First Quarter 2023: Pain, as Promised

Rate Hikes Come Home to Roost Shaking Up the US Regional Banking Sector and Taking Down the 166-Year Old Credit Suisse

In last quarter’s commentary, we noted that ‘interest rate hikes tend to be felt the most 9-12 months after they occur so we should start to see those negative effects in the first quarter of 2023’, and boy did we ever! During the first quarter, we saw Silicon Valley Bank (SVB) and Signature Bank, the 16^th and 29^th largest US banks go bankrupt, and Credit Suisse, the world’s 45^th largest and a global systemically important bank, be forced into a shotgun marriage with its closest peer, UBS. These bank failures were caused by depositors pulling money out during an asset-liability mismatch triggered by poor risk management combined with faster than expected interest rate hikes (i.e. these banks owned too many long-term assets, like mortgages and US Treasury bonds, and couldn’t sell these assets near what they paid for them to cover deposit withdrawal requests).

While the effects of interest rate hikes are starting to show, the equity markets and the global economy have weathered the storm very well. So far, the “pain” that US Federal Reserve chair Powell promised in his August 2022 Jackson Hole speech, seems quite tolerable. Equity markets are actually up since the first of these three banks (SVB) started to encounter problems, partly driven by the rapid response by policymakers to shore up liquidity at troubled banks and prevent the spread to healthy banks. Expectations about future economic growth are now more uncertain, as many forecasters have concerns about potential funding problems for other small- and mid-sized banks and the impact on future bank lending activity, but recent data shows that labour markets around the world remain resilient and economic activity has yet to decline as a result of the recent banking issues. Some pundits are comparing the recent banking turmoil to the 1998 failure of Long-Term Capital Management (LTCM) whereby a consortium of banks stepped in to recapitalize LTCM, which faced a unique, though possibly systemic, asset-liability mismatch. Once the banks stepped in to save LTCM and prevented a broader financial crisis, the historic 1990s bull market continued. Note that this time around, a consortium of banks stepped in to recapitalize First Republic Bank, the 14^th largest in the US which was also struggling with deposit flight, so the comparison between now and 1998 has some legitimacy.

While equity markets have shaken off recession concerns thus far, bond markets appear to disagree. US bond markets have priced in rate cuts starting in the second half of 2023 and have priced in additional rate cuts throughout 2024. Other bond markets around the world have a similar phenomenon priced in. The US Federal Reserve, and other G7 central banks, have stated their intention to keep interest rates roughly where they are for the remainder of 2023 and beyond to fight high inflation, irrespective of recession risks. Inflation has been declining in general around the world but remains a real problem in some countries, including the UK. Bond markets recognize this concern about high and entrenched inflation, which may require higher short-term interest rates to cure, but bond markets have priced in a deep slowdown in economic activity later this year which will force central banks to quickly reverse course and cut interest rates later this year.

One thing is for sure, either bond markets are wrong, and the economy will be able to withstand high interest rates for a prolonged period, or central banks are wrong, and they will be required to cut interest rates to prevent or combat a recession. The direction of equity markets, and other investment markets (currencies, commodities, etc.) will likely be dictated by who is wrong. If bond markets are wrong, and the global economy can continue to eke out some economic growth with high interest rates, then equity and commodity markets may continue to grind higher and outperform other assets. If central banks are wrong, then we may see a more traditional recession and equity markets may struggle for the remainder of 2023. As the first US interest rate cut is priced in for September 2023, and bond markets will need to adjust in the coming months if they’re wrong, we should get our answer very soon.

Equity valuations are still historically high, with the S&P 500 trading at ~19x 2023 consensus earnings, versus a long-term average of ~16x. S&P 500 profit margins remain above historical norms as well, partly due to lingering effects of pandemic stimulus. Profit margins tend to normalize in recessions and/or during periods of high wage inflation, both of which are a possible in the near future. It is important to note that equity markets can remain historically expensive for extended periods of time, and that broad equity market valuations do not indicate the valuation or return prospects of individual stocks. That said, an above average valuation indicates that going forward the return outlook for the S&P 500 index or for the average stock may not be as attractive as it has been in the past especially when there are alternatives – cash, fixed income, alternative investments – that offer consistent returns, and in many cases, with much greater certainty.

