Risk management is something we do consciously and subconsciously every day. From wearing a seatbelt to having adequate insurance, we are protecting ourselves and our loved ones from adverse consequences arising from bad things happening. It’s not that these measures eliminate the risk of these events occurring – just that we minimize the effects. The saying that I used for the title came from hundreds of years ago, when ship captains would order the crew to close the hatches, secure them and lock them in place by placing long battens across them. The battens didn’t prevent a storm from happening, but they helped to limit the water entering the vessel and minimized loss of life.

 

In the financial world, we employ a variety of risk management measures and tools to protect our objectives from economic and financial dangers. To do so requires a combination of strategy and tactical adjustments to manage risks, both visible and unknown.

 

Visible risks would include inflation, fiscal and monetary policy changes, and recession. We don’t know exactly how these will manifest, but they don’t come out of left field. On Tuesday, Federal Reserve chair Powell gave both bond and equity markets a dose of reality check when he testified to the Senate Committee on Banking, Housing and Urban Affairs that rates might have to go to an even higher level than previously thought, given recent economic signals. Bond yields spiked by almost a quarter of a percent at the front end of the curve, and stocks fell sharply in sympathy. Things calmed down a bit on Wednesday when Powell softened his tone in front of the House Committee on Financial Services, stating that the Fed did not want to force a recession. Still, this was a good example of how volatility can arise from an issue that has been known for quite some time.

The unknown risks, or black swan events, will include things like company failures and geopolitical shocks. Russia’s invasion of Ukraine last year certainly fits into this category, but so would this week’s news of one US bank having to shut down and another close to the brink of insolvency. Silvergate Capital Corp., a bank holding company that focuses on crypto clients, has seen its deposits dry up to the extent that it could not continue its lending operations. The stock, which had traded close to $200/share back in 2021, fell to below $3 on Thursday.

 

 

SVB Financial Group (the holding company for Silicon Valley Bank) also saw its shares plunge this week as investors feared it would become insolvent as deposits headed for the exit door. Indeed, several very large venture capital firms advised their partners to pull their deposits in case the bank and holding company went belly-up. SVB specializes mainly in tech start-ups that are backed by venture capital firms. As we know, the rapid pace of rate hikes in 2022 helped contribute to a downturn in the tech sector and as valuations declined, venture capital firms needed to draw down cash reserves held at banks like SVB.

 

This week, SVB proposed issuance of stock and convertible preferred shares to the tune of about $2.2 billion and this was seen by investors and depositors as a Hail Mary pass. To be clear, this stock has been a dud since the end of 2021, losing close to 75% by early December. It even had a bit of a rebound in January thanks to the delusional bullish mentality around no more rate hikes and possible rate cuts this year. Well, as the stock hit $100 on Thursday it had again dropped more than 70% from its peak at the start of February. Come Friday morning, there was a trading halt as it turned out that fundraising efforts had failed and the company was looking at putting itself up for sale.

 

While SVB is not a large bank, nor is it widely held by investors, there was a contagion effect that caused other banks to drop as well. On Monday, the S&P bank sub-index was trading north of 350. By Thursday afternoon, it had slid to almost 310 – a decline of 12% in just four days. Even the TSX bank group lost close to 4% from its peak on Monday and there was no talk of any banks in Canada running in problems – far from it. 

 

What we have here is confluence of visible and unknown risk. We see the Federal Reserve’s intent on wrestling inflation to the ground through higher interest rates and we know that this is creating strains in the banking system. Where it was possible to raise borrowing rates early in the tightening cycle, without commensurate increases in the rates offered on deposits, banks now have to compete more aggressively for deposits and that eats into their margins. Larger banks will be more able to raise capital than smaller ones, but that doesn’t mean their valuations still won’t suffer. And as the economy slows and potentially contracts, loan demand will erode and the ability to raise borrowing rates versus deposit rates will decline.

 

So, how should investors be managing for this risk, as well as others? Over the past two quarters, Ally and I have implemented a few strategies. First, boost cash positions. When you are getting paid close to 4% on high interest savings accounts (HISAs), running with close to 10% into this year made sense. It’s not only a buffer against volatility, but it provides liquidity for when it’s time to re-enter the market.  Second, boost income. Using covered call strategies, looking for higher dividend yielding stocks, and switching out of companies which have done well, but don’t pay close to where prevailing bond yields are, can enhance return in a flat or correcting market. Third, lower the overall risk of the portfolio by allocating more capital to government bonds which have suffered sharp losses as a result of central bank tightening.

 

I have been saying for a while that stocks are going to experience another down leg before we can say the bear market is over and that we may have to go back and re-test the lows from October. Those levels priced in a recession that was about to start in the first half of this year. That wasn’t about to happen, which explains why stocks recovered; but we now are watching stocks repricing for a weaker economic environment beyond this quarter. How much repricing depends on how many more bank problems we encounter in the coming weeks and months, what direction the economic reports take and what the Federal Reserve does at its next meeting this month.

 

“Batten down the hatches” may be construed as selling out of the market and hiding in a cave with some cozy GIC blankets. And, for those with zero risk tolerance, those blankets probably represent the most suitable strategy. Unfortunately, they don’t allow for capital re-growth. Fully investing in undervalued bonds can provide that , in addition to deploying cash into the stocks of companies that are trading low relative to the market and have solid balance sheets and relatively high free cash flow yields. We don’t know what is going to happen tomorrow, let alone next month or next year, but we can manage the risks from those uncertain outcomes such that we don’t end up too far from our intended course.

 

On behalf of the Pyle Group, have a wonderful weekend.   

Andrew Pyle

 

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These are the personal opinions of Andrew Pyle and the Pyle Group and may not necessarily reflect those of CIBC World Markets Inc.