The ETF Portfolio Strategist: 25 MAR 2023
Trend Watch: Global Markets & Portfolio Strategy Benchmarks
Markets are having a tough time deciding if the risk outlook is half-full or half-empty. Depending on the week, this niche of guesstimation bounces back and forth. To be fair, there are always risks to consider for the ex ante outlook, but the “wisdom” of the crowd, for good or ill, usually takes a stance, one way or the other. In recent weeks, however, that collective judgment has turned unusually mushy.
That doesn’t preclude trending behavior that runs for a week or two in one direction. The latest bias is up: the majority of global markets via our 16-fund opportunity set closed higher in the trading week through Friday, Mar. 24. The G.B16 strategy benchmark rose 1.3%, more than reversing the previous week’s modest loss. See this summary for design details on the strategy benchmarks listed below.
Year to date, G.B16 is up a respectable 3.4%, but the ride has been choppy. The turbulence stems from any number of more-than-trivial risk factors lurking on the horizon, including the possibility of wider contagion in the financial sector following the collapse of Silicon Valley Bank (SVB) earlier this month.
Another source of uncertainty is the guesswork in extreme that now dominates the realm of monetary policy. After announcing another 1/4-point hike in interest rates this past Wednesday, the Federal Reserve is tasked with trying to navigate two very different macro scenarios that may unfold in the days, weeks and months ahead. The future’s always uncertain, of course, but rarely in recent history has the central bank confronted such starkly different high-risk possibilities with more than trivial odds of striking.
On the one hand, it’s too early to assume that the recent bank turmoil has run its course. Although shares in the US financial sector (XLF) stabilized in the week just passed, the conditions that killed SVB will continue weigh on banks. Namely, the sharp, rapid runup in interest rates over the past year have heightened liquidity risk for banks and so it remains to be seen if there are more shoes to drop. Much of this will be determined by the warm and fuzzy factor known as sentiment.
One reason to reserve judgment on how much risk continues to prowl: financial stress has spiked in recent weeks. It’s unclear if SVB was a one-off event or an early warning that other institutions are vulnerable. What we do know is that the conditions that felled SVB are still coursing through the economy and so it’s reasonable — some might say inevitable — that the bank crisis is still in its early stages.
To be sure, the federal government — the Fed, Treasury and FDIC — has been clear that it stands ready to nip any future bank runs in the bud by backstopping depositors. That alone doesn’t ensure that sentiment can’t take a fresh dive, but it certainly helps.
The problem for the Fed is that the risk of contagion comes at a time when inflation, although slowing, is still too high to ignore. That leaves the central bank in an unusually tight spot, and one that potentially will press the Fed to choose which battle to fight — reducing financial stress or taming inflation in a timely manner.
With a bit of luck, the pressure on one or both sides will ease in the weeks ahead. Ideally, the banking turmoil fades as a real and present danger while incoming inflation data continues to ease. But if one (or both) deliver troubling news, nothing less than the Wisdom of Solomon will be required to navigate the path ahead.
Fed funds futures are currently pricing in high odds that the Fed will pause on rate hikes at the next FOMC meeting on May 3. But there’s a lot of data to inhale between now and then and so no one should assume that there’s clarity about what lies ahead.
Markets, as a result, will likely trade in a range until there’s a better sense of how the risks are evolving. And just to keep things interesting, the outlook for the US economy remains as confusing as ever. Depending on the data sets, you can make a convincing case that the macro trend remains resilient — or that recession risk is elevated and so the tipping point is clear.
To be sure, this is a ripe moment for speculation as several dramatically different scenario paths, with radically different implications, lie in wait. Choose wisely, grasshopper.
For investors with relatively moderate levels of risk tolerance and a focus on a longer horizon, however, recent events still inspire favoring a defensive posture. ■