The pronounced change in the monetary policy stance over the past year is the most important factor determining the growth of the economy in 2023. Tighter financial conditions and lending standards are slowing credit activity and have already dampened companies’ intentions to expand their capacities in the first three months of the year. The transmission channel from higher policy rates to lower credit activity, weaker economic growth, and, ultimately, lower inflation is characterised by long lags of more than 12 months and is highly dependent on the banking system.

The recent cracks in the US banking system, with small- and medium-sized banks exposed to maturity mismatches between their assets and liabilities or eroding deposits, serve as a reminder that policy rates have already reached a significantly restrictive level. Furthermore, the unusually rapid pace of interest-rate adjustment is challenging the business models of many banks that were established in a regime of record-low interest rates and excess savings.

Outlook: slower credit growth dynamics to be expected
We expect that most of the impact on economic growth will come in the second half of the year, when tighter credit conditions will translate into much slower credit growth dynamics. The 3-month growth of US commercial loans already fell to zero in February 2023, down from double-digit growth rates three months earlier. In the euro area, the corresponding growth in loans to businesses is already contracting after double-digit growth rates in September/October of last year. The still sizeable amount of household savings accumulated during the pandemic in both the US and the euro area somewhat prolongs, but does not prevent, the lag between lower credit growth and lower economic activity. The increasing recognition by central banks that higher interest rates are starting to work signals that the interest-rate peak is approaching. So what is our outlook for the fixed income and equities space?

Fixed income - find the balance between long- and short term

The current bond universe offers opportunities that we have not seen in a while to construct a more robust and yielding fixed income portfolio. We still believe that longer-dated investment-grade bonds can have a crucial role as diversifiers, as we just experienced in the most recent risk-off episode. Moreover, investors can profit from current yields for a longer time and reduce reinvestment risks with longer duration bonds. Admittedly, yields are substantially lower compared to the start of the year, as rate expectations have been recalibrated already. Thus, adding duration (if not done yet) should be done now in a staggered approach.

Meanwhile, the yields of shorter-dated bonds are elevated. Hence, we would still add some exposure there by choosing lower-rated corporate debt, such as low-investment-grade bonds, i.e. the BBB-rated segment, or even some of the better high-yield names. This should keep default risk limited, provide some extra credit spread, and even improve flexibility in the near term, as higher coupons move cash inflows forward. However, we would not add substantial developed-market credit risk into portfolios at this juncture. Rather, we prefer to allocate the risk budget to emerging market debt given the ongoing momentum from China’s reopening.

Equities: The comeback of quality growth

Within the equities space we continue to prefer healthcare, European utilities, and high free-cash-flow stocks. Additionally, instead of cyclicals we rather see an opportunity to buy some quality growth names at attractive valuations. The 12-month forward price/earnings ratio for the segment is back to the 10-year average level (23.3x vs 23.1x). Within the segment, we focus on companies that possess solid balance-sheet characteristics coupled with high margins and cash flows. These companies should do well in an environment of peaking inflation and lower bond yields. The outlook for the non-profitable growth stocks, in contrast, remains challenging, as many are dependent on raising capital externally to remain solvent. We would use the recent strength as a selling opportunity.