Analysis-Investors brace for hard landing as banking woes stoke recession fears

3/3 © Reuters. Destroyed SVB (Silicon Valley Bank) logo is seen in this illustration taken March 13, 2023. REUTERS/Dado Ruvic/Illustration/File Photo 2/3

By David Randall

NEW YORK (Reuters) - Fears of a recession are growing on Wall Street, as stress in the banking sector following the collapse of Silicon Valley Bank and worries over the fate of Credit Suisse (SIX:CSGN) darken the outlook for the economy and markets.

Just weeks ago, analysts and investors were debating whether the U.S. economy would go into recession anytime soon - an outcome dubbed the “no-landing” scenario that projected resilient growth and sticky inflation.

That view has been shaken in the past week. Though recent U.S. data showed strength in key areas such as employment and consumer prices, some investors worry the threat of more ructions in the banking sector on the heels of the Federal Reserve's most aggressive tightening cycle in decades is more than the economy can bear.

“The no landing scenario has quickly evaporated,” said Emily Roland, co-chief investment strategist at John Hancock Asset Management. “Something is breaking right now and we think a recession has potentially been pulled forward.”

Worries over financial stability spread to Europe on Wednesday, after embattled lender Credit Suisse Group AG was caught up in a crisis of confidence sparked by the collapse of Silicon Valley Bank last week, hammering its shares.

The S&P 500 fell 0.7%, while signs of heightened economic anxiety were apparent in a more than 30-basis point decline in two-year Treasury yields - which closely follow interest rate expectations - and a 5% drop in Brent crude to its lowest level in a year.

Analysts at Cantor Fitzgerald and Co noted on Wednesday that the spread between the Fed funds rate and the two-year yield had hit 95 basis points. That level was reached before three out of the last four recessions, they said.

An inversion in the Treasury yield curve, meanwhile, has been flashing a recession signal for months, though market participants have debated whether it would manifest as a mild downturn - often referred to as a soft landing - or a more severe, hard landing.

(Graphic- FED AND STOCKS: https://fingfx.thomsonreuters.com/gfx/mkt/gkvlwbgabpb/Pasted%20image%201678916173649.png)

Torsten Slok, chief economist at Apollo Global Management, was one of the early proponents of the no-landing scenario, envisioning a situation where the Fed was unable to quickly cool growth and inflation, forcing policymakers to raise rates further than expected and causing a recession sometime next year.

He has changed that view in light of recent concerns over the banking sector and now believes policymakers are unlikely to raise rates at their March 22 meeting as the economy faces a potentially more imminent downturn.

“When the facts change, my view changes. A financial accident has happened, and we are going from no landing to a hard landing driven by tighter credit conditions,” he wrote in a Wednesday note.

Futures markets late Wednesday afternoon were pricing in a slightly better- than-even chance that policymakers will leave their benchmark lending rate in its current 4.5%-4.75% range at their upcoming meeting on March 21-22. That compares to a nearly 80% chance of a 50-basis point hike futures showed a week ago.

"The central banks have a history of hiking until something breaks and we are seeing companies and business models break," said Brian Jacobsen, senior investment strategist at Allspring Global Investments.

Jacobsen believes the S&P 500 is likely to fall through its October closing low of 3,577, nearly 8% below its current level of 3,891. That contrasts with his outlook two weeks ago, which saw the index rising to 4,400 by year-end.

He is increasing positions in long-short equity strategies, which he expects to benefit from volatile trading in stocks, as well as Treasuries, a popular destination during times of economic uncertainty.

Some investors believe regulators' quick backstop of Silicon Valley Bank, which included guaranteeing the funds of depositors, will prevent a crisis and allow for a soft landing.

“The high reactivity of US regulators to ensure depositors get their money back has helped put a stop to a potential loss of confidence,” said Paul de La Baume, market strategist at FlowBank. “Recent events also tell us that regulators don’t have the appetite for the economy to be at risk.”

Others are less sanguine. Jason Draho, head of asset allocation Americas at UBS, has not changed his view that the S&P 500 will trade at around 3800 by December, but said the risks of a recession are increasing.

“The odds of a soft landing have gone down and the likelihood of a hard landing has gone up,” he said.