Q1 | 23

Beginning in 2019, and then running full-bore in 2020 and most of 2021, Central Banks drove enormous monetary growth, contributing to a substantial spike in inflation. They are now reversing that increase to bring inflation back to a more manageable 2% target rate. The process of normalizing interest rates has been a bumpy ride, especially in 2022. However, the hiking cycle and the U.S. regional banking turmoil has had a minimal effect on both stock and bond prices in 2023. Equities and bonds in the first quarter are up and have clawed back some of last year’s decline.
During 2022, the U.S. Federal Reserve hiked interest rates 7 times. The trend continued into 2023 with another 2 quarter-point hikes. Even before the collapse of Silicon Valley Bank, investor sentiment was improving as market participants sensed that Central Bankers were nearing the end of the rate tightening cycle. Given the banking turmoil, the market now expects tighter lending conditions to slow the economy, increasing the odds that the rate hiking cycle will end, and fueling the possibility that rates may eventually be cut.
In the first quarter of 2023, the S&P 500 rose 7.5% and the Canadian stock market climbed 4.6%. Leadership in Q1 was the opposite of 2022. Technology was the best performing sector and Energy lagged. Although the fixed income markets were volatile in Q1, both Canadian and U.S. bonds posted positive returns. In Q1, the Canadian Bond Universe was up 2.9% and the U.S. 10-year yield fell from 3.7% to 3.4%. Currencies were stable in Q1. The Canadian dollar gained 0.3% to the U.S. dollar.

Central Banks response to Covid was to inject liquidity by lowering interest rates to essentially 0%. These measures helped to restore investor confidence and economic growth but caused another problem. U.S. inflation rose from 0.1% in May 2020 to a peak of 9.1% in June 2022. The good news is that with the supply chain improving and the Central Banks tightening interest rates, inflation trends are in decline.

The most significant event of the first quarter 2023 was the failure of two U.S. regional banks, Silicon Valley Bank (the second biggest bank failure in U.S. history) and Signature Bank. We believe the greatest effect from these failures is on the broad economy, as credit conditions are tightened, and new regulations are passed to prevent future mid-cap bank failures.

A report from the U.S. Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) on “what-went-wrong” with Silicon Valley and Signature Bank is expected on May 1. Following this report, we expect a proposed enhanced rule set for U.S. banks over $100 billion. Currently, stricter accounting, liquidity and capital rules only apply for banks over $250 billion. Enhancements for this wider range of banks will include liquidity coverage ratios, mark-to-market unrealized-loss disclosure and liquidity coverage ratios.

In a banking environment where there has been a shock to the system, we expect management teams to improve their risk profile. Firstly, we expect banks to increase liquidity and attract capital by increasing their deposit rates. Secondly, we expect banks to reduce risk profiles by tightening lending standards, which should slow down loan growth. Lastly, management teams will boost their balance sheet defenses by increasing their loan-loss reserves and slowing share buybacks.

Although we view the U.S. banking turmoil as a contained problem that will not directly impact our investments, the net result will be to accelerate the fall in inflation which will help end the Central Bank tightening cycle. At the same time, we anticipate some negative revisions to corporate earnings estimates as the economy slows. We believe these two factors will largely offset one another through a brief period of heightened volatility and uncertainty. As a result, LDIC is maintaining its defensive oriented investment strategy. We believe our high-quality companies, with strong balance sheets and cash flows, will do well during this period.