The Federal Reserve (Fed) again but may take a breather. At least so it seems after their most recent FOMC meeting in early May. Is this a sign that they are comfortable with the current inflation outlook? Or is it largely a response to the recent banking turmoil, not wanting to further stress the existing bond portfolios of some institutions? Or maybe they finally see some signs of an economic slowdown on the horizon—those proverbial cracks in the foundation of the economy? 

Whatever the case, there are clearly ample cross currents and challenges facing investors. Here are some high-level thoughts on where we are in the economic cycle and how it impacts our portfolio positioning for the moment. 

Bank stress, and more
When we entered 2023, many pundits seemed narrowly focused on inflation and monetary policy. But those debates were quickly complicated by the two largest U.S. bank failures since the Great Financial Crisis and wavering confidence in the broader banking system.

Yet despite headline-grabbing events in the banking industry, we believe that little has changed over the past quarter with regard to the economic backdrop. Although we did not specifically predict bank failures, we view them as consistent with late-cycle conditions, like we see today. 

In our view, the elevated stress in the financial system is partly a consequence of aggressive monetary policy, but also part of the transmission mechanism through which Fed tightening affects the broader economy. Tighter financial conditions exacerbate the late-cycle challenges to growth and could pull forward the timing of a recession. As such, we see earnings for economically sensitive sectors at significant risk. 

With regard to the banking sector, the Fed’s interest rate hikes were initially a positive, in our view, but they also eroded the market value of long-term securities banks held as capital. While this may not be a problem when securities are not marked to market, high withdrawals at some banks with concentrated depositor bases forced sales of such securities at a loss. This essentially catalyzed the undoing of several high-profile regional banks.  

For now, regulatory backstops generally seem to have contained the risk of financial system contagion, but we believe the market and regulatory uncertainty banks now face will exacerbate pressures on profitability. We were already seeing a significant tightening of lending standards, which can slow economic activity. Now, we also expect bank net interest margins could be squeezed by increased cost of capital, as banks likely need to pay higher interest rates to maintain their deposit base. 

We generally have been avoiding the U.S. Financials sector since mid-2022, along with other highly cyclical sectors, given our outlook for a late-cycle economic slowdown. Recent events in the banking industry simply affirm our near-term conviction in avoiding these sectors.

Late-cycle positioning
In spite of the continuing economic slowdown that we expect, it need not be all bad news for equities. We do not necessarily believe that the broad stock market must decline significantly from current levels. While more market downside is certainly possible and volatility is likely, in our view, the broad market could simply bounce around near current levels even as earnings deteriorate. 

Whether or not the broad market declines materially from current levels, there may be areas of opportunity. We believe economic and market conditions are poised to reward late-phase sectors of the market that tend to have relatively stable earnings growth and which, in some cases, tend to benefit from declining interest rates, such as Consumer Staples and Utilities. We are emphasizing those U.S. sectors, along with Health Care, across our strategies. In contrast, we expect early-phase, economically sensitive sectors like Financials, Industrials, and Energy to underperform, and we are largely avoiding those sectors in U.S. allocations across our portfolios.

All this underscores one of the key tenets of our investment philosophy. We believe that dynamic sector allocation—and avoidance—based on the economic cycle can be a basis for generating excess return over time and irrespective of market backdrop. And sometimes, what you don’t include in a portfolio can be more important than what you do. The recent turmoil in the banking sector has been a stark example. 

Portfolio characteristics and/or allocations are generally averages and are for illustrative purposes only and do not reflect the investments of an actual portfolio unless otherwise noted.  Portfolios that are concentrated in a specific sector or industry may be subject to a higher degree of market risk than a portfolio whose investments are more diversified.  While every effort has been made to verify the information contained herein, we make no representation as to its accuracy.