Monthly Partner Memo – April 2023

March 28, 2023 | Paul Chapman


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Take comfort in the knowledge that your capital is being managed the way your friends complain they wish theirs was managed. The ultimate compliment is a referral to friends & family.

“To know what you know and what you do not know, that is true knowledge.” – Confucius

Note that the contents of this memo are all my thoughts, and not the views of RBC Dominion Securities. As well, no part of this content was AI-assisted or created.


Friends & Partners,

Well, March was a month that didn’t disappoint if we were expecting challenges and volatility. When the Fed hits the brakes, usually someone goes thru the windshield, and we are finding out who wasn’t wearing their seatbelt. Silicon Valley Bank became a household name globally quickly, and many investors because pseudo-experts on bank balance sheet moving parts and mismanagement fairly quickly. Then Credit Suisse was no more. Investors remain scarred by memories of 2008–09, so that any word of bank failures brings fears. But several factors distinguish the current turmoil from the banking system crisis of 2008–09, and that is one positive during this turmoil.

As I have noted in recent memos, this is not 2008, but doesn’t mean we won’t be without volatility, turmoil, and market stresses. In 2008, banks had a genuine problem – assets they had carried on their books were hindered because of extremely lax loan standards that resulted in widespread loan defaults. That created a hole in the banks’ capital and some banks were likely technically insolvent. Today’s issue is not that the banks assets are hindered, as many of the assets with the steepest price declines are U.S. Treasuries that one can fully expect to be repaid on time and in full. But the issue is that more depositors than normal are demanding their cash, driven by fear of bank failure – a classic ‘bank run’.

We will likely continue to see stresses on parts of the banking system (particularly smaller banks in the US), which will be seen in a repricing of the risks in bank bonds and stocks, and effect the overall economy. This will make it difficult for some banks to borrow sufficient money in the public markets at economically viable rates to support their current levels of lending, let alone the type of loan growth companies have come to rely on. The impacts would likely be felt across the economy but would be especially detrimental for small businesses that rely on local lenders, which has become an increasing share of the lending world over recent years.

So, the recent banking stress put markets on high alert and was a most unwelcome development at a time when the Fed and other central banks are trying to engineer a ‘soft landing’ for the U.S. and global economy.

Bottom line, the key issue for the markets in 2023 has been, and remains, whether we get a “soft landing” or “hard landing” (“no landing” is looking increasingly unlikely). The Fed signaling a potential end in sight for rate hikes is a positive in general (that has to happen at some point for pressure on multiples to ease) but if they are ending rate hikes because economic risks are too great, that’s not a reason to buy stocks.

Stepping back, this market reminds me more and more of the early 2000s, where stresses emerged and growth slowed, but by then Fed rate cuts were too little, too late. I hope I am wrong and the Fed nails the soft landing, but the regional banking crisis only makes that task more difficult (and that’s assuming it doesn’t get worse). I think economic growth, not whether the Fed hikes another small amount or not, is the key driver of the next material move in markets.

Looking forward, economic data remains the key. If the data rolls over in the next month or so and points to a quick loss of economic momentum, that will not be positive for the economy or markets and we should expect downside for stocks. We continue to remain defensive and conservative in our positioning, and this has served our portfolios and clients well during the volatility of the last ~18 months that we expect to continue. We are taking advantage of selected opportunities that are developing because of the noise.

The positive for the longer-term set up is that, with all the bad news in March, we’re that much closer to the final chapter of the bear market. And while recession risks are now higher in the aftermath of the March banking stress, recessions are a normal part of this and every economic cycle. This recession is likely to be on the mild side on the back of strong U.S. labor markets and resilient consumer spending. In fact, a mild recession could even speed up the Fed’s achievement of its inflation goals, bring demand and supply back into balance, and form the foundation of a longer, stronger, and more sustainable economic expansion. So we will get there, and the opportunities will continue to surface as we move forward I believe.

I have spoken at length about how a traditional stock/bond portfolio is not adequately diversified, and unlikely to perform well for some time (and it hasn’t in the last year as many know firsthand). Your portfolio should look institutional in nature, and incorporate true risk management that includes holding more than just cash to deal with drawdowns – not unlike that of a pension fund, endowment fund, or large family office. True portfolio diversification includes multiple uncorrelated asset classes within a portfolio, meaning assets and strategies that may be negatively correlated with stocks. This means that they can make money when stocks go down, and add stability when markets are volatile.

