Recent volatility in the banking sector has made a recession likely, according to Emiel van den Heiligenberg, head of asset allocation at Legal and General.
The collapse of Silicon Valley Bank and ensuing turmoil last month had many fearing another financial crisis but concerns over a repeat of 2008 have since subsided.
However, Heiligenberg said that “the longer-term damage has been done” and the likelihood of central banks reaching a soft landing has greatly diminished.
There was a growing weakness in the credit cycle prior to the banking crisis and lending has declined even more sharply since, he added, pointing out that almost $1trn in deposits have left the banking system over the past year – namely due to the Federal Reserve’s rapid monetary tightening in March – and the sector just went through the biggest two-week decline in lending by banks on record.
Indeed, the latest reports from the Fed suggest “tighter bank lending standards” and that loan growth is “cooling, perhaps abruptly in places,” according to Heiligenberg.
Most of these drops in deposits have come from small banks with less than $250bn in assets, but these institutions account for more than half (55%) of outstanding loans.
Heiligenberg said: “Larger banks allocate a much smaller proportion of their deposits towards lending. To compete for deposits, interest on deposits is rising, impacting future bank profitability, which forms another channel for credit tightening.”
This tighter lending environment that has been accelerated by turbulence in the banking sector could be an indicator of an oncoming recession, especially paired with poor earnings from equities.
Future earnings forecasts have fallen for the past six months, but “this warning sign has been largely ignored by investors,” according to Heiligenberg.
He said that positive gross domestic product (GDP) growth in the US has clouded these negative earnings estimates and made some investors overly optimistic.
“We are much more cautious [than the market] on earnings,” Heiligenberg said. “Falling inflation, especially for goods, is a sign of waning demand and inflation is the one thing holding up revenue growth for many businesses.”
This relative calm in the market could be interrupted once companies begin issuing profit warnings, which could catch some investors off guard.
Heiligenberg added: “If, or when, revenues begin to disappoint, operational leverage causes margin degradation to be much more abrupt. This is likely to cause profit warnings and the usual kitchen sinking of companies.
“That’s the moment when markets tend to move from sanguine to deeply pessimistic about the future earnings capacity of the market.”
In the past, companies have countered lower earnings by increasing share buybacks, but this method won’t be as effective in the current environment, according to Heiligenberg.
He said that less than a quarter (23%) of businesses have an earnings yield above corporate bond yields, making buybacks a less attractive approach, even though the number of companies buying their own shares has “risen very strongly” in recent weeks.
“Buybacks as a style are starting to underperform,” Heiligenberg said. “This is the market telling companies that it could be more rational to start paying off debt or invest in capex instead of buying back their own shares.”
Victor Zhang, chief investment officer of American Century Investments, agreed that the recent volatility in the banking sector has exacerbated recessionary pressures.
He said: “The banking crisis should accelerate the recession timeline. We expect banks to tighten their lending standards, essentially doubling down on the impact of the Fed’s rate-hiking regime.”
More assertive action by the Fed could create favourable conditions for bonds, but Zhang said that it is “too early to be aggressive” on equities.
He added: “With unanswered questions about the depth, duration and magnitude of a likely recession and new worries about bank stability, we’re maintaining a conservative stance with an emphasis on higher-quality securities.”
Likewise, Heiligenberg said that he would be holding on to equities through the oncoming volatility even if it is painful over the near term.
“We make no promises of harvesting alpha from the risk in the short term, as it’s a medium-term view,” he said. “Investors must decide whether they have the stomach to hold the line.”