EY-Parthenon Voices in Strategy: banking turmoil adds to economic uncertainty

Welcome to the first edition of “EY-Parthenon Voices in Strategy,” a Q&A series where we cover some of the most pressing issues impacting CEO decision-making today. For our first edition, we thought what could be timelier than placing a spotlight on macroeconomics and the current state of the banking sector.

CEOs were already trying to interpret mixed signals in the US economy before the banking sector added to the uncertainty. Now as they plot the future strategy for their organizations, CEOs need to weigh how broadly the issues in the sector will spread and what the impact will be on the wider economy.

My colleague Gregory Daco is the EY-Parthenon chief economist and brings a wealth of experience to interpreting macroeconomic and monetary policy trends and their impact on the business world. I’m grateful to have had the chance to explore the current banking stresses with him.

BR: What started as a bank-run on a specific bank is now testing the banking sector more broadly.?How long will it take to gain clarity on whether this has spread into a broader banking crisis or has been contained?

GD: I believe that what we are observing may be the sudden realization that a high cost of capital environment is here to stay. The private sector may finally be understanding that it needs to adapt to a world of higher interest rates.

And, while it appears unlikely that we will see a repeat of the 2008–09 global financial crisis, the situation remains fluid with risks from “known unknowns” and “unknown unknowns.”

The “known unknowns” are twofold. First, there is the risk of contagion from the idiosyncratic stress on a finite number of banking institutions into systemically significant domestic and global financial institutions, which could be the catalyst for a financial crisis. Second, there are risks posed by mutual funds’ investments in corporate bonds, municipal bonds and banks, liquidity challenges for life insurers and pensions funds, and significant stress on interest rate-sensitive sectors like commercial real estate.

The “unknown unknowns” are by nature impossible to predict, but we know they exist and the pension funds stress in the UK last September, the cryptocurrency fallout and global banking sector stress are notable examples of the risks. Dollar funding stress and liquidity issues in the US Treasury market could potentially act as catalyst to expose some of these unknowns.

BR: How does this impact the chances of a recession later this year? What impact should this have on the rate tightening cycle?

GD: Before the recent banking sanction stress, we noted that extreme data volatility had made the US economy more difficult to decipher. Our view was that tighter financial conditions and credit standards had led business executives to focus their investments and hiring decisions on growth opportunities, while managing pressures on margins via well-executed pricing strategies and efforts to enhance productivity.

The odds of a recession have undoubtedly risen due to heightened financial market volatility, tightening credit conditions and economic uncertainty in the wake of the issues in the banking sector. While labor market conditions still look relatively resilient, the shift in sentiment, along with a rapid tightening of financial conditions, could push the economy into a recession with businesses and consumers retrenching.

We currently anticipate a peak to trough US GDP contraction of around 0.5% this year, and we forecast real GDP will grow 0.8% in 2023 and 1.3% in 2024, after a 2.1% advance in 2022.

In the wake of the banking sector crisis, the Fed adopted a dual track approach distinguishing monetary policy tools to address price stability concerns from macro-prudential tools to address financial stability issues. The Fed proceeded with a 25-basis points rate hike bringing the federal funds rate to 4.75%–5.00%, stressing that inflation remained uncomfortably elevated and that the labor market remained excessively tight. While the Fed’s median rate expectations were adjusted to show a terminal rate at 5.4%, we believe the Fed will proceed with only one additional 25-basis point rate hike, reaching a terminal rate at 5.1%. We maintain our view that rate cuts are a strong possibility before the end of the year.

BR: In the current environment, where should business executives be focusing their strategic investments?

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GD: At the end of last year, we shared our new paradigm titled “Transforming uncertainty into opportunity .” In it, we described the importance for business leaders, investors and consumers to adapt to a world where the cost of capital was going to be higher for longer.

We stressed that the cost of debt was unlikely to return to pre-pandemic lows and that the realignment in company valuations would continue to weigh on merger and acquisitions and private equity activity. Additionally, we noted that financial market dislocations on the equity, fixed income and foreign exchange front would require increased adaptability and foresight from business executives.

Despite the current bout of banking sector stress, we continue to believe there is ample room for opportunity between the extremes of a world where markets were priced for perfection in 2021 and a world where markets are discounting for disaster.

The no-regrets strategies for business executives include focusing on long-term strategic growth by tapping new, diversified sources of capital (including private capital) to bolster operational capabilities and innovation. Adopting a forward-looking, holistic valuation framework can help transform potential losses into opportunities, if well hedged.

More than ever, a winning strategy will be a proactive strategy leveraging key partnerships and insight, including those from our very own EY-Parthenon teams.

For monthly macroeconomic insights updates, please be sure to subscribe to Greg’s monthly newsletter by visiting ey.com/en_us/strategy/macroeconomics . Read his latest newsletter available here on LinkedIn.

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EY-Parthenon Voices in Strategy is a conversation series hosted by EY-Parthenon Americas Leader Barak Ravid in which he talks with EY-Parthenon professionals from a range of disciplines to help business leaders better understand the forces shaping their strategic decisions.

The views expressed by the author are not necessarily those of Ernst & Young LLP or other members of the global EY organization.