Without this stability and ballast in the portfolio, investors often get spooked into selling and go to cash in times of distress. This is often the wrong approach to risk management for several reasons. First, if you sell investments when things get noisy, you likely had too much risk exposure in the first place. Second, you may crystalize a taxable event. Third, most go to cash after material drawdown, often selling near the bottom. In this scenario, it is highly unlikely that you will buy back below the level you sold, and ‘chase’ markets higher, waiting to get back in when things ‘feel’ better – this is usually when markets have recovered to much higher levels. Remember 2020 after the Covid lows?

 

A Few Other Interesting Things to Highlight

In late March, I was proud to represent RBC Foundation for a United Way screening of “Connecting The Dots”, a feature documentary that offers a raw and intimate look at youth mental health from a global perspective. As a Board Member of the United Way Simcoe Muskoka, I have seen United Way’s commitment to our community firsthand. I am proud that RBC has committed to supporting youth mental wellbeing as one of our strategic funding pillars as the need is critical. I have been touched by this issue first hand, and to be a part of this community engagement to help start some important conversations around some very significant social issues in our areas is critical. Also note this resource I learned about to find medical resources that aren’t always easy to uncover: https://www.handouts.ca/

In partnership with Women Worth and Wellness, we hosted an International Women’s Day event for Mayor Yvonne Hamlin at Butter Gallery. Yvonne was as impactful and inspiring as ever, and is a wonderful example of a “Daring & Caring Woman Leader for Positive Impact”, as evidenced by her stepping up to run for Mayor last year. Yvonne is leading the way for positivity in Collingwood and the community at large. More women like Yvonne in public leadership roles, who are daring and caring, would and could make a world of difference for so many. You can watch a video recap of the event HERE.

We are hosting our third annual golf classic and fundraiser for the Collingwood General & Marine Hospital Foundation on Sept 14th – this has sold out last 2 yrs, so register while you can HERE. This half-day event once again starts with an incredible 2-part clinic with LPGA Champ Sandra Post and Mary Pat Quilty, both owners and operators of their own golf schools. This year we are putting a special focus on ‘mindset’ both for golf and life – included in this year’s event are optional activities after lunch including pickleball, hiking or the driving range.

 

A Rate ‘Pivot’ Is On The Horizon – But What Are The Implications?*

The market was expecting interest rate hikes only a few weeks ago, and is now pricing in significant cuts through the end of this year. Equities tend to perform well once rate hikes have stopped:

Source: RBC GAM

The interest rate ‘pivot’ is an interesting talking point, but a pivot doesn’t guarantee smooth sailing for financial assets. Despite that near-unanimous belief, the longer-term data implies that the outlook for stocks once the Fed pauses is not nearly as positive as the consensus might initially think. This is especially the case if inflation remains an issue, as that scenario hasn’t been a guaranteed winner for stocks historically.

Stocks are historically volatile heading into final interest rate hikes, and were actually often weak heading into first interest rate cuts:

Source: RBC US Equity Strategy, Bloomberg. Periods with positive performance shaded in green; periods with negative performance shaded in red.

 

The Next Buried Body – Is It Commercial Real Estate?*

Now there's another problem that may arise: Commercial Real Estate (or ‘CRE’). The US CRE industry is a $20.7 trillion market. Core segments include office, industrial, multifamily, retail, hotels and land. A record number of mortgage loans mature in 2023. Unless vacancy rates change, that's going to be a potential problem. The next boogie man might be less liquid and lower credit quality real estate loans.

As well, smaller banks are much more relevant in this area of the market to boot. Small banks hold ~80% of commercial real estate loans worth ~$2.3T. Once defaults begin, the US banking sector and its stakeholders might feel some pain. And there are ~$270bn in loans in this sector due by the end of the year.

We’ve already had a few billion in defaults recently. In Feb, Brookfield, #1 largest office owner in LA, defaulted on $784mm. Then in March, PIMCO defaulted on $1.7bn of mortgage notes on 7 assets. Then, Blackstone defaulted on $562mm in Nordic CMBS. This likely isn’t over.

Here is some colour on the unoccupied space in the 10 biggest U.S. office markets from the Financial Times: “Commercial property loans are joining deposit flight and bond portfolios as the biggest perceived risk for U.S. banks. Strains in the $5.6tn market for commercial real estate loans have deepened in recent months as the Fed’s year-long series of interest rate rises leads to sharply higher borrowing costs and weakening property valuations. Analysts fear any further reduction in lending could make a perilous situation worse. Thousands of small and medium-sized banks that make up the bulk of U.S. lenders account for about 70% of so-called CRE (commercial real estate) loans. Offices are seen as the area of biggest risk after tenants cut back on space to reflect the popularity of working from home following pandemic lockdowns. Vacancy rates have risen in each of the top 25 markets since 2019. In San Francisco, the worst-hit city, almost 19% of space was unoccupied at the end of 2022, up from 5% three years earlier.”

