The collapse of Silicon Valley Bank has led to a sharp increase in volatility across financial markets last week and raised concerns of financial stability. From an asset allocation perspective, Fidelity Solutions & Multi Asset remains defensive overall.
Asset Allocation Perspective: Underlining the case for caution
Current events have not yet been enough to change our broad asset allocation views, where we continue to see the need for a cautious approach. We are mindful that markets often overreact in the wake of these types of events, which may present some short-term opportunities, especially in areas where market moves diverge from fundamentals. However, we believe the longer-term picture appears unchanged for now from an asset allocation perspective.
We continue to express our defensive outlook through a strong underweight on credit and an overweight position in cash. We are neutral on equities and government bonds overall, although taking a selective approach – for example, preferring emerging markets to developed markets in equities, particularly the US where we believe the US Federal Reserve’s (Fed) speed of tightening makes the equity market more vulnerable to economic slowdown. The team continues to monitor the situation closely as it evolves, adjusting asset allocation where necessary while avoiding any knee-jerk reaction to unfolding headlines.
Overall, our multi asset portfolios are structurally diversified and designed to provide an element of stability versus single asset classes in response to periods of market stress. We believe this remains the right approach for navigating the current market environment, where fast-moving cycles lead to periods of volatility.
Macro backdrop: SVB highlights the risks of Fed’s hawkishness
The Fed appears ready to step in to protect SVB depositors and contagion looks unlikely at this point. However, this case lays bare the risk of things breaking because of the significant monetary tightening carried out since the start of last year. The strength of the labour market does not give the Fed an off-ramp to change course significantly, meaning we still believe a hard landing is the most likely outcome.
Our assessment of the possible range of scenarios is driven by the Fed's reaction function and we have calibrated hard landing pathways on the back of sustained Fed hawkishness driven by the strength of labour market data (and it’s read across to future inflation by Federal Open Market Committee (FOMC) members). Our indicators and assessments have shown the current tightening (both the change and duration of rates above neutral being signalled by the Fed) is the second strongest since the 1980s at a time of nearly unprecedented labour market tightness.
One of the transmission channels of tighter policy is pressuring financing flows, which leads to the risk of financial stability. Given the history of 2008/9, the overall financial sector is in much better shape. However idiosyncratic risks and toxic combinations exist, but they are always very difficult to predict as they need several things to go wrong at once, such as a confidence shock in SVB’s case.
In the short term, the Fed has the tools to stem the contagion and hopefully memories of 2008 will lead to quick action, as we saw with the Liability-Driven Investment (LDI) crisis in UK last year. Statements and forceful actions are coming out already. However, the mechanisms which caused this remain in place and balance sheet risks are still a viable pathway next year as corporate refinancing flows pick up.
In terms of immediate policy implications, this event could lead to a lower terminal rate in the US with fewer rate increases than previously expected. SVB containment in itself is unlikely to change the thrust of policy direction as financial stability tools are activated (although a more generous use of the discount window or changes to quantitative tightening, as in the UK, may become more likely as a short-term relief option, but signalled as a liquidity adjustment rather than a change in monetary policy). That said, we are already in territory where the rate hiking carried so far is dangerous given how far above neutral rates currently are. The continued strength of the labour market and stickier inflation still leaves little room for complete policy reversal. Indeed, these dynamics and liquidity withdrawals create the non-linear risk of an inflationary bust and our macro framework captures that through the risk of a balance sheet recession.
Overall, we still believe that a hard landing is the most likely outcome and consider the current strength of the labour market as delaying this scenario rather than cancelling it. If anything, it increases the probability of an inflationary bust down the line, and SVB is a timely reminder of the increased risks. A cyclical recession this year would have given the Fed an off-ramp to reverse monetary tightening. Indeed, market expectations of a soft landing actually reduce the likelihood of a soft-landing outcome, because if forces the Fed to undertake more tightening against the backdrop of record high debt burdens.
We see risks gravitating towards the US compared to China, where policy stance remains more supportive. While swift liquidity measures from the US regulators can arrest the immediate concerns and contagion, the underlying cause of stress which comes on the back of the significant policy tightening and is unlikely to reverse soon, portends more episodes of stress for the US in the future.
