MBB - Bank Failures Contagion Fears And Why A Little Perspective May Be Needed

2023-04-04 03:08:00 ET

Summary

• Why the banking sector fallout may require a more sober second look.
• What the next stage of this late-stage economic cycle might look like.
• Amid banking fears, are mortgages the next domino to fall?

Recent fears about the banking sector have led to broader concerns about financial conditions. Brad Simpson, Chief Wealth Strategist at TD Wealth, discusses the importance of putting recent events into proper context and what the implications may be for your portfolio.

Transcript

Greg Bonnell: Concerns about the global banking sector have put financial conditions under a microscope. It's also raising questions about whether another domino may be about to fall, and what that domino might be. Well, my next guest says the recent bank failures are not what everyone should be focusing on. Here to tell us what we should be looking at is Brad Simpson, Chief Wealth Strategist at TD Wealth. Brad, always great to have you on the program.

Brad Simpson: Hey, Greg. it's great to be here.

Greg Bonnell: All right, so that's a pretty enticing lead into our conversation.

Brad Simpson: Yeah!

Greg Bonnell: What should we be thinking about these bank failures in terms of a broader context?

Brad Simpson: Well, I think to start out with-- which I think might sound a little bit surprising-- but having banks collapse at this kind of time really isn't that big of a surprise. And let me explain that a little bit. Which banks collapse-- let's say the Silicon ( SIVBQ ) and Signature ( SBNY ), and to far lesser degree, Credit Suisse-- now that's a surprise which particular names were. Now I say Credit Suisse is less as a surprise because I think anybody who's been active in investment markets over any kind of-- let's say, the last 5 to 10 years or more-- would realize that they were really in pretty tough shape going into the banking volatility we saw the last few weeks. And that was kind of like the final straw for them.

But really overall, one of the things I think that you have to remember is that we're in a late stage environment. And if you understand that and think about that, that kind of changes the way that you look at things. And so one of the things that I think really helps is that for us, is that we're always framing things and we're always doing so in a really disciplined way. So today what I did is, I brought a chart. I think you know how much I love my charts. So--

Greg Bonnell: All right, let's see it. Let's see it, yeah.

Brad Simpson: And really what we're looking at here is that-- we look at and frame the system on where we are today. So you have this black line right down the middle. And if you look at all the dots over to the left, that's everything that you would assume, that you would say are on a risk-off environment. And the further you go to the left, the more risk-off that you are.

So the things that we have in our way of looking at things-- growth, inflation, housing, financial conditions monetary policy, and ultimately risk sentiment, we would frame those out as your risk-off. And when you're in an environment like that, that's how a late-stage economy looks like. Over at the right, what you're looking at is business conditions and employment. Those are both still very positive.

But there's a lot more negatives than there are positives that are out there. And in environments like this, this is when you get the bank collapses. This is when you start seeing companies that were on the margin, or are-- they've made mistakes. They start to get into trouble.

And so if you look at it like that and you understand it in those terms, when things like that happen, you don't really have a sense of fear because you kind of go, well, yeah. I've been planning for that. And we also construct our portfolios because of this environment that we frame and go, well, we should be prepared for that. And I think if you keep that context, all of a sudden it takes an awful lot of the emotion out of it.

Greg Bonnell: All right, so we understand where we are in the economic cycle. We're in the late stage, as you said-- the things that we're seeing and what we would expect to see. We take the emotion out of it. What do we expect we would see next, given the conditions?

Brad Simpson: Well, I think that then what you're going to see is, you're going to see the economic growth start to slow even more. And I think ultimately, you're going to start to see inflation go from high to medium high to low. You're going to see monetary policy continue to be tight. You're going to see tighter credit conditions, and that's what we're moving into now.

And we've seen-- so far, we've seen unemployment really not get touched, but we'll start to see that move as well. And finally, you'll start seeing publicly traded companies start to experience margin pressure and lower earnings. And that should be consistent with the type of environment that we're in.

And I think if you step back a little bit and you look at fixed income markets, that's kind of how fixed income markets are trading right now. They're really oscillating between this struggle with coming to, where are we in the macro environment. And the macro environment, it's slowing.

If you look at the Main Street economy, and look at, for an area, you look at unemployment, and you look at it through that lens, what you see is still a pretty-- and the consumer, excuse me. But if you look at it through that lens, it's still pretty healthy but there's increasing headwinds coming to that. And then you start to see, well, things will-- and the fixed income market is trading that way.

And the equity market, if you look at it, it's kind of trading in a way of what you would expect as well. If you took a look at the S&P 500-- and there's seven big names and we all know them, the Microsofts ( MSFT ) and Nvidia ( NVDA ) and Google ( GOOG ) ( GOOGL ) and Meta ( META ) and Tesla ( TSLA ) and Amazon ( AMZN ). Year to date, the S&P is up 4%. You take out those seven names, the S&P 500 is down 1.75%. And my point into this is that that's a pretty textbook late-stage equity market. And that, I think, we're just going to start seeing more of that same as we go through the coming weeks here.

Greg Bonnell: Now Brad, in the year that took us to where we are right now, we've obviously seen a lot of interest rate hikes from central banks. What does it mean for Canadian households with debt, with mortgage debt? What should we be watching there?

