Hello, and welcome to the Download. I'm your host, Dave Richardson, and this is a special edition of Stu's days because as we've talked about a lot on this podcast over the last several months, when you start tightening monetary conditions by raising interest rates, or when the central banks— like the Federal Reserve and the bank of Canada— are going out and selling billions of dollars of treasuries in the market with quantitative tightening, at some point, even though there's a lag in that effect, it kind of kicks in. And we've just seen it with a failure of a bank in the US. I think another one has gone and there may be a couple of others that come along the way. We're starting to see the impact of those tighter financial conditions. So I wanted to get Stu Kedwell on early this week because again, he has an incredible amount of expertise in this space. He is the co-head of North American Equities at RBC Global Asset Management, and he’s probably the smartest guy I know. One of the things about intelligence— I try to tell my kids this when I'm being a bit of a simpleton in their eyes—, it's one thing that intelligent people can understand complex issues and explain it to other people who are experts in the field, but the real intelligence is being able to take complex issues and break them down into terms that an average person who's maybe not in the financial business can do. And that's what's so special about what you do on this podcast every week. So when you're looking out and if you're thinking about this from an investment perspective— you're an investor—, where would you start in terms of what's going on here?

Well, when interest rates rise, you know there’s tightening financial conditions somewhere and you have a list of places that it might manifest itself. But you don't know exactly where or when that will manifest itself. So the notion of dealing with that type of an environment is to say, well, eventually that will start to bite a little bit, eventually that will be concerning to earnings. But the dynamics around how much and how fast, those are pretty hard to measure sometimes. In the case of these banks last week— there were three banks in the United States that went into FDIC, the Federal Deposit process— and each case was slightly different. A couple of them were crypto oriented. But in the case of Silicon Valley, which is the biggest one, their deposits had surged in reaction to what we've seen in the last twelve months, and they didn't make loans against those deposits, which is often the place that trouble arises. You make a bunch of loans, and we don't know if the credit is still good, so that becomes a concern. Most of the securities are government-backed securities. But what we've seen is, when you get a very rapid rise in interest rates, even short-term bonds can go down in value. And there were different regulatory constructs for different banks. What they call systematically important financial institutions, the SIFIs, they have a higher standard of regulation when it comes to some of these events. But nevertheless, you have these securities that are sitting on your balance sheet and in the fullness of time, they're money-good because, as I say, in most cases, they're the full faith and credit of the US government. But what's required to get to money-good is having deposits to keep financing that security portfolio along the way. Again, a global systematically important financial institution would have access to all sorts of deposits: wholesale funding, small accounts, small business, commercial accounts. On the menu of deposits, you name it, and they have it. Some smaller banks might be more dependent on just one cohort of those deposits. And in the case of Silicon Valley, it was highly dependent on venture-capital deposits. Say I raise money as a new startup, and I put it on deposit at Silicon Valley. If my business is not generating cash, I'm very sensitive right off the bat because I know I have no inflow. So at the first sign of trouble, I might take my deposits to a different institution. And many of my cohorts did the same thing on the same day, at the same time. Silicon Valley had some $160 billion of deposits, and I think they had requests for $40 billion last Thursday. That's something that's very hard to come up with on a dime, so to speak, if you're a bank. That has in turn led to the demise of Silicon Valley. In the United States’ banking system, you have, give or take, two and a half trillion of deposits. About a trillion of those are in smaller banks. And that's why you saw central banks on the weekend move very aggressively to shore up some of the things that will be available to those banks to create cash, should the need arise to protect the deposits. The Federal Reserve announced a facility where you can take those securities that are on your balance sheet and you can take them to the Federal Reserve and they'll give you $100 of cash in return for $100 of bonds, even if they have marked-to-market losses in them. So that goes a long way to taking care of depositors.

Let me just get in, because I want to define a couple of the things that you've said just for some of the listeners. So FDIC, for Canadians, would be somewhat equivalent to CDIC deposit insurance. So government deposit. Not exactly the same program; different minimums and things of that nature, but that would be the comparable. And then, could you give me an example of a SIFI in the United States? Are there any banks in Canada that are considered SIFIs?

