With recent bank failures among 'canaries in the coalmine,' veteran PM shares cautious outlook
After a streak of 10 consecutive rate hikes since March of last year, there’s no questioning the Federal Reserve’s commitment to tamping down inflation and restoring price stability in the U.S. But with recent bank failures hinting at broader weakness, could the central bank be taking its fight too far?
“The Fed has been in this mode for at least the last five or six months,” says Michael White, portfolio manager at Picton Mahoney Asset Management. “They made it clear that the fight with inflation was more important than the risk of an economic contraction.”
Canaries in the coalmine of credit
In its recent Q2 Outlook, Picton Mahoney took the view that the U.S. central bank is “likely to cause an economic contraction and further financial accidents in its quest to beat inflation.” White says the primary vulnerabilities exist in the financial sector, with the recent failures at Silvergate Bank, SVB, and First Republic being high-profile casualties.
The Fed appears to be waving off those concerns. In its March rate decision, it described the country’s banking system as “sound and resilient,” and reiterated that view in this week’s rate hike statement.
But rather than idiosyncratic risks, White argues the recent events have been “canaries in the coalmine.” He also noted signs of very weak loan origination and softening demand for credit in the broader economy, which have historically tended to precede recessions.
“Economics 101 tells you that credit is the grease in the wheels of the economy. If there’s no credit impulse, you're bound to lack growth or if not contract,” he says. “Higher rates are definitely having an impact on business investment.”
Take caution in tech
Bond markets are reflecting the risks of an economic slowdown or recession, White says, with the yield on the 10-year Treasury coming well off its highs. With the markets pricing in lower interest rates, valuations in growth stocks – including tech, where the pain was most acute amid the carnage of 2022 – have seen a boost, which has helped drive the equity markets higher this year.
“There’s a lot of nuance there. Tech’s a much higher percentage of the [U.S. stock] market, so passive investing tends to flow in and out and reflect on technology disproportionately,” he says. “I wouldn’t necessarily call the rebound in tech a head fake, but it’s really just a reflexive action to this lower movement in interest rates.”
Picton Mahoney is adopting a cautious position over the next three to six months as it continues to see vulnerabilities in the equity market. Given the firm’s outlook of lower or slower growth, it expects companies that can grow irrespective of economic activity to be rewarded by the markets. While tech companies have usually waved that flag, there’s a big asterisk to consider.
“Investors paid a lot in multiples for technology during the COVID slowdown … a lot of future growth for these companies was pulled forward,” White says. “With a fresh dollar to invest today, I don’t think all in on tech is necessarily the wisest play. There’s likely to be more volatility within the sector, which I don’t think an equity investor would necessarily want to stomach, so they’ll probably want more ample diversification within their portfolio.”
The Fed-BoC divide
With the Fed’s latest rate hike, the Federal funds rate stands at 5% to 5.25%, compared to 4.5% for Canada. The Bank of Canada has held that rate for its past two decisions, following its declaration of a conditional pause as it hiked in January. Noticeably absent from this week’s Fed speak is language about further tightening, indicating it may be ready to pause as well – but markets are already pricing in more dovish moves to come.
“There’s approximately 200 basis points of Federal Reserve cuts priced into the market between now and the end of 2024,” White says. “It’s just a question of timing, and how quickly they eventually start cutting rates.”
The Fed’s hawkish stance compared to the BoC, he says, reflects how the U.S. population is more able to tolerate higher debt costs. While Americans have been relatively well-positioned with higher savings rates coming out of COVID, there’s no shortage of stories about Canadian homeowners feeling vulnerable to increasing mortgage rates and worries over refinancing in the next couple of years.
“I think the Bank of Canada is very, very sensitive to that. They do not want to effectively kill the golden goose, which is the housing market and all the wealth it’s created in this country,” White says. “If we do get an economic slowdown, I think the Canadian economy, being a little more cyclical and resource-centric, will probably show a little more negative beta relative to that broader recession.”
