Some food for thought from JP Morgan on the SVB/Signature depositor rescue.
Cross-Asset Strategy:
Yesterday, the Fed/FDIC provided funding support for a specific carry trade that was threatening market stability. Buying longer-term higher-yielding bonds and funding with short-term funds doesn't work with steep yield curve inversion and downward pressure on the price of the long-term yielding asset.
While Fed actions reduce the risk of this specific development, we believe there are many carry trades that will be under pressure and it will not be possible to backstop all of them. Carry trades develop during a period of cheap financing such as the one we had over the previous decade and in particular during the post-COVID QE. For instance,
- commercial real estate has been under fundamental pressure for a long time (work from home, online sales, etc.) but was a good investment at zero interest rates.
- Private equity and venture capital produce yield via risk premia advantage at suppressed mark-to-market volatility and unlimited low-cost funding.
- Auto loans, levered loans, credit cards all yield well while short-term funding is plentiful and consumers strong.
- The Bank of Japan's unlimited bond buying funds various higher yielding assets globally, and so on.
When the economy is slowing down and financing costs are rising, all these implicit or explicit carry trades are pressured to unwind, leading to an end of the cycle. We believe we are in that stage and remain negative on risky asset classes.
As such, we maintain a defensive tilt in our model portfolio, and further increase our UW in equities vs. raising our cash allocation this month. Yields came down sharply off recent highs in the wake of last week's market distress, so we wait for a better entry point to add to duration. The China reopening trade stalled over the past month, but we think its impact will continue to be felt in coming months/ quarters and we keep exposure to this theme via OWs in commodities/Energy and EM equities.