JPMorgan would be the most classic example. In Canada, every bank, or the big six anyways, are what they call domestically significant; D-SIFIs. TD Bank and Royal Bank are G-SIFIs. But what the Canadian regulator did was, when TD and Royal became global SIFIs, they effectively made the same regulation for all six banks.

From a Canadian perspective, I just wanted to put on the table, this is very different. We have a small number of big banks in the US. There are some big banks, but there's also hundreds of smaller banks that are taking deposits. And that's a significant difference as we talk about this. Then the other thing is terms. Take for example in Canada, you buy a GIC at a bank. Say you deposit $1,000 for five years. There's an established interest rate. The $1,000 that comes in is paid out as $1,000 at the end of the term. The bank pays you interest. There's no fluctuation in value because you're holding it to maturity. Typically, when banks are doing what Silicon Valley Bank was doing, they would typically take that money and invest it and they would vouch that it's to maturity. So again, their billion dollars in is a billion dollars out. But that wasn't the case here, right? They were investing in some things that could fluctuate in value. And when they're marked-to-market, if you have to cash those in, that creates the issue.

100%. Say I had started off and I had $100 for a one-year bond, and it paid $4 of interest. If interest rates went to 5% the next day, what would you pay me for the 4% bond? I could put $100 and get 5%, or I can buy yours and get 4%. So I would pay you $99. And I would get an extra dollar of principal. So the two bonds equate. But if I have that one bond on my balance sheet, it's down by 1% until the 365 days pass. So many banks would operate with these security portfolios, and they would have a duration of maybe two or three years, something that would be quite reasonable in the context of matching the deposit franchise. In the case of some US banks, they bought mortgage-backed securities. And mortgage-backed securities work differently, particularly in the United States, because when you get a mortgage, you get the interest rate, and if it drops, you get to refinance. And if it goes up, you get to use that interest rate for 30 years. It's called convexity. What happens is when you own that mortgage-backed security and interest rates go above the rate that is embedded in, the duration of that security extends quickly and the value of the security drops by more than just the interest rate. It's not like they had all their security portfolio in this, but maybe they had a percentage of it, and that caused more alarm.

Exactly. And then I should clarify, when I said marked-to-market, that means it's valued at the market level at a particular point in time. If you were to sell it at this point in the market, here’s what it's worth. For example, another comparison is your house. You're living in your house. It has a value that you paid for, but until you sell it, that value is somewhat insignificant. But you could place a value or take a guess on what your house is valued at today. If you were, say, going to get a loan on that house, it would have to be valued that day. Maybe not the best explanation, which is why I should leave this more to you. But Stu, what is the implication for the broader market? We've seen a huge selloff or a huge flight to quality. Bond yields have come down dramatically from 2 to 30 years, and then obviously it increases a little bit of fear. Again, this is your whole concept that at some point, tighter monetary policy impacts the economy.

A couple of things. First off, with the interest rates dropping as aggressively as they have in the last three days, it does alleviate some of those negative marked-to-markets. So that is a minor positive in this. The second is that, in all likelihood, there'll be tougher regulation as banks start to see deposits move around the system. Notwithstanding the Federal Reserve's action that might protect deposits, I'm not sure it will stop some migration towards some of the stronger banks. That is bound to tighten financial conditions and those tightening financial conditions often lead to tougher time to get credit, higher cost of capital, and they can become impactful to earnings. And I think that's what the stock market is attempting to handicap or deal with. As you say, when you have marked-to-market, the stock market is going to come in and try and recalculate the odds of a variety of scenarios that might be in front of us. We had a soft-landing scenari; we had a harder-landing scenario— these ratios of earnings outlooks—, and that's what the stock market is trying to readjust or reorganize in the last couple of days, and we'll take it from there. In the short term, it is likely to be volatile. In the longer term, just as we were discussing before the call, this notion that when inflation peaks, twelve months later, interest rates peak. So inflation peaked end of last spring. Interest rates look like they're definitely in the final stages of the increase. We do have a big CPI number tomorrow, but what's going on in the banking system is likely to be taken into consideration. And then earnings often bottom twelve months after that. So there's this historical measure of how things play out, even though the stories that emerge at any given time are a little bit different. That's what we're focused on. So this does move the plot along, for sure. Bonds have had a very strong couple of days, and now we'll be just continuing to work on earnings and looking for some of those key vulnerabilities to make sure the portfolio is buttressed against that. But it's always hard to say which inning you're in. It's probably near the 7th inning stretch or something, I'm not sure.

