No 2008 redux, but recession coming

The market gyrations of the past week are not rooted in a banking crisis, in our view, but rather are evidence of financial cracks resulting from the fastest interest rate hike campaigns since the early 1980s. Markets have woken up to the damage caused by that approach – a recession foretold – and are starting to price it in.

The latest cracks have appeared in the banking sector on both sides of the Atlantic. The cases are different – but markets clearly are looking at bank vulnerabilities through a new, high-interest rate lens.

Markets have slashed their expectations of interest rate paths, expecting central banks to come to the economy’s rescue by cutting rates as they used to do in episodes of financial stress. We think that’s misguided and expect major central banks to keep hiking rates in their meetings in coming days to try to rein in persistent inflation.

The trade-off for central banks – between fighting inflation and protecting both economic activity and financial stability – is now clear and immediate. The financial cracks are unlikely to deter central banks from trying to get inflation back closer to their targets. Instead, we think the European Central Bank (ECB) and Federal Reserve will go as far as possible to distinguish their inflation-fighting campaigns from measures to deal with bank troubles and safeguard the financial system.

The ECB did so on Thursday by hiking rates 0.5%, as it originally had telegraphed – even as markets had started to doubt its resolve. The recent market and bank convulsions represent a tightening of financial conditions and should curb bank lending, helping do some of the tightening work for central banks. This could result in policy rates peaking at lower levels than they otherwise would have.

U.S. authorities provided support to the banking system after the failure of two regional banks. And the Swiss National Bank offered a credit line to a major Swiss bank when its shares and bonds plummeted. We think the move to support this systemically important financial institution will help buy time. We don’t see a repeat of 2008, when the downfall of Lehman Brothers spiraled into a global financial crisis. The Swiss bank’s woes have long been known, banking regulations are much stricter and the bank’s assets are of higher quality. A longer-term solution is needed to avoid leaks in the financial system’s global plumbing, in our view.

The bottom line: We see significant opportunities in short-term government bonds for income – even as yields have fallen recently. We also prefer emerging market equities over developed markets, where we stay underweight. This is not a 2008 redux, and we stand ready to seize opportunities as the damage of rate hikes becomes priced in.

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