In April, market volatility subsided, bringing a sense of calm to stock and bond markets. UK equities had a positive return of 3.6% for the month, while the MSCI All Country World ex UK Index showed a marginal negative return for sterling-based investors. Gilts yields rose, but longer-dated and index-linked bonds experienced sharp declines.
The recent calmness in the markets is a welcome development following the panic that arose in March due to concerns about the health of the banking sector. The rapid and significant increases in benchmark interest rates over the past 15 months have had adverse consequences, particularly for banks. Their business models, which often involve lending money long-term while relying on short-term borrowing for funding, make them vulnerable to potential liquidity mismatches. When short-term rates rise faster than long-term rates, it can squeeze profits and make it harder to attract sufficient deposits. Larger banks are less susceptible to this due to greater diversification.
The main concerns for the markets now revolve around how the relevant authorities manage the rehabilitation process for affected regional banks and the potential for widespread contagion. Central banks have the ability to provide liquidity and prevent a total collapse, but their current focus on fighting inflation may limit their willingness to pursue this approach.
It is expected that the situation will persist at a similar level to the present conditions, creating a delicate balancing act. This will likely have adverse effects on the broader economy, increasing the likelihood of a recession and leading to tighter lending conditions as standards are raised. However, the issues that have arisen are mainly confined to US regional banks, with larger multinational institutions in a stronger position due to regulatory changes implemented after the 2007-2009 financial crisis. Credit Suisse is an exception, as its problems can be traced back to poor business practices that were exposed by the recent change in the interest rate environment.
The current landscape of numerous US regional banks is not well suited to the evolving financial environment, and consolidation is expected in the coming years. It wouldn't be surprising if the number of regional banks decreases by half within five years through defensive mergers. One of the significant challenges facing troubled banks is a lack of capital to support their loan books, leaving them exposed to changes in the lending landscape.
The Federal Reserve has increased its balance sheet significantly since the collapse of SVB, providing additional liquidity and helping to dampen volatility. UK shares gained around 2.6% in April, and the pound strengthened against the US dollar. Government bond yields in the UK rose, with the 10-year gilt yield ending April at 3.78%.
UK inflation continues to be higher than expected, with the consumer price index showing a reading of 10.1% in March for the seventh consecutive month in double-digit territory. Continental European shares have been performing well, outperforming their UK and US counterparts and showing an increase of over 4% in April.
There is a noticeable divergence between the manufacturing and services sectors in leading economic indicators from the UK, Eurozone, and the US. Manufacturing has experienced a significant slowdown, while services data continues to show expansion. This divergence has been persistent and adds complexity to the overall economic outlook.
In terms of company earnings, first-quarter results have generally been positive, particularly for large-cap US tech stocks. Although profits have declined compared to last year, the decline has been less severe than feared, and many companies have exceeded analyst forecasts. One common theme emerging is companies seeking to offset rising costs by increasing prices, even if it results in small declines in volume. This approach has allowed some consumer staple and discretionary firms to achieve overall sales revenue growth despite lower volumes. This strategy contributes to inflationary pressures going forward.
While developed economies have held up better than expected so far, there are indications of a slowdown. Dynamics such as companies raising prices to pass on rising costs further complicate the outlook for central bankers aiming for a swift return of inflation to target.
The Federal Reserve's current funds rate stands at 5.25% after a 25 basis point increase in May. However, derivatives markets are still pricing in interest rate cuts before the end of 2023, indicating an implied rate of 4.3% at year-end. In contrast, the UK market expects interest rates to be higher by the end of the year, with Bank of England rate setters maintaining their vigilant stance on stubbornly high inflation despite a softening economy.