On the Money with Dynamic Funds

PARTICIPANTS

Tom Dicker
Vice President & Portfolio Manager

Nick Stogdill
Portfolio Manager

 

Mark Brisley: You're listening to On the Money with Dynamic Funds, the podcast series that delivers access, insights, and perspective from some of the industry's most respected active managers and thought leaders. From market commentaries and economic analysis to personal finance, investing, and beyond, On the Money covers it all because when it comes to your money, we're on it.

Tom Dicker: Welcome to another edition of On the Money. I'm your host, Tom Dicker, and I'm here with Nick Stogdill, our lead portfolio manager of the Dynamic Financial Services Fund and co-manager of the Dynamic Alternative Yield Fund, as well as a few others. Nick started his career out as an accountant, and then started covering financial services in 2010 before joining Dynamic in 2017 and recently became a portfolio manager with us. Our listeners will recall that Nick and I sat down back in March in the depths of what was the U.S. regional banking crisis, or we might even call it a mini-crisis now, to get his thoughts on what was happening.

We dug into the particulars on Silicon Valley Bank and Signature Bank and everything that was going on at that time. We wanted to revisit the financial services sector as a whole and give an update on where we are headed now. Nick, could we quickly recap what happened in March of this year, maybe starting with Silicon Valley Bank? What happened?

Nick Stogdill: Sure. At the highest level, what we were seeing in March was simply the result of tightening monetary policy, central banks were starting to raise rates, and you had a few U.S. regional banks that had problems in this backdrop. I would argue they had idiosyncratic issues and unique business models, but the core of the issue was that these banks took customer deposits. They can be withdrawn relatively easy. The banks took those deposits, invested them in longer-dated bonds. When rates went up, that caused the value of these bonds to go down. That created unrealized losses for these banks. At that same time, clients started needing these deposits back.

They started pulling money. That meant these banks had to sell these bonds at losses and trigger these losses, and that in turn, spooked the market, spooked investors, it spooked depositors, and it morphed into your classic run on the bank scenario. Then depositors just started running en masse, pulling their deposits and withdrawing funds, particularly from those banks you mentioned, Silicon Valley Bank and Signature Bank.

Tom: Like every crisis, it ended. What led to the end of the crisis and how did you know when it was over?

Nick: I don't want to say everything is over and we're back to full normalcy here in the U.S. banking market. I think there's a lot of U.S. banks still facing challenges today because certain parts of the economy are struggling under high rates. As you would know, commercial real estate, office properties, there's still pain being felt. That could pose a problem down the road for smaller banks that have monoline business models that only do lending to mid-market real estate borrowers. We're not fully out of the woods yet.

In terms of the initial wave of failures, I think once we saw governments and the regulators step in and act swiftly to provide liquidity to these other banks, we felt that would contain a lot of the fears about future failures. That part of the crisis was probably resolved within a few months. Again, I don't think we're fully out of the woods and we're still going down the path of tightening monetary policy from these high rates and we're still seeing the effects on the banking system and the broader economy.

Tom: How important was JP Morgan stepping in to buy First Republic and putting a bottom under the crisis?

Nick: That was also a pretty pivotal moment in this initial wave of failures because First Republic was a very large bank, top 10, top 20 bank in the US, and without JP Morgan stepping in, you didn't know how it was going to unfold. There was a lot of loans to be absorbed. JP Morgan stepping in and taking over this bank and putting all those loans on its balance sheet did give a lot of comfort to the market that we were getting through the initial panic and initial wave of failures. It was critical.

Tom: Was it good for JP Morgan?

Nick: It was fantastic for JP Morgan. First Republic had a unique business model. They banked a lot of millionaires, high net-worth people, a lot of people with high incomes and high growth potential. It was a really coveted customer base, if you will. JP Morgan was able to step in and basically buy this bank for cents on the dollar. A lot of clients banked with First Republic because it had a high-touch model, a good service-oriented model. Some of that may fall away under JP Morgan, but a lot of these customers may stay with them. That's really only upside for JP Morgan if they acquired all these customers, and the ones that stick with them, will drive a lot of future revenue growth and profitability growth for them.

Tom: Why were they able to do it and why were they able to get such an attractive deal?

Nick: Size. That's the main reason why JP Morgan was able to buy them. When you look at the asset base and the deposit base of First Republic, there were very few banks with enough capital and liquidity and size to step in. Really, JP Morgan was probably almost the bank of last resort. There were not really many people that could step in and acquire a loan book of that size in one fell swoop.

