Mark Zuckerberg, founder, and CEO of Facebook, coined the phrase “move fast and break things” and made it a rally call to his employees to act with urgency and remove barriers that come in the way of innovation. Some have interpreted the phrase as a push to disrupt the status quo through innovation. While the intention may have been noble, Zuckerberg distanced the company from the motto after realizing that it did encourage innovation but was blind to side effects and unintended consequences (think misinformation leading up to the 2016 U.S. election). Jerome Powell, Chair of the Federal Reserve, and his fellow governors that set interest rate policy seem to be following Zuckerberg’s playbook. Indeed, interest rates have moved fast, and now things are starting to break.

Although the pandemic is fading into the rearview mirror, and global supply chains have returned to pre-pandemic levels (as measured by the Global Supply Chain Pressure Index), the effects of massive government stimulus and the zero-interest rate policy during the pandemic continue to echo. Intent on repairing damage to their credibility, central banks have been raising interest rates at the fastest pace in 40 years even as the rate of inflation has been decelerating in a symmetrical fashion to its rise. In the U.S., the Federal Reserve’s myopic attitude has already triggered a crisis in the banking system that we think could hasten a recession later this year.

With challenges in the banking system likely to increase near-term economic headwinds (discussed below), our investment strategy is tilting toward defense in the near term and we expect to put the offence back on the field later this year. Looking past the next 2-3 quarters, we think a combination of falling interest rates and more reasonable valuation should contribute to strong asset price performance over a 24-36 month period. While capital market volatility is likely to remain high in coming months, our portfolios will continue to be focused on dividends, quality, valuation and a higher fixed income weighting.

The downside and upside of a banking crisis

The current U.S. banking crisis is not a redux of 2008. Fifteen years ago, large and small U.S. banks alike were eating from the same contaminated buffet of subprime mortgages that were underwritten against overvalued homes. The current crisis has less to do with the loan quality within the banking system and more to do with the interest rate mismatch on loans versus deposits.

A prolonged period of low interest rates before and during the pandemic resulted in bank loans and mortgages being locked in at low rates. The sharp increase in central bank rates over the past year has raised funding costs for banks at a faster pace than they can reprice their loan portfolios. Bank balance sheet stress has also been aggravated by a drop in the market value of their safest assets, government bonds, brought on by the spike in interest rates.

While there is plenty of blame to go around, ranging from mismanagement to lapses in regulatory oversight and to highly inaccurate forward rate guidance from central banks, the weakest members of the banking herd have already fallen. With confidence being an essential prerequisite of a well-functioning banking system, the failure of some U.S. regional banks has shaken depositor confidence even though it is becoming more apparent that issues in the banking system may not be widespread. Nevertheless, with many banks now anxious about deposit flight risk they are losing their appetite to lend. This was confirmed in the latest Senior Loan Officer Survey which showed a net 46% of respondents reporting tightening lending standards, a cyclical high and considerably higher than the 30-year average of 4.4%. With economic growth strongly correlated to availability of credit, the current banking turmoil is expected to add additional headwinds to an economy already navigating high interest rates.

Recognizing the potential impact of tightening lending standards, and seeing ongoing progress with inflation, it is not surprising that the Federal Reserve recently shifted its tone by hinting that it may pause. Market-based forecasts of short-term interest rates now suggest that the Fed will pause through the summer and may begin cutting interest rates as early as this September. Rates could be a full percentage point lower by January 2024 from the current 5.25% overnight rate. Similarly, the Bank of Canada is expected to remain on hold until October and then start cutting. Even though economic conditions are likely to soften in the near-term, we think the accelerated time to the first rate cuts should eventually give birth to the next economic cycle and support medium-term asset price appreciation.

Fine tuning our equity exposure given elevated recession risk

Based on commentary from various market participants, economists, and portfolio strategists, we can’t remember a time when the outlook was as polarized as it is currently. Full year 2023 aggregate earnings estimates from the top 25 strategists for the S&P500 Index range from a 16% YoY decline to a YoY improvement of 3%, with the median calling for 6% decline. Similarly, year-end price targets for the S&P50 index range from a 22% drop to a gain of 15% from current index levels, with the median strategist forecast calling for the index to close the year near current levels. The wide range of forecasts is undoubtedly being driven by heightened economic uncertainty fed by ongoing interest rate uncertainty, banking crisis, debt ceiling debate, and geopolitical factors.

