TLT - JPMorgan Acquires First Republic. What's Next For The U.S. Banking Sector?

2023-05-03 01:36:00 ET

Summary

• Why there may be other small lenders set to fail.
• The Fed is sticking to plan and focusing on fighting inflation, and nothing else.
• Are niche banks bearing the brunt of interest rate hikes?

JPMorgan Chase ( JPM ) has agreed to buy failed lender First Republic Bank ( FRC ), as part of a government-led deal. Michael Craig, Head of Asset Allocation at TD Asset Management, speaks with Greg Bonnell about the state of the banking sector and the implications for markets.

Transcript

Greg Bonnell: We're starting the month with plenty of news for investors to chew on, regulators forcing the sale of another beleaguered US regional bank to one of the majors.

Joining us now for his view on where the markets go from here, Michael Craig, Head of Asset Allocation at TD Asset Management. Michael, great to have you back with us.

Michael Craig: Pleasure to be here, Greg.

Greg Bonnell: We always have the good fortune of having you back when we have some of these large events south of the border. Another US regional bank, another seizure by regulators. How do we read this? The markets are pretty calm right now.

Michael Craig: Yeah, so it's May Day in Europe. So there is quite a bit of light trade today with Europe out. I think with the First Republic deal, it takes a real kind of source of risk out of the market. JPMorgan bought them for about $10 billion out-- from the FDIC. Bonds and equities all written to 0. Their bonds were trading at about 150, 120 about two years ago and have sold off precipitously and now are basically 0 recovery.

But it does take a source of stress out of the market. This probably won't be the last casualty of this hiking cycle. But the story now is, for all intents and purposes, over.

Greg Bonnell: Yeah, Jamie Dimon, in his commentary today, seems to be that he's saying this part of the crisis is over. He's not ruling out, perhaps, another smaller regional bank getting into the same kind of trouble. But they're not reading it through as to problems for the wider banking system. What do we think about that?

Michael Craig: This wasn't looked at as like a systematic bank. It was large. It had a very nichey, kind of high-net-worth targeted set, big, big push into wealth. JPMorgan, they've got some guaranteed financing. They have some reasonably attractive terms. But it is a fairly small acquisition for them going forward.

So we did some work on this. When you do look at Fed hiking cycles, you always tend to have breakdowns. And it's really the weaker business models that tend to get put under a lot of stress. And this would-- there will be more, I think, as we go into the latter half this year and we stay at very, very restrictive levels of interest rates.

Greg Bonnell: Let's talk about interest rates because, of course, at the heart of this is the effects on some of these smaller institutions in terms of how they had sort of structured taking deposits, where they were putting them. It did not all work out when the rates got so aggressively higher.

In the course of the year, the Fed is on deck-- and the expectation is that we're getting another rate hike from them. I mean, is-- the Fed is watching this. But they don't seem that concerned.

Michael Craig: Yeah, I still think their number one priority right now is getting inflation to come down. And it's proven to be sticky. It's slower than, I think, people expect. And I think they have the tools, or at least the belief in the tools, to take care of events like this.

A lot of money was put at the discount window in March. And you saw the Fed balance sheet momentarily expand again and has since started to contract. So I believe they feel they have the tools to deal with these kind of flareups. But they're not backing down until they see inflation start to behave.

And there are parts of the inflation story that have come off. Goods prices have come off materially. But wage and employment growth still remains quite strong and the services part of inflation is still quite biddish.

So I would expect-- I think this will likely be the last hike. Maybe one more in June-- but the question now one has to ponder is how long we stay restrictive. And the longer you stay restrictive, it's almost like a slow poison into your economy. It really does crimp business activity and will crimp business activity in the quarters to come.

Greg Bonnell: Some parts of the market that are wagering that the Fed-- even though they will, more than likely, I mean, those are the odds this week, maybe one more-- and then they're going to be cutting by as early as the summer. To me, that seems like quite a quick reversal, quite a change of pace, dare I say it, even the word pivot.

Michael Craig: So I think this is where a bit of confusion comes in the market. And the Fed hasn't done themselves any favors by saying, well, this is where we think things are and the market's way too aggressive.

I think what the market is telling you is that this is really a collection of probabilities. So the path doesn't make any sense on its own. But what it is, it's a combination of nothing, or we go into a severe recession, and they cut 300, which is generally, historically what they would do. And so that small-- you see that another hike and then 300, or 150 basis points or 100 basis points of cuts at the end of the year. Highly unlikely, I think, that we see 100 basis points. The two I would be looking for is nothing or 300 or 400 in a situation where we have a hard landing, if you will.

And I think that's what you should draw out of that-- the SOFR curve is the probability of, really, a binary outcome in the world. And the IMF talked about that last month about a one in seven chance of a real material global contraction this year.

So again, to say what's going to happen is kind of a mugs game. You've got to look at the probabilities. And that would just be one state of the world that I think investors need to be very, very aware of into the end of the year.

Greg Bonnell: OK. With all these major forces at play right now, we are in the thick of earnings season. As you take a look at what we've seen, kind of just starting to sort of ramp up a little more robustly this week. We've had some pretty heavyweights already report out of the States. What are we seeing through those earnings?

Michael Craig: I think, generally speaking, better than expected, some weakness in the real economy sectors. Tech came in fairly good, if you will, better than expectations. And you've seen a pretty, a big rally in tech shares this year.

I would kind of-- I wouldn't get too excited about it. Amazon ( AMZN ) did warn on cloud. And that sent their shares down quite a bit. And so I think this is better than expected but we are seeing a slowing.

And again, I don't expect to see earnings start to inflect anytime soon. I think you're going to continue to see earnings struggle to beat last year's comps into the remainder of the year.

Greg Bonnell: From an asset allocation perspective, given the fact that this is what we're seeing from earnings, given the fact that the Fed is on deck this week, and the stresses in US regional banks, where do you put it all together? What should investors be thinking in terms of putting money to work in the markets, allocating cash?

Michael Craig: For us right now, the word du jour would be patience. We're running a fairly defensive positioning. We still hold equities. We've migrated to kind of larger, higher quality parts of the market, survivors, if you will, companies with business models that will tend to actually thrive through this as their weaker counterparts succumb to the stress of a slowing economy.

We do have-- we have in past and continue to favor fixed income. And it's one of those where we can have a defensive setup earn 5% on the income side. On dividend yields, dividend yields are, outside of the US, are pretty attractive around the world. And it's one of those periods where you just want to minimize mistakes right now.

I think we're at the third kind of mark of the year. We've had this pretty aggressive rally in tech, which was a real weakness last year. Much of this, I believe, has been positioning, a lot of investors getting caught short or underweight or whatever. And so there's been this bit of a catch-up.

And that's always the analogy from bear markets is that if you try to do something or be clever, you get hurt. And it's really about being patient and consistent right now, waiting for things really to start presenting opportunities again.

Greg Bonnell: Any signposts while we're being patient, things to watch for to start to get a sense that, OK, maybe our patience will start to pay off for us?

Michael Craig: The two things I think that are still outstanding for us is one would be to see valuations come in line with bond yields. I still think that valuations, particularly in the US market, are too high. The second is really starting to see inflation crack. And that will require the housing aspect of inflation-- rents, et cetera-- coming off as well as services. So core services, or they call them super-services, major-- core services excluding housing in the US.

You want to see those two sectors. Because until you see that, you're going to continue to have restrictive policy. And like I said earlier, more things will break. Those would be the two things I'd want to see improve materially into the end of the year before we start getting a bit more excited about the backdrop.

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