Banking system struggles

Concerns about the stability of the global banking system have emerged recently, following the failures of some U.S. banks and signs of stress at a major European bank. That said, policymakers reacted quickly and the situation has since stabilized somewhat... at least for now.

History has taught us that certain groups of investors find themselves in a vulnerable position almost every time financial conditions tighten. This is largely due to over-reliance on cheap financing to enhance returns, fund spending and increase profits. The first signs of trouble emerged in the venture capital sector when banks began raising rates nearly a year ago, quickly cutting off access to low-cost capital for young companies.

The Bank of England threw a curveball last fall when it decided to help several U.K. pension funds that had seen their bond portfolios melt away after interest rate hikes. Further difficulties have arisen in recent days as large numbers of customers have lost confidence in the banking system and have rushed to the banks to withdraw their funds. This bank run led to the failure of several regional U.S. banks.

We believe these events have two near-term implications:

• First, financial conditions are likely to tighten further as banks prioritize liquidity and capital. This will inevitably weigh on growth, as some consumers and businesses may find it more difficult to access credit
   
• Second, some central banks such as the U.S. Federal Reserve will likely take time to carefully consider their future policies, as they will have to balance the stability of the financial system, inflation and growth
   

Not surprisingly, Canadian bank stocks have been volatile, as they move in tandem with their peers. However, we remain confident in the stability of the Canadian banking sector because unlike some U.S. regional banks, Canadian banks have a few advantages:

• Deposits, assets and customer base are all very well diversified
   
• Liquid positions and capital are high
   
• Tighter regulatory requirements in recent years may have limited the profitability of the Canadian banks, but they have allowed the group to better withstand periods of stress

Interest Rates

On March 22, the U.S. Federal Reserve (the Fed) raised interest rates by another quarter percentage point (0.25%). This ninth consecutive monthly increase to fight inflation brings the benchmark federal funds rate to a range of 4.75% to 5%, the highest level since September 2007.

Will this rate hike be the last? In its post-meeting statement, the Fed suggested that stresses in the banking sector could prompt the central bank to change course. Despite Chairman Jerome Powell's assurance that the banking system is sound, stocks retreated.

Our strategy

As the Fed continues one of its most aggressive rate hike cycles in history, domestic credit conditions have become progressively more restrictive. Our colleagues at RBC believe that this tightening of credit conditions will eventually push the U.S. economy into a recession. Recessions typically impact corporate earnings, investor confidence in the future and stock prices.

This prompts us to reduce exposure to sectors and companies that are highly sensitive to economic cycles and to focus on quality stocks and consistent sustainable dividends.

While the magnitude and duration of an economic downturn is subject to speculation, it seems certain that we will have to manage volatility for several quarters to come. Regardless of where we are in the economic cycle, we will continue to focus on capital preservation through quality long-term investments and diversification. For example, in recent weeks, we have increased the cash in our portfolios and decreased our exposure to U.S. stocks.
 

There are three main reasons for this change:

• The U.S. dollar was expensive
   
• The U.S. stock market, represented by the S&P 500, is at a high premium to the TSX (16 times earnings versus 11.7 times earnings, estimated for 2024)
   
• Higher dividend yields are available in Canada, in addition to tax credits for Canadian dividends

To manage the risk of rising rates and inflation while earning income, we believe in focusing on companies with above-average dividend growth or sectors that tend to benefit from higher inflation, such as financials, energy and materials.

Our portfolios hold a good portion of cash and a solid exposure to these sectors. Although the risks of a recession are increasing, we are positioned for an economic downturn and our holdings should continue to provide very good dividend growth for years to come.
 

"The market often doesn't make sense, but you shouldn't focus on that.
Focus on the underlying value of dividend income."
-John C. Bogle, founder of Vanguard
 

If you have any questions or concerns, please know that we are always here to help.

Best regards,

Benoit, CIM, FCSI

Senior Portfolio Manager and Wealth Advisor