Tom: It sounds like banking is, like a lot of other sectors, where the big just continue to get bigger. What were the other key lessons you learned about banks during this crisis?

Nick: I think more broadly, one of the things I learned, and we learned through this is just that real material risks are hard to predict and that they surface in unexpected ways. I say this because no one was talking about deposits running out of the banking system on mass before this happened. No talking heads, analysts, bank executives were talking about mass deposit outflows. That was something that was unexpected. On the same side of the coin, regulators for the last 10 or 15 years have been doing stress tests on banks. They never stress for an environment of rising rates and what impact that would have.

In hindsight, stressing banks for a higher rate environment seems logical, but it wasn't being done. You can be sure that will be done in the future. Again, it's just really hard to predict real material risks and no one saw these things coming no matter how much you could have prepared and tried, you just didn't see it.

Tom: Do you think that was just a case of the generals fighting the last war, that regulators were more worried about write-downs in real estate or write-downs in the commercial loan book or consumer loans and they weren't worried about the effects of rising rates?

Nick: I think that's an accurate statement. If you can predict a risk, is it really a risk? I think that's the challenge we all face in investing is you can't predict real risks. That's why I'm saying that's one of the lessons from this crisis is things will always come out of left field and hit you in the back of the head.

Tom: Yes, that's what Oscar Belaiche, the co-head of our team always says is bad news does not hit you between the eyes, it always hits you in the back of the head, and this is another case of that happening. How did the lessons that you learned during this mini crisis, how did it affect your positioning in the Dynamic Financial Services Fund?

Nick: The Dynamic Financial Services Fund is already quite diversified. I think partly what this crisis showed is that diversification is important. Look, we owned a number of U.S. banks in the fund. Those stocks went down, but we also had other businesses that did quite well. If we were running a U.S. bank fund, we would have had a lot of challenges and a lot of problems. How has it affected our positioning in the last three to six months since the crisis? At the margin, we've actually been increasing our U.S. bank exposure very modestly.

What we've also learned is it's better to stick with more resilient banks that have diversified business models that do retail banking and commercial banking and wealth management and investment banking. If you're a monoline bank that only does lending and you're concentrated in one asset class, that can create a lot of risk. Again, it really emphasized, not only the importance of diversification in a fund, but importance of a diversification in a business model, particularly a bank which can have these systemic risks.

Tom: Did you undertake any particular portfolio changes as a result of everything that took place in March and April of this year? Did any opportunities present themselves?

Nick: Yes. Again, at the margin, I think we took the opportunity to high-grade the portfolio and increase our bank exposure in some of the larger money center banks, the Bank of Americas of the world, the Wells Fargos of the world. You realized going into the, again, the monoline, smaller regional banks is probably a riskier place to be and you can probably get comparable returns by being in a bigger, more diversified bank than going into the smaller banks. Those have more torque, but the risk-reward is probably less favorable in the smaller regionals versus the big money center banks that still offer pretty compelling upside on the other side of a recovery.

Tom: How did Canadian banks do during this whole episode?

Nick: Actually, they did quite well. The Canadian banks only declined by about 5% or 6%. If you look at the regional bank index, they were down 30% to 35%. The broader U.S. banking index, which has some of the bigger banks, that was down a little over 20%. Canadian banks actually did quite well. Why is that? A couple of reasons. Market structure in the U.S. is very different than Canada. Again, they've got thousands of banks, so when you're worried about money leaving banks and flowing from one place to another or deposits being pulled, you don't know where it can go. In Canada, we have really five or six banks with 80% market share, so the money only had so many places to go, so that was less of a risk.

Secondly, again, our banks run diversified models, as I mentioned, with wealth, investment banking, commercial retail banking, international banking. Then I would go back to we just have a superior regulatory model, which is partly due to the fact that our market is more consolidated. It was much easier when this crisis unfolded for our banks to get together with our regulator and our central bank and our government and really look into the banking system and see, do we have any problems? Do we see anything bubbling up? They could get together quickly and try and pin that down.

That's not possible in the U.S. when you have 3,000 or 4,000 banks. There's too many cooks in the kitchen, there's too much oversight, it's too dispersed, and it was too challenging for them to do that in as quick a manner.

Tom: Were the Canadian banks on the phone with the regulator every day during this crisis? Was it at least that big of a deal here for them to do that?

