Hello, this is Jeremy Richardson from the RBC Global Equity Team here with another update. And what an interesting month March proved to be. There we were hoping that there would be a no landing, soft landing kind of economic scenario, when all of a sudden there is a crisis within the US banking industry. Now I won’t bore you with all the detail about the which bank got into difficulty, I'm sure everybody's had the opportunity by now to catch up with the newspapers. But what does it all mean? So, three observations to share with you.

The first of which is that it has, I think, led to a change in the industry. There are times when you get changes like this. Most of the time industries are slow to change, but occasionally there is something which is much more profound, a little bit like what we saw with the energy industry earlier in 2022. This time it's really been a division that's opened up in the industry between smaller regional banks and larger, more systemically important banks. And the reason for that is because whereas earlier, before this month's episodes, smaller banks may have had a competitive advantage from being closer to their customers, allowing them to deliver better levels of customer service, more relevant products and services, and actually because they're based in the community, being able to price local risk more keenly. Those advantages have now been overtaken by a competitive disadvantage, which is that for depositors there's now a real economic incentive to move to a larger institution, one that has got an implicit guarantee of being considered too big to fail. That was the sort of message from a number of the bank failures that we've seen in March, and it's something, I think, that is going to lead to an impairment of the profitability of some of these smaller regional banks. And the reason for that is twofold. The first of which is that they're going to have to offer depositors more to attract deposits, and so that's going to cost them more money. And the second thing is that the regulation is very likely to end up having to be tightened, particularly around the management of liquidity, and that too is likely to come at a cost. So, we've seen an ongoing change, therefore, in the competitive dynamics of the US banking industry. That's notable.

The second thing, the second observation, is that it has potentially changed the economic outlook because, as I say, we were all hoping for a soft landing, no landing kind of scenario, but now there's a possibility that we end up with a credit crunch. If banks are finding that their lending activities, the cost of being able to attract depositors is rising, their profitability is reduced, and they're probably going to need more capital as well to satisfy these new regulations. That means lending officers are going to be very wary of making mistakes. They don't want any credit losses which could undermine that capital, so bank lending is going to be harder to come by. And this is probably something that's going to be most impactful in the short term to Main Street rather than Wall Street, because it's those small, medium-sized enterprises who are often the customers of those regional banks who are likely to be impacted first. But of course, you know, small, medium-sized businesses employ a lot of people, about 70% of US jobs. And as a result of that, we should expect the ripples of this to spread quite broadly into the real economy.

Third observation, though, is really that we need to keep an open mind about this. And the reason I say that is because it is very tempting to think that this is like 2008 all over again. Just read the newspaper headlines, ‘banks are in trouble’, it's natural to draw those conclusions. But the essence of the issues that we're dealing with here does feel very, very different. Of course, in 2008 it was all about credit losses, you know, lending decisions that went bad and which undermined banks profitability and capital. It does feel different this time because the issue at hand is not bad lending decisions, but actually more to do with investment decisions, and in particular to the way in which many banks have taken those customer deposits and invested them in fixed income security portfolios on the other side of their balance sheets. And it's the rise in interest rates that has reduced the value of those fixed income portfolios, creating unrealised losses. And that's been the catalyst for many of the investor’s concerns in this particular industry. Of course, if there is an economic downturn, if the credit crunch leads to slower economic growth, maybe even a recession, then we should expect interest rates to fall. In fact, the bond market is predicting that interest rates fall from the summer onwards. Now, if that is the case, then actually there is a powerful mean reverting mechanism at hand here because as interest rates fall, the value of those fixed income portfolios will rise again. And that's very different compared to the credit lending 2008 episode where falling interest rates had no such effect in terms of repairing balance sheets, in terms of credit losses. That required injections of new capital, that's different from what we're looking at this particular time. So, we shouldn't sort of draw a neat straight line from 2008 through to 2023.

The other issue as well, which provides some degree of comfort, is about deposit flows themselves. Once you've moved your money, you've moved your money - you can't necessarily move it twice. So there has been a sort of a wave of deposit flows within the banking industry. There are some early signs that those are beginning now to slow down, and that too provides some degree of comfort. That comfort is very much appreciated because the banks will be amongst the first companies reporting the results as we head through April into the Q1 earnings season. And I think a lot of investors will be paying very close attention on those deposit flows to get a sense of how deep this particular banking issue is within the US economy. But more broadly than that, again, it will be interesting for investors to see just how the strength of businesses over the course of the last three months or so. Our sense is that business conditions haven't improved materially, and again, like we spoke about last quarter, it doesn't appear to be a lot of incentive for management teams to give positive guidance at the moment.

However, I still remain of the opinion that actually the medium-term outlook is improving, and we are on a journey, not a smooth journey and not a linear journey, from quantitative easing and loose monetary conditions to something which we might characterise as being more ‘normal’ (in inverted commas). There’s a lot of debate about what that normal should look like, but for investors, it should actually do away with a couple of the major uncertainties that we've had to face over the last 18 months. We've spoken about this previously, the two things that investors need to think about when valuing companies: the profits on the numerator of the valuation equation and secondly, the discount rate on the denominator. And of course, a lot of the focus and attention has been on that denominator driven by inflation and the outlook for interest rates. If the bond market is right and interest rates are beginning to fall, then that headwind for valuations should abate, maybe it turns into a tailwind in the second half of the year, which then should allow focus to come back onto the profits of individual companies, onto the fundamentals of those businesses. And if you're a long-term minded investor like ourselves, then you'll understand that it's the long term fundamentals of those businesses that ultimately drive shareholder value creation and add value to portfolios over time. And that continues to be our focus. I hope that's been of interest to you, and I look forward to catching up with you again soon.