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THIS WEEK WITH SADIQ

The Dark Cloud Over U.S. Banks

August 14 to 18, 2023

THIS WEEK WITH SADIQ

The Dark Cloud Over U.S. Banks

August 14 to 18, 2023

Commentary

Market Recap

  • Equity markets were mixed this week alongside more evidence that inflation is coming further down the mountain. The S&P 500 slipped 0.3%, with technology and banks trailing as energy and health care led the pack. The index has faded in recent weeks, but is just running into the 50-day moving average and remains well above the 200-day mark.
  • While the year-to-date 16% gain is still very top heavy—technology and communication services are each up more than 35%—the gains have broadened out recently.
  • Over the latest three months, five of the ten major sectors have posted gains of 10% or more, and just two (consumer staples and utilities) are stuck modestly in the red. In market speak, this looks action that has moved toward pricing in a soft landing.

U.S. Banks

Last week, Moody’s downgraded their credit ratings for 10 small-to-midsized U.S. banks and lowered their outlook for several others. In our view, these moves simply represent the ratings agency catching up with developments over the last few months. Yes, there was a bit of a selloff on the day of the announcement because of how the downgrades highlighted some of the banks’ underlying problems, including real estate and credit issues as well warning of additional downgrades. But overall, we don’t view it as particularly big news or a major concern for the U.S. banking sector. What it does remind us, however, is that while most of the damage from the banking crisis is likely behind us, there will still be a dark cloud hanging over banks for some time. While that sounds ominous, it also means that U.S. banks are undervalued, which creates a potential opportunity for long-term investors. Many of these companies still offer strong growth, healthy dividends and long-term value The realization of that value may take time, but it’s there nonetheless. Meanwhile, we view the chance of another bank failure like Silicon Valley Bank (SVB) or First Republic Bank to be very low. Those crises were largely brought about by the numerous interest rate hikes in a very short time frame, and while rates may continue to trickle higher, it’s unlikely that we’ll see a spike of that extent.

Bottom Line: There is potential value in U.S. banks, though it may take some time to realize.

China

The United States has placed constraints on Chinese investment in high tech, including the semiconductor and artificial intelligence (AI) spaces, prompting questions about possible retaliation and the potential impact on investors’ portfolios. Tensions between the U.S. and China are unlikely to go away any time soon, and political games will continue to be played, especially as we approach the 2024 U.S. presidential election; a tough stance on China is one of the few things that Democrats and Republicans can broadly agree on. Parts of a portfolio that involve intellectual property are most likely to be affected by these sanctions, with Technology leading the way. But while some kind of retaliation from China is likely, it won’t necessarily take the same form as the U.S. constraints. At this stage, pessimism about the Chinese market remains quite high, but that caution can create attractive valuations. Over the last few weeks in particular, Chinese equities have done well, even outperforming the S&P 500 in some cases. Tensions between the U.S. and China are already largely priced in, which is one of the reasons why Emerging Markets (EM) has lagged behind other regions, the other being China’s disappointing reopening. We’d been expecting a strong rebound in the first half of the year, and while that didn’t materialize, it could happen in the second half—and if valuations continue to drop, it makes the trade even more attractive.

Bottom Line: Tensions between the U.S. and China are likely to continue, but there are nonetheless some attractive investment opportunities available in Chinese markets.

Inflation

Which way is inflation heading? That’s the question preoccupying investors’ minds. In our evaluation, inflation is under control, meaning that it’s unlikely to skyrocket again. This does not mean, however, that we’re going to see it at or below 2% in the near term. Energy prices have moved up over the last month or so, which will create upward pressure on headline inflation. That said, we believe that inflation is at a point where central banks don’t necessarily need to raise rates any further. If inflation remains around current levels for an extended period of time, then central banks—and especially the Fed—may be tempted to increase rates again. But it’s very unlikely that we’ll see hikes of 50 or 75 bps at a time or increases at several meetings in a row. If inflation proves sticky even after the central banks have given ample time for previous hikes to filter through the economy, then another one-time increase may be in the offing, after which they’d be likely to pause again to see its effects. That possibility is likely not fully priced into markets at present.

Bottom Line: The Fed and Bank of Canada are likely to pause at their next meeting, but another rate hike down the road cannot be ruled out.

Positioning

We’re entering a period of seasonality that we expect to be relatively soft compared to other parts of the year; historically, the middle of August into September is typically not great for markets. This means that unless one has a very bullish or very bearish outlook, it’s not a bad time to be a little more defensive. We remain largely neutral in our house view, but we have taken certain steps of a more defensive nature in our portfolios—for instance, our allocation to gold. Some sort of pullback should be expected, but that doesn’t mean that the growth story has gone away entirely. We believe there is still room for markets to go higher, but it won’t necessarily be in a straight line. That’s why we’re remaining neutral on our allocation of equities versus bonds at this time.

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