Nick: I can't say with certainty that's the case, but my experience covering the sector for a decade plus tells me that they would have been in close communication with the regulator, with the central bank, with the government, and collectively all the banks together. That's typically what happens in times of crisis.

Tom: What is the regulator focusing on when they're talking to the banks on a day-to-day basis in a crisis?

Nick: I would think in this case, a lot of the Canadian banks have U.S. operations. I'm sure they were drilling down into their operations and asking for shorter term trends, "What are you seeing in the business models? Do you have this mismatch of assets and liabilities?" They're looking at all those kinds of things that were causing the same problems with those U.S. regionals. Again, this is a bit of a nuance, but in the large U.S. banks and the large Canadian banks, when you have unrealized losses on certain parts of your bond portfolios, you take that into your capital. Even though you don't realize a loss, you say, well, I'll put it in my capital anyways.

These smaller regional banks didn't have to do that and that was a big problem. That rule is going to change going forward out of the regulations and the regulatory reviews that are happening. Already these bigger banks like the Canadian banks, like the JP Morgans, they were already taking some of these unrealized losses into their capital.

Tom: Could we talk a little bit about that, the changes in the regulatory environment in the U.S. that were announced in July of this year? It seemed like the U.S. banks reacted in a relatively benign way to them. The stocks at least did, but certainly, we've heard since then from some of the CEOs that they're quite negative on some of these changes. Could you talk a little bit about what those changes are and how they could affect the U.S. banking system?

Nick: I think what's going to happen is basically U.S. banks are going to have to hold more capital for the same business they were already doing. In some places, it may make sense, and some places, it doesn't make sense. Depends on who you ask, but at the end of the day, capital requirements are going to go up. For every dollar of loan that a U.S. bank makes, they're going to have to hold more capital and more liquidity. That's going to hurt profitability. It means U.S. banks are probably going to exit some businesses and you're going to have more things move out of the banking market into the non-bank channel and be done by non-bank financial companies.

It's hard to say what will unfold. I think it's going to take several years to get the final proposals and final rules implemented. There's a long lead time between the comment period that's underway today on the rule changes and when they actually get implemented and a lot will evolve and change. The immediate impact we're seeing is that U.S. banks are already hoarding capital. They're already looking to turn off buybacks for the most part. Again, keep capital to build the ratio stronger in preparation for whatever changes may come.

Tom: As I recall reading, they have until 2028 to actually implement the rules as they've been proposed right now. Of course, that could get extended out even further, presumably. Does it matter whether or not there's a Democrat or a Republican in the White House as to whether or not this rule changes?

Nick: Yes, the head of some of the major banking agencies are appointed by the government, so having a Republican in the White House could be more favorable for the U.S. banks than a Democrat. If we go back to the Trump administration under the Republicans, the regulator was a little more lenient and allowed some of these banks to not have to adopt certain rules. That actually was a direct benefit to regional banks pre-COVID in the ‘16 to ‘19 era. A lot of them didn't have to incorporate unrealized losses on their bond portfolios into capital.

Again, that was a direct reflection of regulation at the time under the Republican Party. Depending on who is elected in the next election, that very well could change and rules could become tighter or looser depending who gets in the White House.

Tom: How about we turn and talk a little bit more about the Canadian banks? They did do fairly well during and immediately after the U.S. regional banking crisis, but they performed fairly poorly since then. At least the stocks have. Can we talk a little bit about why that is?

Nick: The simple answer is recession. If you look at Canadian bank stocks, they historically have only declined by 10 percent or more in a calendar year during recessions. That was the case in 1981, 1990, 2007, 2008. Now sitting here in 2022 and 2023, we've had declines of I think about 13% last year and 12% year to date. While the economic data isn't telling us we're in a recession in Canada, the bank stocks are. That's the simple answer on what they're pricing in.

Tom: Who do you believe, the data or the bank stocks?

Nick: The bank stocks.

Tom: If you think we're in a recession, what do you think that means for the next few quarters for Canadian bank earnings? I know that that's obviously really tough to predict, but how do you think about how it should go for the next little while? Should loan losses start to come up? What are you modeling in now?