How To Position Portfolios Going Forward?

Defensive and dividend paying blue chip equities, our bread and butter, performed well in the first quarter. Falling interest rate expectations made the dividend yields of defensive stocks relatively more attractive relative to bonds, and defensive stocks tend to carry much more debt than average so they benefitted from the perception of lower interest costs in future, when their debts are renewed.

While interest rate expectations fell in 2023, the rapid rise in interest rates over the past year has created opportunities in defensive sectors as well. Some defensive companies are struggling under the weight of their large debt loads, and in some cases, the rise in interest costs over the past year is making their dividends unsustainable. Companies can come under extreme scrutiny leading up to and after dividend cuts, but we see dividend cuts as excellent buy opportunities if the dividend cut makes the new dividend sustainable and if the long-term earnings consistency of the underlying business remains intact.

Algonquin Power & Utilities (AQN) is a case in point. AQN stock fell by more than 60% from January 2021 to January 2023 as the company’s industry leading indebtedness and rapidly rising interest costs made its dividend noticeably unsustainable. Following the dividend cut, and an announcement to sell non-core assets, we jumped on this opportunity as the company went from trading at a significant premium to peers (on an EV/EBITDA basis) with an unsustainable dividend, to a significant discount with a sustainable dividend, and we verified that little had changed with its underlying business over this time period. This was a classic Buffett-style fat pitch.

Another example with its own nuance is TC Energy (TRP), formerly TransCanada Corp. TRP has struggled with cost overruns at its development projects for the past couple of years and its stock paid the price, falling as much as 30% since early 2022. If we were in a period of low inflation, these cost overruns would be more concerning, but in a period of universally high inflation, cost overruns are expected and high inflation simply means the value of TRP’s current asset portfolio is likely higher than it gets credit for. TRP went from trading at a 10%-20% premium to peers (on an EV/EBITDA basis) to trading in line with peers, despite its superior asset portfolio. TRP outlined plans to sell some non-core assets to cover the cost overruns, solving the short-term cash crunch and making its dividend much more sustainable. After we verified that little had changed with TRP’s underlying business, we felt confident adding to the stock.

We typically don’t go into detail about individual equity buys in our quarterly commentaries but it is worth highlighting the opportunities created by rising interest rates, not just the risks. There are two sides to every coin! We also love highlighting defensive companies with consistent earnings that investors suddenly have a distaste for. In our experience, household names selling things we need now and in the future tend to stick around and distaste tends to dissipate.

Focusing on quality companies with consistent earnings remains the best course of action, though being mindful of valuation and its effect on expected returns is important as always. As mentioned in last quarter’s commentary, with high interest savings accounts (cash) yielding ~4.5%, GICs yielding 4.5% to 5%, and bonds yielding 3%-6%, equities face competition for investor dollars for the first time in nearly 15 years and holding cash and fixed income is no longer punitive to portfolio returns. Alternative investments, particularly conservative mortgage pools, also look to attract investor dollars, targeting consistent returns of 6%-9%, depending on risk and liquidity.

This market environment arguably offers the best return outlook for balanced, pension-style investors in over a decade. We think a pension-style, multi-asset approach will continue to perform well relative to a traditional 60/40 asset mix of equities and fixed income, as it has since the beginning of 2022.

We are here to help you navigate this uncertain environment and help keep you on track to achieve your financial goals. Please feel free to reach out if you have any questions or concerns.

Sincerely,

Steele Wealth Management

The information contained in this report was obtained from sources believed to be reliable, however, we cannot present that it is accurate or complete. Information has been sourced from the RJL Bond Desk or RJ Private Client Solutions, unless otherwise noted. Index and sector returns represented in this commentary are measured using the S&P/TSX Total Return Index and S&P/TSX GICS Sector Indices as detailed in Raymond James Ltd.’s Insights & Strategies: Quarterly Edition. This report is provided as a general source of information and should not be considered personal investment advice or solicitation to buy or sell securities. The views expressed are those of the author and not necessarily those of Raymond James Ltd. (Member Canadian Investor Protection Fund).

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