Yeah, an important point for bond investors. A typical Canadian is about 55% invested in bonds, 45% invested in equities. It's quite likely your bond portfolio, or particularly the more conservative part of your bond portfolio, has done very well out of this because of the move in those government interest rates.

100%. And a couple of interesting points. First, yes, yields are down, so prices are up. The second thing is something we've talked a lot about: the slope of the yield curve, between twos and tens, has narrowed dramatically. Still negative, but it narrowed dramatically. And we'll see inflation tomorrow. But on the payroll data last week, the wage growth was a little bit better. I hate to say it, but better means that it was lower, in this case. You always like to see higher wages for people you know, but not higher wages generally for the economy, when you're an investor. So wages were a little bit lower, to the extent that inflation can continue to come down. What the slope of the yield curve would suggest is that the Fed can then begin to think about how high do interest rates need to go and could there be, in fact, an easing down the road. And what's going on in the banking system might accelerate some of that discussion.

Okay, so that’s a fantastic synopsis. But I just want to finish though, for folks of our age— 35 and older—, perhaps the most important memory they have of markets in an unusual economic circumstance is the global financial crisis back in 2007 to 2009, and the recession that carried through 2010. And the immediate question that people ask is, as they see a bank failure: has this the potential to become another global financial crisis? And if so, why? And if not, what's different this time?

Well, the main difference is that, in the financial crisis, leverage was higher. And the second thing is that we worried about the quality of the assets. The pricing of an asset is driven by your concerns over quality and then the discount rate you use to create the price. So the pressure here has been the discount rate. So rising interest rates has pressured the value of some securities. But just like we've seen in the last three days, that's like saying the Fed knows how to stop inflation and they know how to start the economy again with lower interest rates. Lower interest rates will ease some of the pain that is causing the current consternation around asset prices. So it's not a credit-quality issue. I have no doubt there'll be some loan losses, but there's not this vanishing credit that took place in the financial crisis. Not only were some of the mortgages under significant pressure, but they've been sliced and diced in manners that led some securities to be worthless in a very fast manner. This is more the impact of higher-interest rates taking its toll and that's a meaningful difference. And then, the amount of regulatory change since the financial crisis, particularly in those SIFI institutions, is quite significant.

Yeah, and I think it's also safe to say that regulation is working. Based on my recollection of 2007-2008, as these pressures were building in the financial system, regulators were somewhat unaware and were a bit slow to act. What we've seen over this weekend is that the regulator and the US government have stepped forward very dramatically to send a signal out to markets that they're going to support this and make sure that it doesn't spread across multiple financial institutions. And that in and of itself, I think, should make us feel a little bit better. They were watching so closely; they were there the minute it happened.

Yeah, that's a great point. From Friday at lunch, when they closed the Silicon Valley, to Sunday night, that's a pretty fast reaction on their front. I do think that most of the homework here in the next little while will be in the short term, just thinking through the way it could ricochet around the banking system. And then the second order effect is, what does it do to the economy and the earnings profile? And then the third impact is, is that priced-in enough? And then we'll go from there.

Okay, well, let's leave it at that. Stu, thanks again for your time this morning. I know we pulled this together very quickly, and I know how busy you are, again, particularly in light of this. So thanks as always for your time, Stu.

Great. Thanks very much, Dave.