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CIO Macro and Market Observations from Multi-Asset Solutions

April 28, 2023  |  6 Minute Read

Maria Vassalou, PhD

Co-Chief Investment Officer, Multi-Asset Solutions

Maria Vassalou, PhD

Amy Yifan Zhou, PhD

Multi-Asset Solutions

Amy Yifan Zhou, PhD

Ongoing concerns over the health of US regional banks and commercial real estate may lead to credit contraction, with initially negative effects on small and medium sized enterprises (SMEs). Stress in the SME sector—traditionally a major engine of US growth—may then filter into the bigger companies through weaker consumer demand and affect equity markets through a second-order effect. As a result, we remain cautious on the outlook for risk assets, including equities and credit, in anticipation of a mild recession.


Credit Contraction to Weigh on SMEs

Developments in the US regional banking sector and Commercial Real Estate (CRE) have been top of mind among market participants in recent weeks. Challenges for the office space segment of CRE existed before the recent banking crisis, due to pandemic-related socioeconomic shifts and a decline in office occupancy. There had been a somewhat similar decline in office occupancy in the aftermath of the global financial crisis (GFC), but the funding environment then was quite the opposite of today. In the current cycle, stubborn inflation pressures have prompted central banks to raise interest rates rapidly, parting ways from years of ultra-accommodative policy and shifting toward a much more restrictive regime. This makes refinancing of existing loans expensive while signs of restricted credit availability were already showing before the US regional bank crisis. This year, borrowers’ woes have coincided with newly unveiled issues among US regional banks, which are the primary lenders for CRE. Even with emergency regulatory intervention to contain the situation, structural issues related to macro regime shift, declines in occupancy and rental income, and reduced credit availability are not yet resolved.



Exhibit 1: Source of Funding for Commercial Real Estate


Source: Autonomous, Mortgage Bankers Association, FED Flow of Funds, SNL (Bank Loans), Morgan Stanley, Statista, McKinsey, NAREIT, Goldman Sachs Asset Management. As of March 31, 2023.



On a standalone basis, the challenges for CRE do not seem to amount to a systemic threat to the financial system. CRE investments are mainly held by institutional investors, whose capacity to absorb losses is expected to be relatively high compared to retail investors. While the degree of exposure may vary from bank to bank, our team’s analysis shows that estimated losses on maturing CRE loans should be relatively small compared to 2022 Q4 Tier 1 Capital, even if we assume losses worse than the GFC. Overall, the probability of spillover effects to the rest of the economy appears to be limited, if any.2 However, CRE issues will likely lead to credit availability restrictions from regional banks, who are also a major lender to SMEs. Rattled by recent developments, banks may be under pressure to shore up capital reserves and raise lending standards at a time of already heightened financing costs, leaving SMEs as collateral damage. Unlike larger firms that can raise capital through publicly traded markets, the funding needs of small and medium-sized enterprises are usually met by banks. According to the US Chamber of Commerce, local banks or credit unions can be even more important than national banks, especially for the smallest firms with less than 20 employees.3 When bank credit contracts, SMEs are expected to feel the impact before larger firms, especially in industries that rely more on financing. In the March 2023 NFIB Small Business survey, US credit conditions—as measured by availability of loans—had already deteriorated to the lowest level since 2012.



Exhibit 2: U.S. Small and Medium-sized Enterprises are Likely to Feel the Impact of Credit Contraction Sooner Than Larger Firms.


Source: Bureau of Labor Statistics, Goldman Sachs Asset Management. As of Q1 2022


When small and medium-sized enterprises come under stress, knock-on effects impacting larger firms are likely to follow. As illustrated in Exhibit 2, in the US, firms with less than 250 employees account for more than 99% of the private sector universe and nearly 45% of private sector employment. Smaller businesses also account for 40~50% of GDP growth and are often an important source of innovation. Higher defaults and unemployment in the SME sector can have a material impact on aggregate demand, especially discretionary consumption. A deterioration of conditions for SMEs is likely to be transmitted to publicly traded equities through a deterioration in aggregate demand and discretionary spending. This could result in reduced profitability for stocks. As these effects tend to appear in public equities with a lag, the current relative resilience of the equity markets makes sense. Any downward pressures are likely to be kept in store for the quarters ahead.


The implication of the above expected transmission mechanism is a possible mild recession in the upcoming quarters. Unlike previous episodes of economic downturn, this time around we expect that Main Street will lead Wall Street into the slowdown but not necessarily on the exit. In theory, small businesses are typically more resilient and adaptable to economic changes, so they can get out of a crisis faster and help drive the economy out of a recession. This time, however, credit contraction is expected to hit SMEs directly and impact their ability to thrive and grow. Any upcoming recession may be mild but also potentially harder to exit without restoring credit availability to SMEs. Upward consolidation and acquisitions by larger firms may help; however, in an economy significantly reliant on SMEs, the channels of credit availability would have to be reopened before a robust economic recovery can get under way.



Investment Implications

Our outlook for risk assets remains cautious given our expectation of a potentially mild recession with lagged effects on public markets. We are positioned with a small underweight to equities and credit. We also hold a neutral exposure on the real estate sector. But we acknowledge that more bottom-up opportunities may emerge since most of the CRE issues are concentrated in the office space segment rather being widespread across the sector.


Markets are currently still pricing in Federal Reserve (Fed) rate cuts toward the end of the year. In our view, these are unlikely to materialize without a broad credit crisis—a scenario which we regard as unlikely at present. While this time around a recession may be shallow, the challenging part would be its length and the path out of it. Small and medium-sized enterprises, the growth engine of the U.S. economy, are at risk of being impaired. This may slow the exit from a recession and could require broader policy interventions to boost growth, well beyond the purview of the Fed.





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1 The estimates have been collected from various sources but there is some uncertainty given the high share of private owners with limited reporting requirements, if any.

2 See also Cohen & Steers (2023), "The Commercial Real Estate Debt Market: Separating Fact from Fiction". The study reports that for regional and community banks, CRE accounts for 18.6% of total assets (office CRE accounts for just 3.0% of total assets). As of March 31, 2023

3 U.S. Chamber of Commerce (2023), “The State of Small Business Now”. As of 1Q, 2023


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Date of First Use: April 28, 2023 316312-OTU-1789399


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