Equities

• For Canadian banks, deposit growth has been slowing and deposit costs are on the rise, but the dynamic in Canada is a lot different with a significantly slower pace of slowdown.
• The asset-liability mismatch we have seen at US regional banks is not a risk to Canadian banks as they actively hedge off these types of interest rate risk.
• Additionally, the concentration of the Canadian banking system reduces the risk of deposit flight in these periods of stress.
• We believe that even the best banks will remain under pressure in the near-term but that the risk of a SVB and Signature Bank situation in Canada is very remote at this point.

• For the time being, we believe the issues are contained to within US regional banks. We remain cautious given that we are in the early innings of these events and are continuing to analyze implications.
• On the U.S. Federal Reserve’s (“Fed”) Bank Term Funding Program (BTFP) specifically, it is relatively expensive funding for regional banks (>5.25% compared to the average securities yield in their portfolios of 2.6%) and we believe it is meant to act more as a signal that liquidity is available to banks that are in trouble but is not a backstop/bailout.
• We believe regional banks, especially ones with relatively concentrated deposit bases who have benefited over the past few years from large deposit inflows, are in a tough spot as profitability issues compound with deposits leaving the system.
• The recent events have shown how some of these regional banks reached for yield in their securities books to drive earnings growth in a period of low rates (short term gains) – a behaviour that is proving to be a major risk management flaw and likely leads to significant regulation down the line.
• The larger global systemically-important banks (GSIBs), although not immune to elevated recession risks, are largely beneficiaries of this current backdrop as depositors (both consumer and commercial lenders) look for safety and soundness in banks – this likely further concentrates the banking system in the US towards the large systemically-important institutions.

• Views have not changed materially at the margin. As a refresher, our comments in our last market outlook were as follows as they relate to financials and the market at large:
  • “Throughout the year, the markets continued to price in increased odds that central banks will not be able to manufacture a soft landing in their attempt to curb inflationary pressures. Credit-sensitive financial stocks felt the brunt of this, validating our more defensive positioning in the sector. We continue to remain cautious on the bank group, as yield curves remain deeply inverted, net interest margins are nearing peak levels, loan growth is moderating, deposit outflows are accelerating, credit losses are at trough levels and migrating higher, and capital levels remain relatively thin, something with which regulators on both sides of the border increasingly seem to be taking issue.”

Fixed Income

Philip Mesman, CFA | Sam Acton, CFA

• It is important to recognize how rare this event is – a single-A rated credit defaulted with the SVB sub notes now trading at ~5 cents on the dollar.
• The most direct impact is to the US regional banks where spreads are gapping out, while the larger US and Canadian banks are also wider, but prices are relatively unchanged given the government bond rally.
• Broad credit markets are seeing spread widening with HY (high yield) spreads +100bps and IG (investment grade) spreads +30bps in a week – however all-in yields are flat to slightly down as government yields have decreased. Trading volumes are fairly muted outside of the regional banks. 
• Fed expectations are moving rapidly – last week terminal rate was priced at 5.7% in September and now seeing 4.8% peak in May – we think this puts the Fed in a difficult position as they now have to balance fighting inflation with financial stability concerns – continued hikes would likely pressure markets however pausing on hikes could revive inflation fears.
• Extreme moves in government bonds with US 2yr Yield declining 106 bps in 3 days and Canada 10yr Yield dropping 73 bps since recent highs.

• At this time, we don’t see the SVB event as being a systemic risk, however credit valuations are not cheap historically and we think the Fed is in an incredibly awkward position heading into the March 22^nd FOMC meeting.
• We see the potential for further spread widening and could see the market re-test last years’ wides (i.e., another +90 bps for HY and +20 bps for IG).
• Our positioning in financials is focused on investment grade names including the big six Canadian banks as well as select legacy issues in the UK with regulatory catalysts (LIBOR cessation and Basel III capital treatment). On the short side, we are focused on higher beta European contingent convertible bonds (CoCos) and subordinated debt. We have no exposure to regional banks.
• Our portfolio hedges include a significant position in put options on credit ETFs.
• We are positioned with dry powder to take advantage of potential dislocations and would be looking to buy high quality BB issuers as yields approach 9-10%.

