The market mood continued to improve last week, as the VIX fell below 20, credit default swap spreads narrowed somewhat, and stocks and yields rose for the most part. This unwinding of the risk-off environment means that attention returned to economic data, which have been mostly supportive of the positive mood in markets. The banking sector appeared to stabilise with issues at least temporarily abating. As a result, financial conditions are easing but with significant differences between assets and regions.
New data show that the Fed's concern about a credit crunch has eased as the use of FED lending facilities has moderated. However, there are reasons for medium-term concerns as the NFCI survey and the Dallas Fed banking conditions survey, both suggest an ongoing deterioration of credit availability. Our main concern is the correlation between the velocity of money supply, inflation expectations and the loan-to-deposit ratio. This means that any significant drop in banking credit will have a larger contractionary impact on growth and inflation, now that monetary aggregates, such as M2 and M3, are also declining.
Markets are gradually adjusting again to higher-for-longer rates. Treasury yields rose last week, up c.12bp across most of the Fed rates curve, on sticky core inflation data and the continued easing of tensions in the banking sector. We believe front-end rates could move modestly higher over the next few weeks, as markets align with our rate view that the Fed is not yet done raising rates and will keep them higher for longer than the market is currently pricing in. This will also limit the scope for an additional steepening of the curve.
USD weakened in March following the stress in the banking system and the downward revision of rate expectations in the US vs. RoW. In the short term, there should be a cap in the dollar move at 1.10-1.12 EURUSD, but the medium-term trend of the dollar is still down based on cheaper international valuations and high hedging cost for international investors, as the FX basis works in favour of US investors.
Earnings season kicked off last week with robust 1Q23 prints from large US banks. This said, the guidelines for regional banks this week will not be that positive. Overall, consensus expects 1Q23 EPS growth of -5% in the US and flat in Europe, with earnings revisions fading in both regions. Despite increasing evidence of economic resilience, the risk-reward in DM equities is becoming less attractive than at the beginning of the year. Stretched valuations, overly optimistic consensus EPS growth expectations, and a Fed that is unlikely to cut rates this year render the risk/reward trade-off in equities unattractive considering the yields available on safer assets.
Actionable idea: Infrastructure stocks proved their resilience in 2022, despite the challenging market. We expect this trend to remain intact in 2023, as the macro backdrop remains prevalent and given the sector's inflation protection attributes, predictable (regulated) long-term cash flow profiles, stable dividends and resilience during economic downturns, support our thesis that the Infrastructure sector is a good place to be. This is without taking into account the long-term secular tailwinds that the sector should benefit from, such as sustainability, digitalisation and demographic changes.