Nick: When I look at the Canadian banks, I don't think the market is pricing in enough loan losses yet. I think we're getting there. You're just trying to look at the probabilities of how bad is the recession? Is it going to be really bad like the early '90s? Is it going to be mild? No one really knows. When I look at where loan loss estimates are for Canadian banks today in 2024 and 2025, I think they either need to go higher or you need to at least assume that they're a bit higher. That's the point where stocks will become attractive once they start to price in something a little more severe. To give you some context, average loan losses for Canadian banks are 30 basis points.

That means you take the loan book and 30 basis points of that is your typical loan loss on average. I think the market's pricing in 40 to 45 basis points of losses next year, but again, if you go back to the early '90s, losses got as high as 190 basis points. I'm not saying we're going all the way there, but I think something more than 40 would make sense for the group. If we start to price in something in the 50, 60, 70 basis point range, the stocks will look more compelling, and they could become better point of entry then.

Tom: Are you underweight the Canadian banks in your portfolio relative to your benchmark?

Nick: Yes. We're always probably going to be structurally underweight because Canadian banks are such a big part of the Canadian financials index, but we are more underweight Canadian banks than we have been in some time. We're really looking to get a bit more visibility on the credit cycle before we look to increase that weight. We've also been more selective in the banks we do own, and we think this is a better environment where you can actually pick within the banks and generate incremental alpha because I don't think all banks are equal in a more challenging environment.

Tom: What do you think is causing the recession right now?

Nick: In Canada, our consumers are running a quite high amounts of leverage, particularly with mortgage debt and higher interest rates are causing a lot of consumers to start to feel pain.

Tom: You're seeing that pain result in a pullback in consumer spending?

Nick: Correct.

Tom: Are consumers generally able to service their debt so far in Canada? Do the risks building or plateauing?

Nick: It's a tough question to answer. I think the key to all of this is employment and what happens with the jobs market because as long as people have jobs, they'll find ways to make payments. the first step is just cutting out unnecessary expenditures, reducing discretionary spending, and adjusting to higher interest rates. It'll take some time. There might be a bit of pain along the way, but I think you can make the case that Canadian consumers are resilient, and they'll find ways to pay their bills. At the end of the day, the most important part of all that is the employment and the job market.

Tom: Employment's been strong, but rates have been high. Those are two push-pull factors on the housing market. Housing's obviously super important for banks in terms of loan volumes, in terms of collateral that they have. How do you think about the Canadian housing market?

Nick: I'm generally less worried about the Canadian housing market. This has been a huge focal point for over a decade. The banks are constantly stress testing that, looking at the loan to values, looking at income ratios. Regulations around mortgage lending have been tightened for over a decade as well. We're always constantly tweaking and tightening at the margin. Truthfully, where you'll see more problems emerge first is in things like credit cards and auto loans and unsecured personal loans that people have taken out. I'm not overly worried about housing at this point.

I think there are some fundamental tailwinds for housing, particularly the supply-demand imbalance, so I would expect to see more challenges in other parts of the consumer loan book for the banks first before we see problems in housing.

Tom: If you're underweight U.S. banks, especially regionals, and you've reduced a bit at the margin some of the Canadian banks, obviously there are other areas outside of banks in financial services that you can own. Can we talk a little bit about some of the things that you own, be they things that are maybe a little less rate sensitive or less economically sensitive that you think are interesting in financial services, things like alternatives and payments, stuff like that?

Nick: This is a key value proposition of the fund and that we can own other financial businesses outside of Canadian banks. We talked to a lot of Canadian investors. They tend to be, again, overweight Canadian financial ETFs, which are very heavy in banks. Our fund, typically, we can go half of the fund outside Canada, half inside Canada, and there's tons of other areas you can invest in within financials. Unfortunately, many of these businesses aren't in the Canadian market. You have to go to the U.S. market or global markets to get them. From a very high level, we built a diversified portfolio.

Again, to give you a broad sense of what we invest in, we have, call it, 20% to 25% Canadian banks, 10% U.S. banks, but then we have 15% in alternative asset managers, 10% in property and casualty insurance, 10% life insurance, 10% in payments businesses, and then another 10% to 15% in exchange businesses, data and analytics companies, and specialty finance businesses. You can see there's really a lot of other companies out there outside of banks in the financial ecosystem. To give you a sense on two areas that maybe have less rate and economic sensitivity that have done actually very well this year are property and casualty insurance.

This has actually been one of the best-performing subsectors within financials. These are companies that don't take credit risk like banks. They don't lend money to consumers. They adjust pricing annually. It's short-tailed. You think about your home and auto insurance. If the insurer writes a bad policy or has a bad year for claims, they're just pricing at the end of the year and take it up. The good companies can adjust quickly, and they generate good returns. This is a very good defensive steady business that has a lot of different attributes, I should say, than a typical bank.

