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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%



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