First Republic is Gone. Now What?

Weekly Commentary

Market Recap

• U.S. equities ended April with nice gains as a number of big-tech names reported better-than-expected earnings.
• That lifted sentiment despite slowing economic growth and high inflation.
• The Dow and the S&P 500 gained 0.9% this week, while the Nasdaq was the big winner, jumping 1.3%. Meantime, the TSX finished 0.3% lower.

First Republic Bank

This morning, news broke that First Republic Bank had collapsed and been seized by the FDIC. Shortly thereafter, most of First Republic’s assets were sold to JPMorgan in a $10.6 billion deal that ensures the safety of customers’ deposits. As the third failure of a U.S. bank in the last two months, these developments have prompted concerns about broader risks to the banking sector. Despite the eye-popping headlines, we don’t see the risks as being particularly severe at this stage. This is a different scenario than Silicon Valley Bank (SVB). With SVB, the government realized that they needed to react swiftly or else risk contagion to other companies and sectors. Now, the first wave has already passed; we’ve already seen money move out of the regionals and into some of the bigger banks. But alongside those massive outflows, we’ve also seen some stabilization, and even inflows starting to come back in to other regionals. As a result, this appears to have been a company-specific crisis rather than a broader issue. If there is one surprise, it’s that we didn’t see a deal sooner. But that situation is now resolved, and at the moment, it doesn’t appear that there have been any significant negative knock-on effects: trading following the sale showed no signs of a sell-off of other regional banks, and JPMorgan’s stock was actually up. From a Canadian standpoint, we believe that the Big Six banks are undervalued—they were hit with some of the negativity that afflicted their U.S. counterparts, but in our view, it wasn’t really justified.

Bottom Line: The risk of contagion stemming from the First Republic collapse is likely to be low.

Earnings

We’re now deeper into earnings season, and so far, this quarter’s results have been mixed. Our belief that Quality companies would outperform is bearing out—Google, Microsoft, and Meta have all reported strong results. Some companies have benefited from themes like AI, while other have benefitted from cost containment. But in general, it’s Quality companies with strong balance sheets that are doing well. Meta is an excellent example of a successful pivot—the company is in much better shape now than it was six months ago. That’s a good sign, but it’s also company-specific, and therefore not necessarily representative of a broader theme across other companies. The day before Meta announced, Google and Microsoft reported good news, and one might have expected positive results from those two heavyweights to lift the broad market. But that didn’t happen—Nasdaq was up a bit, but not as much as it had been earlier in the day, and the S&P 500 was actually down. However, when Meta reported the next day, the markets really took off and continued that momentum the following day. There is no doubt that the bar for earnings was low, but despite that, earnings beats are getting rewarded quite well. The question is: will earnings be sufficient to push the market to new highs? For now, with still some uncertain macro conditions ahead, we think the answer is no.

Bottom Line: Going forward, we expect earnings to continue to be a mixed story, where quality companies continue to outperform .

Bonds

With interest rate expectations seemingly bouncing around from month to month, what does the outlook for the bond market look like? At this point, our expectation is that the U.S. Federal Reserve will raise interest rates by 25 bps at their next meeting. We also believe that the Fed remains data dependent—they want to see where inflation goes and will react accordingly. We wouldn’t be surprised if this 25 bps hike is the final increase before a pause, but we also wouldn’t be shocked if another 25 bps comes through later on. Anything beyond that, though, would be surprising, and would probably only be precipitated by a spike in inflation. In this environment, with the economy gradually weakening, bonds remain attractive. They are providing good yields, and are once again providing diversification as well, which they didn’t do last year. Investment Grade credit tends to do well in a recession, especially relative to High Yield bonds, which excel coming out of recessionary periods but don’t do as well during the downturns themselves. Similar to our view on equities, Quality is the deciding factor: like dividends, bond yields can earn investors 4-5% just for sitting there and doing nothing, on top of downside protection and upside potential.

Bottom Line: In bonds as in equities, Quality is king.

Positioning

During a recession, we continue to believe in company-specific stories. But once we’re closer to a recovery, we would look more at Technology, as results are starting to come around after it was one of the first sectors to go through an earnings decline. Small-cap stocks are another interesting area. With credit a bit tight, there are certainly negatives, but there is upside potential as well. Regionally, the U.S. tends to do well coming out of a recession, and the Canadian dollar should also appreciate. Those are some of the potential developments that we’ll be watching for. Until then, we’re playing it safe: taking covered positions to generate additional income, staying range-bound, and potentially taking off some profits if we see run-ups in markets (like we did with our very profitable energy trade), since we still expect the economy to weaken. Going forward, the bigger priority will be monitoring the economy and markets, seeing if things are proceeding as expected, and adjusting as necessary.

Originally Posted May 2, 2023 – First Republic is Gone. Now What?

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