The past few weeks have come as a relief to investors as bond and equity market volatility has subsided to some extent. Positively, the recent turmoil witnessed in the banking sector appears to have been contained. That should leave investors feeling more confident around the stability of the banking system. Nevertheless, credit challenges still lie ahead, as they often do through economic cycles. We discuss more below.

 

The measures taken by the U.S. Federal Reserve a few weeks ago in response to signs of stress facing some of the U.S. regional banks have proven successful so far. More specifically, the central bank created a liquidity facility that allows commercial banks to exchange eligible securities (valued at par) for up to one year in exchange for U.S. dollars. This addressed one of the key challenges that some regional banks were dealing with as they were having to sell investments at a loss to meet client withdrawals. The facility has seen meaningful use to date. Encouragingly however, the total amount of funds U.S. banks have had to borrow from all of the Fed’s facilities has recently declined, suggesting deposit outflows from banks may be steadying. Overall, signs of stability have helped equity markets recover.  

 

We still believe investor caution is warranted as we see credit clouds on the horizon. The U.S. banking industry can be broken into two categories: the large national franchises that more closely resemble the Canadian banks, and the regional banks that have a relatively smaller footprint. The latter group is now much more likely to focus on liquidity, loan quality, and capital going forward given the recent stress they have endured. As a result, they may become strict with respect to their lending practices. And, that’s particularly important because they have an outsized influence on the U.S. economy despite the fact they are smaller and more regionally focused. For example, the regional banks account for about half of all commercial, industrial, and consumer loans in the country. More striking, they account for a disproportionately large share (around 80%) of U.S. commercial real estate loans.

Commercial real estate may be a growing source of economic vulnerability. The group includes properties across industrial, lodging, health care, retail and office sectors, among others. As with the Canadian residential real estate market, the U.S. commercial real estate market has a substantial amount of loans that need to be refinanced over the next few years at potentially much higher rates of interest. The heavy dependence on regional banks that may be more reluctant to lend exacerbates this potential challenge. Moreover, some pockets of the commercial real estate market, like retail and office properties for example, continue to grapple with structural headwinds. Some of these forces are relatively new such as the pandemic-induced work from home policies that have created higher office vacancy rates. Other forces are longer standing such as online shopping that has pressured retail for years. Regardless, the combination of all of the above has created a challenging outlook for pockets of the commercial real estate market. These issues may inevitably bubble up to the surface over time.

 

A deteriorating credit backdrop is not uncommon by any means. As economic cycles come and go, so too do credit losses as some consumers and businesses inevitably have a harder time repaying their debts. The banks continue to prepare by setting aside capital to absorb future losses. Overall, the industry is well capitalized, both in Canada and the U.S. Nevertheless, any turn in the credit cycle is likely to be accompanied by the typical bouts of market volatility and weakness as investors try to gage the gravity of the situation. For this reason, we continue to remain patient with our expectations and lean on the income producing parts of our portfolios.