Did Central Banks Break Something


Highly Publicized Banking Woes Overshadow a Positive Start to 2023


The first quarter of 2023 will be remembered for the failing of Silicon Valley Bank, the bailout and acquisition of Credit Suisse by UBS, and the question of have central banks tightened financial conditions to the point of breaking something in the financial system, and what that portends for the remainder of 2023 with respect to central bank policy, interest rates, and economic activity.

Q1 in Review

2023 started far better than 2022, with global equities higher, led by the Nasdaq, as seen in Chart 1. We can see in Chart 2 below that the global sectors that led in 2022, namely global energy, were the main laggards in the first quarter of 2023. On the other hand, the technology and communication services sectors, which were the weakest sectors in 2022, have led the way so far this year. So, there was a pretty significant reversion on both ends of the spectrum.

The other key takeaway for equities to start 2023 is that we saw a significant weakening of breadth in the US indices. Breadth is a measure of how widespread strength or weakness is in the market. What we saw in the US, particularly after the banking issues presented themselves in the US and Europe, was a move by investors to defensive names. In this case, that meant a move to mega cap, cash rich, technology and communications names.

One of the ways we look at evaluating the breadth of a market is how the market capitalization index (the headline indices, where your weight in the index is your market cap divided by the entire index market cap, so the bigger you are, the bigger your weight and impact is on the overall index) compares to the equal weight version of the same index (where all the constituents are equally weighted, meaning that all the constituents of the index have the same impact on index returns). In chart 3, we plot the TSX, S&P 500 and Nasdaq 100 on a market cap weighted and equally weighted basis. We see the sharp outperformance for the S&P and Nasdaq as we moved into March.

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Chart 1- Global Equity Snapshot

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Chart 2- Global Sectors 2022 and 2023 YTD

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Chart 3- North American Market Cap Vs. Equal Weight

What’s Changed & What We are Watching Moving Forward

What caused this sharp flight to safety, of course, was the failure of a Top 25 US bank, Silicon Valley Bank. This event, coupled with the failure of two smaller financial institutions that had strong crypto exposure, led to dramatic moves in interest rates, and equities, and represents the major change to the global economy and financial markets over the quarter. The US 2-year treasury yield fell over 100 basis points from its high, as seen in Chart 4. The collapse of these institutions, followed swiftly by the troubles faced by Credit Suisse, which resulted in them being taken over by UBS, has led financial market participants, central banks, and government to take a step back and evaluate if the amount of financial tightening done over 2022 with the swift rise in monetary policy rates to combat elevated inflation has broken something in the financial system. The fact is, central banks globally were initially slow to embark on normalizing rates coming out of the COVID pandemic, and then over-reacted once inflation was in fact prevalent and they were behind the curve and possibly have gone too far, too fast with their rate hiking programs throughout 2022.

Our view of these events in the financial system is that this presents significant challenges for central banks. Central banks that were not yet on pause, such as the US, will need to tread carefully as the first major signs of damage to the financial system and economy are felt. This will make the ongoing balancing act between tightening financial conditions and a higher inflationary environment against the prospect of causing more trouble in the financial and banking system tougher. While inflation continues to moderate, it is still far from central bank targets. The Bank of Canada has held their policy rate steady for the last two meetings, and while the US Fed raised at their last meeting, the language from Chairman Powell in his press conference indicates that the issues in the banking system could alter their view for the path of policy moving forward.

The other major repercussion from SVB is that more bank regulation is likely. This can have repercussions ranging from increased market share for global and major money center banks, lower overall banking profitability potential, decreased credit availability to the economy, and reduced dynamism in the American economy. Regional banks are key providers of credit to small and medium businesses, and reduced risk appetite by these institutions to lend would be a negative for economic growth potential. Another knock-on effect of the rapid rise in interest rates is that there again are legitimate alternatives to bank deposits, in the form of money market funds, typically yielding more than chequing and savings accounts. This has the further potential in light of SVB to see more money flowing out of the banking deposit base, which is a risk to the financial sector.

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Chart 4- US 2- and 10-Year Treasury Yields

We have been consistent in our view that the Canadian economy is more sensitive to changes in interest rates, due to factors such as higher overall debt levels on Canadian household balance sheets, shorter mortgage renewal cycles, and higher housing prices overall. To that end, it was not a surprise the Bank of Canada has led when it comes to moving from raising rates to holding steady for the last two decision dates. Yield curves in North America remain deeply inverted, which is the bond market saying that rates are going to come down from present levels, and the reason rates come down is due to weakening economic fundamentals. Over time, the yield curves will revert to a non-inverted state, where the long end of the curve yields more than the short end. The major question is how this process will take place, as this will be very important for bond portfolio positioning. If the back end of the curve steepens, that will cause duration to take a hit as those yields back up. If the short end comes down below the long end, then there remains potential upside to bond prices in that maturity range as yields fall.

Elsewhere in Canada, the federal budget was released recently, and while some of the speculated tax increases on things like capital gains inclusion rates did not come to pass, they did increase the Alternative Minimum Tax, which can have an impact on high-income earners. The goal to balance the budget was dropped, which should come as little surprise given governments’ inability globally to stop spending, even in the face of high inflationary pressures in the economy. Finally, for those in Alberta, there will be a provincial election at the end of May, which should be closely contested and has implications for the Canadian Energy sector.



Conclusion & Portfolio Considerations

We now have clear evidence that the raising of interest rates in the fight against high inflation is impacting the economy and putting economic growth at risk. While corporate earnings over the most recent earnings seasons came in slightly better than expected, the fact remains that earnings growth is challenged, and margin compression is a key risk for businesses. Therefore, it remains critical in our view to focus capital on businesses that have defensible business models or moats, that enable them to defend margin and market share. We continue to view that our long-term investment themes remain intact, both in the secular growth space as well as the commodity, real asset, and infrastructure space.

Our bias in bond portfolios is to remain shorter in duration, with an eye towards extending duration when rates look set to fall. Credit spreads remain tight, and do not signify major stresses in lending markets, and as a result we continue to focus on high quality bonds to hold to maturity. As always, we continue to hold very high-quality portfolios, consisting of Tier 1 assets. We also believe that in times of crisis in financial markets, opportunities can and do arise, and we are constantly on the lookout for these opportunities.