Turmoil in the U.S. banking sector in early March upended the prevalent market narrative centered on economic resilience and the need for additional Federal Reserve (“Fed”) tightening. The policy response to bank tensions was decisive and succeeded in preventing systemic contagion.

However, expectations for terminal U.S. rates repriced lower as investors incorporated higher recession risks (see Exhibit 1). Lower yields contributed to dollar weakness while emerging market (“EM”) assets held up well, consistent with a “soft landing” scenario of contained spillovers from bank failures, easing price pressures and an orderly slowdown in U.S. activity.

Monetary Policy

The debate yielded a narrow consensus that believes the Fed’s tightening cycle was over or nearing its end with a final quarter-point hike in May. Participants also highlighted that U.S. bank failure and ongoing deposit flight is translating into even tighter lending standards. In turn, this credit crunch would “finish” the tightening job for the Fed, allowing the central bank to stay on the sidelines. There was greater disagreement on whether the Fed would deliver the cuts currently priced in – starting as early as midyear – or whether rates would stay higher for longer. At the core of the debate was uncertainty about the Fed’s reaction function and if, as the market seems to be assuming, policymakers will shift their focus squarely to growth considerations even as inflation pressure lingers. Speakers stressed this critical question would only be resolved by the Fed’s reaction to incoming data.

EM Resilience

The bank-related spike in asset price volatility – particularly in U.S. Treasuries – and financial stability fears in Europe and the U.S. did not lead to outsized pressure on EM assets, in what many considered a benign development (see Exhibit 2). While dispersion of performance at the country level stayed wide and portfolio flows mixed, EM equities kept up with the gains of their developed markets (“DM”) counterparts, and local EM government bonds outperformed; sovereign and corporate credit lagged U.S.
benchmarks, but they still ended the month in positive territory. Some TRG participants pointed out that part of the story may come down to long-standing factors supporting EM such as compelling valuations, resilient fundamentals, light positioning, and high carry. The boost from China’s ongoing reopening is an additional factor supporting the case for EM, as is the perception that the U.S. economy will slow further while avoiding a “hard landing”.

The bank-related spike in asset price volatility – particularly in U.S. Treasuries – and financial stability fears in Europe and the U.S. did not lead to outsized pressure on EM assets.

U.S. Cycle

One result from bank tensions is the potential acceleration in the transition of the U.S. economy from a regime of above-trend inflation and decelerating growth – or “stagflation” in our investment clock framework – to one of “reflation” as inflation rolls over while growth stays weak. That transition would be consistent with current pricing for rate cuts in the U.S., and with the recent reversal in the correlation between stocks and bonds. Unlike the relationship observed during most of 2022 when inflation fears dominated, today stocks and yields more often fall and rise together – suggesting a greater market focus on growth as any disappointment in the economy leads to declines in both yields and stocks. If this transition to a “reflation” regime carries on, TRG participants preferred exposure to quality (such as high-grade corporates) and longer duration bonds as the curve bull steepens. High carry remained a favored strategy, which wouldn’t require additional dollar weakness to perform.

Bond Value

Uncertainty about financial stability in industrialized countries and the Fed’s reaction function, plus questions over the outlooks for activity and inflation create what some participants called a “low conviction” investment environment. Portfolio construction and asset allocation became areas of discussion against this uncertain backdrop. The focus was on the merits of bonds performing the role of a compelling hedge again. Even among the TRG participants who argued that the recent rally in U.S. rates overstated the speed and magnitude of potential Fed rate cuts, exposure to bonds still made sense insofar higher-than-normal recession fears are present. TRG believes that higher quality EM sovereigns and corporates are more likely to hold up better with DM growth risks titled to the downside. Lastly, the recent underperformance (relative to U.S.) in EM sovereign and corporate credit likely created some valuation cushion, thereby strengthening the case for bonds as a hedge in the event of more extreme outcomes.

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Exposure to emerging markets generally entails greater risks and higher volatility than exposure to well-developed markets, including significant legal, economic and political risks. The prices of emerging market exchange rates, securities and other assets are often highly volatile and movements in such prices are influenced by, among other things, interest rates, changing market supply and demand, external market forces (particularly in relation to major trading partners), trade, fiscal and monetary programs, policies of governments and international political and economic events and policies. All investments entail risks, including possible loss of principal. Past performance is not necessarily indicative of future performance.
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