Navigating a Trilemma

Key points

  • Dilemma to trilemma: Banking system stress has added a third dimension of financial stability to the existing policy challenge of balancing inflation and growth objectives.
  • Decoding the market disconnect: Alternative data indicators show signs of continued labor market strength amid shifting consumer confidence. Are bond markets accurately predicting a recession or does the persistent strength of equities suggest that expectations of a hard landing are misguided?
  • Equity market positioning: Positioning has turned more defensive, with a preference for quality, large cap companies. A data-driven, systematic approach may help investors capitalize on opportunities in security selection amid heightened dispersion.

The sudden collapse of two US regional banks and the forced acquisition of Credit Suisse in Europe introduced a third dimension to the existing policy dilemma of balancing inflation and growth objectives: financial stability. The swift policy reaction from government officials appeared to stem widespread contagion and systemic issues across the banking system. Now, markets are reassessing the economic outlook given the new constraint that banking stress puts on the policy framework to fight inflation and the potential economic impact of tighter lending standards. These dynamics, along with the trajectory of inflation and growth, are at the center of the new policy trilemma.

As the bank run episode unfolded, market focus shifted from inflation and policy direction for much of 2022 to growth and recession fears in 2023. Rate volatility soared as bond markets priced in a higher likelihood of recession and the end of the hiking cycle. Conversely, equity markets have shown greater resilience on the surface with strongly positive returns throughout the start of 2023.

Divergence in market pricing across asset classes raises questions over what lies ahead for investors. Is bond market pricing of a recession justified? Is the rotation away from value and in favor of large cap equities a recessionary canary in the coal mine? If we are headed for a recession, why have equity returns held up so strongly? To help answer these questions, this outlook explores alternative data measures across each element of the policy trilemma: financial stability, growth, and inflation—to gain a better understanding of what they may mean for markets and portfolios.