Banks

If the recession begins this year, it is unlikely to be mild, because inflation will not have fallen by enough to allow the Fed to cut rates aggressively. In contrast, if the recession starts in 2024 or later, when inflation is likely to be much lower, the Fed will be able to cushion the blow. Our base case remains a 2024 recession but the risks around that view have increased in light of recent banking stresses.

The dollar has entered a structural bear market. Although the greenback could get a temporary reprieve during the next recession, investors should position for a weaker dollar over the long haul.

Is the European banking system hiding nasty surprises? How will the recent stress affect European growth and the ECB’s policy outlook?

It is a big mistake to think that rate cuts or lower bond yields will ease credit conditions. Quite the contrary. After an aggressive tightening of monetary policy, the first rate cuts always coincide with much tighter credit conditions. We discuss the implications for credit, government bonds and equities. Plus, we find a startling anomaly in equity sector performance.

It is too early to know whether the drop in bond yields will offset the drag on growth from tighter lending standards. But if it does, the net effect on equity valuations could be positive. This is enough to justify a modest tactical overweight to equities, with the proviso that investors should look to reduce equity exposure later this year in advance of a mild recession in 2024.

The turmoil in US regional banks will weigh on economic growth. Arguably, it would be better for the broader stock market if growth slowed because banks became more conservative in their lending than if it slowed because the Fed had to raise rates to over 6%. In both cases, economic growth would decelerate but at least in the former scenario, the discount rate applied to earnings would not be as high.

Long-term drivers, including the growing ability of banks to returns cash to shareholders, point toward a strong structural performance for European financials. However, the ECB’s aggressive tightening campaign could still spoil the party.

We explore the eight major themes that will define economic and market trends for Europe next year.

On their third quarter earnings calls, the largest banks indicated that their household and business customers remain in surprisingly robust shape. We interpret their observations as supporting our constructive near-term take on the economy and financial markets.

Banks face many challenges from a slower economy and tighter financial conditions, which offset benefits from rising rates and higher net interest income. It is likely that things will get worse, a sentiment supported by many banking executives. However, negative expectations have already been priced in. We will maintain our overweight for now but will fade this position after a bounce in the next bear market rally. The long-term outlook is negative. We prefer Regional Banks to Diversified Banks.