May 2023 update - Banking contagion spreads

The banking drama somehow only worsened this week in the US. After several weeks of customers withdrawing their deposits and its stock price tumbling despite a cash infusion from other major banks, First Republic Bank was seized by regulators, topping Silicon Valley Bank as the 2nd largest bank failure in US history. With First Republic being sold off to JPMorgan Chase, it was hoped this would be a turning point in the crisis. Instead, the markets worried that PacWest Bancorp and Western Alliance Bancorp were the next weakest links and their share prices plunged. PacWest went from just above $10 to start the week to a low of $2.50 by May 4th (and down over 85% since the start of the year), while Western Alliance went from just above $37 to below $12 in the same timeframe. The sentiment affected other bank stocks as well: Toronto-Dominion and First Horizon had to cancel their merger agreement as the latter’s stock valuation melted. The SPDR S&P Regional Banking ETF dropped almost 20% from the start of the week, and the broader stock market was dragged down as well. On Friday, stocks rebounded: PacWest jumped to $5.76 and Western Alliance to $27.16. The S&P 500 was up almost 2% for the day. But this episode shows that uncertainty is higher than ever in the stock market, especially for banks.

This leaves a negative picture for the economy and risky assets. The Federal Reserve raised rates again by 25 basis points on May 3rd and doesn’t seem to contemplate lowering them, unlike what some market commentators think or hope for. Inflation remains stubbornly high at 5% in the US and unemployment dipped down to 3.4%, a new record low. To bring inflation back down towards 2%, the Fed will have to at least maintain current rates, if not raise them further. But the US Conference Board organization sees a higher chance of recession, its Leading Economic Indicators index falling at a faster pace in March and consistent with a contraction before the end of the year. With these in mind and despite the market rally so far this year, safety remains the course of action. There is one change worth making to portfolios. With bond and cash yields in the 4-5% range, gold looks relatively unattractive since it yields nothing but is more volatile. So, it makes more sense to be in bonds as a recession looms. It is reflected in the recommended portfolios below, selling out of gold and splitting the balance into bond funds.

Sample portfolio for a Canadian investor

Asset class	ETF ticker	Weight
Canadian stocks	VCN	2.25%
US stocks	VUN	11.25%
Foreign stocks	VIU	9.00%
US corporate bonds	ZSU	0.00%
Canadian corporate bonds	XSH	0.00%
Global high yield bonds	MHYB	0.00%
Emerging markets bonds	ZEF	0.00%
Global real estate	TGRE	2.50%
Canadian mortgage-backed bonds	ZMBS	37.50%
Canadian government bonds	CLF	18.75%
Global government bonds	XGGB	18.75%
Gold	KILO	0.00%

Sample portfolio for a US investor

Asset class	ETF ticker	Weight
US stocks	SCHX	11.25%
Non-US stocks	SCHF	11.25%
US corporate bonds	SPIB	0.00%
Non-US corporate bonds	PICB	0.00%
US high yield bonds	SPHY	0.00%
Non-US high yield bonds	IHY	0.00%
Emerging markets bonds	VWOB	0.00%
Global real estate	REET	2.50%
US mortgage-backed bonds	MBB	37.50%
US government bonds	VGSH	18.75%
Non-US government bonds	BWZ	18.75%
Gold	GLDM	0.00%