense is that the market shifts have been consistent with the developments of the past weeks. Most intuitively, banks have been under the most stress, because they’re obviously at the epicenter of the crisis.
In broader equities, we think that the decline has been relatively orderly and modest so far. The S&P 500, for example, is down about 2-3% from just before the onset of the banking turmoil, which seems consistent with the relatively modest drag in estimated GDP growth that I mentioned earlier.
Now, some people have made the argument that broader equity markets should be down a lot more. But we think it’s important to keep in mind that the S&P 500 was already in a double-digit drawdown from last year’s peak when this recent banking stress began.
One way that we try to calibrate where the market is and whether that’s reasonable is to consider that in a typical recession, the equity market is down about 30% on average. At its current level, the S&P 500 is down about 17% from its peak. That’s about midway to a recessionary outcome, implying the markets may be putting about even odds on a recession. That’s consistent with the range that we have for recession of around 45 to 55%. So to us, the market is putting elevated, but not overwhelmingly large, odds on a recession.
What are the signals from outside the stock market telling you?
Outside of equities, there are areas where we see a bigger divergence in what the market seems to be pricing, and I think the most obvious candidate is short rates in the U.S. Here we’ve seen the U.S. market go from pricing 100 basis points of additional hikes to almost a 100 basis points of cuts by the end of the year. Not only is that 200-basis-points-swing in one week highly unusual by historical standards — it’s just a very large move — but that nearly 100 basis points of cuts by the end of the year would also seem to imply growth outcomes that are much worse than what is apparently embedded in equities.
So the jury, in our mind, is still out as to whether fixed income has moved too quickly or equities have moved too slowly. But given equities seem to reflect better than even odds of a recession and that technical factors in the bond market likely amplified the move — you had extreme short-bond positioning among investors before the recent bank stress began — we would give the edge to the interpretation that the fixed income markets may have moved beyond what is justified by fundamentals. The move higher in yields from their lows at the beginning of the week also lends credence to that view.
The last point I would add on that dimension is that there is precedence for the Fed to cut rates outside of recession. For example, the Fed did cut rates in response to shocks in the 1990s, namely the rapid rise in bond yields that we saw in 1994, and then again during the Asian Financial Crisis and the Long Term Capital Management Crisis in 1998.
So that might be another way to square the bond market pricing of cuts without necessarily implying a recessionary outcome.
Disclaimer: The Investment Strategy Group, part of the Asset & Wealth Management business (“AWM”) of GS, focuses on asset allocation strategy formation and market analysis for GS Wealth Management. Any information that references ISG, including their model portfolios, represents the views of ISG, is not financial research and is not a product of GS Global Investment Research and may vary significantly from views expressed by individual portfolio management teams within AWM, or other groups at GS.
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