Merger Arbitrage

• March has come in like a lion! TD Bank trying to buy the regional bank First Horizon Bank (FHN) in the middle of a banking crisis is tough timing!
• We witnessed a bit of mini arb-ageddon to start the week as there was mass risk-reduction across most arbitrage names. Other than FHN most names are now orderly but just about everything is a bit softer as some arb books have been forced to reduce risk. Unfortunately, this shock to the system has come after a period of protracted weakness from the pain of many arb situations going pear-shaped recently: Euronav NV was a blow-up to start the year; Rogers-Shaw merger delayed by ISED (Innovation, Science and Economic Development) minister even after winning at the Tribunal and Court of Appeals; Horizon Therapeutics PLC sold off after drawing a surprise second request; Activision Blizzard Inc (ATVI) got hung up with all three major regulators; ATVI had knock-on effects for VMware Inc; Tegna Inc. ran into trouble with the Federal Communications Commission (FCC) approval; Tower Semiconductor Ltd. continues to be delayed by China and chips; Richie Bros’ acquisition of IAA Inc. had a contentious vote that led to wild trading; Black Knight Inc. was sued by the Federal Trade Commission (FTC) to block their deal; and First Horizon was affected by regulatory delay - and that was all before the regional bank crisis.
• The bright side of all this havoc is that our exposures are relatively small right now. These reduced exposures are due to the challenging environment which hasn’t provided a very attractive opportunity set that exceeds our risk/reward threshold. Additionally, SPACs have been unaffected which has helped. It’s times like these where the two components and return drivers used in our merger arbitrage strategy particularly help.
• This certainly isn’t the start to the year that we had hoped for, but we always like to be as transparent as possible about the current environment. Moving forward, hopefully this set up will lead to capital leaving the space and an improvement in spread pricing for us to take advantage of.

Multi-Asset Strategies

• The SVB episode is the first sign of potential systemic risk caused by the current Central Bank tightening cycle. Up to this point, the result of the tightening was the unwind of the crypto/unprofitable tech/SPAC bubble. This unwind had been contained to systemically unimportant parts of the financial system. In terms of follow-on systemic risk, regulators followed the GFC (global financial crisis) playbook and over the weekend resolved the SVB situation (ensuring all depositors whole) and instituted new programs to try to stop contagion. It isn’t clear if the contagion has been stopped at this point. In addition, it isn’t clear if the inflation fighting resolve of Central Banks will be sidelined due to the emergence of systemic risks. We believe these are the go forward risks to financial markets. 
• Our portfolios can be broadly classified into two groups, those without market exposure, Absolute Alpha Strategy, and those with market exposure, Multi-Asset Strategies. 
• The portfolios without market exposure, our Absolute Alpha Strategy, have been well behaved showing very little sensitivity to either stock or bond markets. These portfolios have provided uncorrelated and positive returns through this episode. The modest exposure to tail-risk hedges has helped add to positive performance and this event provides ongoing evidence for why we use them in the first place. Other than trimming our tail risk hedges, we don’t envision changing our portfolio allocations due to this episode as these portfolios have been relatively unaffected and have performed well. 
• The portfolios with market exposure, Multi-Asset Strategies,  are more sensitive to asset class dynamics.
• The largest relative asset class moves through the current episode have been in Government Bond markets due to the dramatic decline in yields. The government bond allocations in both the Multi-Asset Strategies portfolios have helped performance. In addition, the diversified exposure across a variety of asset classes and strategies have helped the portfolios. As a result of the current episode, we have trimmed our tail risk hedges, sold some market hedges. Going forward, we have added hedges to protect the portfolio in the instance of a reversal in government bond yields.  We will maintain our existing weight to uncorrelated strategies.