Little Wooden Boat
Legend has it that sometime in the 23rd century, the Kobayashi Maru (Japanese for “Little Wooden Boat”), struck a gravitic mine on the Klingon side of the neutral zone, breaching the ship’s hull and endangering the lives of the more than 300 civilians aboard. The Star Ship Enterprise received the Maru’s distress call and warped to the neutral zone border in hopes of a rescue. But the Maru was on the wrong side of the neutral zone border and crossing into the neutral zone to rescue the stricken class III neutronic fuel carrier, would violate the tenuous Klingon/Federation treaty, potentially putting the entire crew of the Enterprise in danger and risking all-out war.
The No-Win Scenario
The Kobayashi Maru and the choice facing the Enterprise has become lore as the classic no-win scenario. Ethically speaking, the Enterprise captain should and must cross into the neutral zone in an attempt to rescue the ship. But considering that the crew of the Enterprise numbered more than 900, not to mention the potentially millions of lives at stake should the treaty violation lead to war, the logical thing for the captain to do would be to leave the ship to its fate, protecting the crew of the Enterprise and averting all-out war.
U.S. Federal Reserve Chairman Powell faced his Kobayashi Maru moment this week. As we wrote last week, the global banking sector is in a tenuous state. Normally, during times such as this, the Federal Reserve would be looking to reduce the burden on the banking sector through a variety of measures designed to ease stresses in the system. Some of these steps have been taken to be sure, but the biggest tool the Fed has is to reduce it’s overnight lending rate and signal that further rate cuts are coming. However, inflation remains a problem and Chairman Powell has made it clear over the past year that the Fed will continue to aggressively fight inflation, regardless of the economic consequences, until the Fed is convinced that inflation is not only on track to reach it's 2% target, but also that the risks of any flare-ups in inflation are low.
So, what do you do? End your rate-hiking cycle early and potentially even explore cutting rates and risk re-invigorating inflation in an effort to provide some relief to the ailing banking sector? Or, continue the fight against inflation with further rate hikes and hope that the other measures you have taken will protect the banks not only from the aggregate of rate hikes made over the past year, but the new rate hikes that you are pushing through the system?
We do give Chairman Powell some credit, for while the Kobayashi Maru is truly a test of the no-win scenario, he at least attempted to find a win. The Fed did indeed raise rates by 25 basis points, but this was less than the 50 basis point rate hike that had been expected a few weeks back; although, investors had priced out the risk of the 50 basis point hike by the time of the Fed announcement. Further, the Fed’s messaging that accompanied the rate hike seemed to suggest that rate hikes may now be at an end, which caused bonds to rally across most maturities.
What does this mean to markets? Not surprisingly, stocks do not tend to like Kobayashi Maru moments. Both the TSX and the S&P 500 tried to achieve warp speed into the middle of the week (we are going to abuse this analogy for as long as we can), but a volley of photon torpedoes in the global banking space (Deutsche Bank is the latest global bank to come under pressure) weakened the market’s shields, leading to a relatively flat week for investors.
Our Thoughts: Our view remains that recession risks are high for the back half of 2023. While the job market remains robust, most other areas of the economy are struggling under the weight of high interest rates. The banking crisis, while not really a Canada issue, will likely weigh on lending as the banks pull back, which will further weaken the near-term economic outlook. We like to say that times like this tend to present generational wealth opportunities as good businesses go on sale during times of crisis. We expect this to be the case as the year unfolds, so while the “little wooden boat” gets blown around a bit over the next few months, we will continue to watch for opportunities.