Brad Simpson: You know what, Chadi Richa, who's a senior analyst on my team, wrote a paper last week that he published. And it was called The Last Domino, with a big question mark on it. And it was really-- we went through and thought about, well, what does all this mean? Because I think most of us-- if you're a Canadian and you're a homeowner or you wanted to buy a home, you've realized and watched the incredible growth of the real estate market in Canada over the last decade or so. And you also know-- either you've tried to get a mortgage or you have somebody who has-- and know that mortgage rates have gone up.

And so what we wanted to look at in the time when people were on pins and needles a little bit and saying, well, what would this mean, and should we be concerned about the mortgages in Canada? We dug into that. And really, if you look at it, first of all, the Canadian banking system is incredibly well capitalized and in really terrific shape. So I think that's the first thing you've got to considers.

Secondly, when you start digging into these mortgages, is that what you find is that the banks are incredibly well prepared for it. And basically, they've been going through a process-- and you can almost split this down the middle between the big six. And on one side look at it there, taking the mortgages that they have. And if you look at all the mortgages to start with, is that delinquencies are incredibly low. And they're probably too low. And they're probably incredibly low or too low because of all the financial engineering we've done the last few years, with either A, having people stay at home for the pandemic, because savings went up, and then some of the money that was sent out which went into people's savings, which gave them more ability to continue to build, to fund their mortgage payments-- all of those have meant that there's been almost no delinquencies to speak of.

As we move forward with this is that, what you'll see the big banks are doing-- again, on one side is that-- either take those payments, adjust those payments as interest rates have gone up, develop the help with folks being able to make those payments, or take the payments and put them on the principal and then put them on the late stage on the other side. And you work through the banks, that's what you'll find.

So we don't think that in the immediate here, that this is a real concern. But we think it's something that you need to watch. We think it's a bigger concern-- you get two to three years down the road. And if we had much higher interest rates and a lot of these mortgages start coming up, that's where it would be more of a concern. But we would put that in a pretty low probability because we think the rest of the things that you're seeing going on around you-- that ultimately, we think that the chance of interest rates being a lot higher from where they are today, two or three years down the road is infinitesimally low.

Greg Bonnell: All right, Brad, let's talk about those interest rates then. We have the Bank of Canada on a conditional pause. The Fed had to change its tune to a certain degree recently because of the stress in the banking system. What do you think is going to happen with interest rates for the rest of this year? The big question I always get on other programs I do is, when's the cut coming?

Brad Simpson: Yeah, and boy, you can look at-- if you watch the fixed income market over the last week and a half, the amount of changes between going up and raising them higher or starting to cut them, have swung in oscillations that I think you may never see again. It's been really something quite to behold.

I think that you'd have to look at it like this. Of course, Bank of Canada, I think, has been really clear that they're done. I think for the US Federal Reserve Board, you're probably 25 to 50 basis points more. But I think there's a big question point on that. And I think the question on it is that, it takes us back to the beginning here. Look, the bottom line is, the central bank needs to combat inflation, and they're doing that. And in doing that, you raise interest rates and you start to create-- things start to slow. Then you start to have things like what happened in the banking sector last week.

And the net result of that is that, that's going to start having an impact on inflation. Because what's going to happen is, these banks are going to reduce their lending and we're going to start seeing that the loans that are going out start to tighten, which will tighten credit even more, which will create another headwind for the economy-- which quite frankly, is kryptonite to inflation.

So I think what we need to look at this-- and if you look at the way the bond market is trading right now, you go out-- and if you go out and get a 10-year bond right now, you're getting 3.5%. If you go and get a one year bond right now, you're getting 4.5.

And that's the bond market telling you that inflation and interest rates-- inflation is headed downwards, and interest rates are doing their job and likely to start making their way back down again. We think that that is the mid to long term trend. In the short term, what we think you need to do is expect interest rate volatility. And we think you should expect sometimes quite a lot of it, and that's OK. I mean as an investor, that's actually a pretty good environment to be allocating into.

Greg Bonnell: OK, Brad. Only have about a minute left with you-- a little unfair. But let's talk about portfolio management. We do have a checklist we can show to the audience. Walk us through this in 60 seconds if you can.

Brad Simpson: Sure. Look, I think the first and foremost is that I think we have to look at this and go that-- for Wealth Asset Allocation Committee, that we are underweight fixed income right now and max overweight-- are underweight equity right now and max overweight fixed income makes a ton of sense. I think in fixed income, you really want to take advantage of an environment like this. When I look at the sort of cash positions that people are building in their portfolios, they're missing an incredible opportunity in fixed income that we haven't seen in a generation.

So I think you've got to be really active there. In equities, you've got to avoid the expensive areas of the market and overweight the defensive stuff. And I think it's imperative here that folks need to be able to look at their portfolios and add absolute return strategies to the portfolio. Running long/short portfolio strategies and hedging strategies, both in your fixed income-- from duration and investment grade and high yield on fixed income.

And on the equity side, making sure you're running market neutral and long-short strategies on both sides of those, make an awful lot of sense for hedging purposes. And when you have more volatility in the market, they make an awful lot of sense here. And this really is the type of investment market where allocation makes a ton of sense, and being really tactical with it.

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