 

Silicon Valley Bank & The Current Bank Crisis – What You Need To Know*

There is no shortage on information and speculation around this issue, but as I try to do in these memos, I will cut out the noise and explain this in a brief, concise and understandable manner.

Silicon Valley Bank (SVB) had a solid deposit base, but funded it differently that the ‘big’ banks that are subject to more stringent regulatory oversight. What this means is that the bank was not subject to regulatory liquidity coverage ratios and the net stable funding (NSF) ratio that the big banks all are (and Canadian ones as well). This meant that SVB could do whatever it wanted with its deposits they couldn’t lend out, choosing to buy long-dated fixed income securities. When interest rates rapidly rose, they got crushed on those holdings, and also didn’t ‘hedge’ them, something that isn’t difficult to do.

Interestingly, the regulator’s requirements after 2008 encouraged or mandated that banks hold more Treasury securities, which in theory have no credit risk. They didn’t consider the interest rate risk banks would take by holding those bonds.

It’s important to note that while headlines are quick to highlight that Silicon Valley Bank is the largest bank failure since Washington Mutual in 2008, the events leading up to this are to some extent isolated to specific risks taken by SIVB. Today’s environment is quite different, for the better. The quality of the banking sector’s assets is not in question like they were in 2008. Rather, in the current environment of rising interest rates, it has been the mark-to-market value of securities that has been impacted – the price at which banks can sell their bonds ahead of maturity. SVB was forced to sell their long bond holdings at a loss, though those holdings would have come back to full value if they were held for their full term. But that wasn’t an option as SVB needed to access the liquidity to fulfill their depositors’ withdrawals.

What other industries could be affected?

Our research team has reviewed the comments that Russell 3000 and S&P 1500 companies have made on Silicon Valley Bank, Signature Bank, and Silvergate from March 10th through 13th through 8k’s, press releases, and event transcripts.

  • They analyzed 198 documents. The sectors that commented the most were Health Care (114) and Technology (41). At the sub-industry level, Biotech was most in focus (70 documents). Overall, five of the six most involved sub-industries were from Health Care.
  • For the most part, companies characterized their exposure as immaterial or low (114). Overall, 98 companies indicated that they had cash at Silicon Valley Bank, while 86 indicated that they had no cash held at Silicon Valley Bank and/or had no other business relationship with them.
  • With regulators guaranteeing deposits at SIVB and SBNY, the cash exposure issue seems largely in the rear-view mirror.

 

‘Peak’ Inflation Has Positive Implications For Future Returns*

Peak inflation has traditionally sparked a recovery for the S&P 500.

RBC’s Portfolio Advisory Group also notes positive takeaways on this front. Since 1929, 1) the U.S. stock market has typically generated subpar returns in years where inflation has risen on a year-over-year basis, alongside a lower rate of positive outcomes compared to the long-term averages; but 2) in contrast, the years when inflation has fallen on a year-over-year basis have tended to see the S&P 500 deliver above-average annual returns, with a higher rate of positive outcomes compared to the long-term averages.

However, inflation expectations may be optimistic. In the 70s, it took inflation much longer to normalize:

 

Other Points To Ponder That Are Positive For Stocks*

Investors are sitting on cash – lots of it.

Source: Fundstrat.

I have spoken about the risk of earnings estimates needing to come down. We will potentially have seen the bulk of that decrease soon:

Source: RBC GAM

Stocks can perform well even through periods of decreasing earnings. This chart shows the top 10 (12-month) rallies from bear market lows since 1950. The interesting point is how earnings were still lower 12-months later for the top 4 instances.

Source: Stifel

 

The Federal Budget – What You Need To Know*

On March 28, the Honourable Chrystia Freeland, Deputy Prime Minister of Canada and Minister of Finance, delivered the Liberal Party’s federal budget. Budget 2023 does not change the corporate and personal tax rates under the Income Tax Act. Instead, it makes specific changes of particular relevance to businesses and high net worth individuals. Find more detail in a summary note HERE, with summary points as follows:

  • Substantially revising the alternative minimum tax rules for 2024 and subsequent years. These changes could result in additional tax on capital gains and stock options realized post-2023.
  • Revising the general anti-avoidance rule to expand its scope and impose penalties.
  • Providing further detail and enhancements to previously announced clean energy tax credits and incentives, including a significant credit for certain expenditures related to clean technology manufacturing and processing and the extraction and certain processing activities related to critical minerals.