A large number of real-time and forward-looking economic indicators and market-driven signals that we follow suggest that the economy is already cooling, and near-term caution is warranted. As an example, prices for bellwether economically sensitive commodities, such as oil, copper, steel, and lumber, have been declining in recent months despite a global post-pandemic reopening. Shipping costs and freight volumes, considered prescient indicators, have also been trending lower. The current inversion of the yield curve in the bond market (i.e., short-term interest rates are higher than long-term rates), has historically been a telltale signal of slower economic activity ahead.

As of the time of writing, the S&P/TSX Composite Index of Canadian equities was
trading at a 13.1x price-to-forward 12-month estimated earnings, a 14% discount to
its 10-year historical average of 15.2x. This is to be expected as banks and energy
have the largest index weights and both have been under pressure this year, banks
due to poor investor sentiment and energy due to declining oil/gas prices. Despite
elevated recession risks ahead, we consider our Canadian equity portfolio positions
to be attractively valued and offer cyclically high dividend yields at present.
In the U.S., the heavily weighted technology sector and a few mega-cap technology
companies have skewed YTD index performance. The lack of breadth is apparent in
the wide gap between the market cap weighted S&P500, which is up 7.3% YTD in CAD
terms while the lesser-known equal weighted S&P500 is up only 0.9% in CAD terms.
Similarly, the Dow Jones Industrial Index, which has better sector representation, is
up only 1.3% in CAD terms (all data per Bloomberg, as of May 5). Valuation of most
U.S. equity sectors looks reasonable to us, except for the technology sector which
trades at a 30% premium to its 10-year historical average.

We have been making portfolio adjustments to trim exposure in areas where valuation appears full and add where higher dividend yields and low valuation can improve buoyancy for anticipated near-term volatility.

Although we have trimmed overall equity exposure in our managed portfolios, we
expect recession-related repricing to be short-lived and do not want to be materially
underweight. Furthermore, we think our equity exposure has an attractive risk/
reward proposition, as valuation for many positions is already near cyclical lows and
dividend yields are high and appear sustainable. As the year progresses, we expect
investors to begin valuing companies based on 2024 earnings expectations, which
are widely expected to be higher than 2023. Combined with a forecast for lower
interest rates, we expect our equity positions to perform well over a 12-18 month
period.

Bonds remain a preferred asset class

Bond prices move inversely to interest rates, and price sensitivity rises as the term to
maturity increases. With these inherent relationships in mind, it shouldn’t come as a
surprise that an index of long-term U.S. Treasury bonds declined 31.2% in 2022. An
index of long-term Canadian Government bonds declined 21.7% last year. Indeed,
bonds of all stripes performed poorly in 2022. With interest rates now hovering near
cyclical peaks, and cuts becoming more likely, we view bonds as an attractive source
of interest income and potential capital gains over the next few years.
We started adding exposure to long-term U.S. and Canadian government bonds in
the second half of 2022. With hindsight, we were a few months early as the interest
rate hiking cycle went longer than we originally anticipated. With strong conviction in
this investment opportunity, we continued to add to this asset class and have been
rewarded in 2023 as long-term government bonds are amongst the best performing
asset class YTD.

The banking crisis and increased risk of recession has further raised our preference
for bonds. As outlined below, we have increased overall bond exposure by adding
two additional strategies, both relating to investment grade corporate bonds.
U.S. debt ceiling deadline quickly approaching

The debt ceiling refers to the legal limit on the amount of money that the U.S. government can borrow to fund its operations and programs. It was first enacted in 1917 and has been raised numerous times since then. Since 1960, it has been raised a total of 78 times, and more often under Republican administrations than Democrat ones. As with previous negotiations, when the control of Congress is divided between the two parties, the debt ceiling is being held hostage to gain budgetary concessions. Current Republican demands for budget cuts are no different to Democrat strategies during the Trump administration. While the actual deadline is a moving target (latest estimate is June 1), we expect rhetoric in Washington to get louder and investor anxiety to rise over the coming weeks. We expect the debt ceiling debate to exacerbate near-term market volatility but are confident that our current positioning is both conservative and allows flexibility to take advantage of opportunities should they arise.