Another subsector that's done very wellin 2023 has been exchanges.

These are capital-light companies that tend to benefit from increased market volatility. We think certain exchanges can do quite well looking forward because, when rates were zero, volatility was lower, and when rates come off zero, you start to have volatility in all kinds of assets and interest rates and credit and FX. When things are at zero, you just don't see that. This could be a very good period branching for exchange businesses.

Tom: How do exchanges make money?

Nick: Typically, your traditional exchange makes money from trading. You or I or bond managers want to trade the names in their portfolios, they transact. Again, when rates aren't zero, there's more opportunity to make alpha, there's more opportunity, there's more dislocation. That increased volatility increases volumes and exchanges are typically a fixed cost structure business. The more volume you layer onto it, the higher the profits will be. The other point I would make is particularly on the bond side is you've had 10 years of quantitative easing from central banks where they're buying bonds.

Now we're in an environment where there's quantitative tightening and they're not buying these bonds, so those are going back into the market. If you look back 10 years, no one was trading these bonds. These were going on to central bank balance sheets and looking forward. If central banks aren't buying them, that means investors in the market are buying them, which means there's more trading and more volume. That could be another tailwind that's maybe underappreciated for certain exchanges, particularly in the U.S.

Tom: That makes sense to me that if you have an indiscriminate buyer who's just holding them and doesn't care what the price is, that would lower volatility, but then when you have an indiscriminate seller who doesn't care about the price and is just selling them, that that could increase volatility pretty meaningfully. Who benefits from that in particular?

Nick: There's a few exchanges. There's CME, Intercontinental Exchange, NASDAQ. There's a number of ones in the US. Even TMX in Canada to a degree does have interest rate and credit trading. There will be some benefits there as well.

Tom: How about the businesses within financial services that are able to do well in an inflationary environment? What sorts of businesses can do well as the price index goes up?

Nick: One subsector in particular that is benefiting today from higher inflation is the payment sector, particularly the networks. Again, a lot of the networks, they generate revenue from consumers and businesses buying and selling goods and products and services. The higher the dollar value that goes through the networks, the more money they make because they make a cut, I guess, if you will, of what's spent on the credit card or debit card. That has been a relatively good environment for certain payments businesses as well.

Tom: There is a lot of negativity around Canadian banks in the market right now. Are there any positives?

Nick: Look, it's very easy to be focused on the negatives, but there are a lot of positives, Tom. First, you have bank dividend yields near all-time highs. They've really only ever been here in stress periods. Again, pretty compelling. Payout ratios for the banks are reasonable around 50 percent today, 40 to 50 percent. There's good coverage on the dividend, is my point. Capital levels for the banks are near all-time highs. A tool that they haven't typically used is managing expenses. We're seeing the banks start to pull that lever, and that may be an underappreciated lever for the group going forward if things are a bit tougher. Then lastly, the valuation is attractive.

If we look at bank valuations today, they're in the lowest decile they've been looking back over the past 15 years. Some analysis we did shows that if you bought banks in this decile over seven different periods of this presented itself, investors earned an average return of over 15% over the ensuing five-year period. While we may not be at the bottom, if you have time on your side and can be patient, there is a compelling argument to be made to buy bank stocks today.

Tom: Some of the changes that are happening in the bank regulatory environment are actually beneficial for some of the alternative managers. Could you briefly give U.S. an idea of what those headwinds for U.S. banks on the regulatory side could be as tailwinds for the alt-managers?

Nick: Sure. This is a real secular theme that's been going on again since the great financial crisis in 2008 and 2009. A lot of these alternative managers, their businesses really morphed and reformed after that financial crisis because in 2008 and 2009, a lot of bank regulation came in and things that the banks were doing were no longer allowed to do. Who stepped in? These alternative asset managers like Blackstone and Apollo and KKR and Ares. For the last 10 years, they've been exhibiting very strong growth by doing more things the banks weren't doing in an unregulated fashion.

Now with new regulations coming down for banks, we're seeing more banks sell off loan portfolios, looking to exit certain businesses, and who's stepping in once again? The alternative asset managers. The hot topic today is private credit, but all that is alternative asset managers making loans to small and medium businesses, particularly in the U.S. that are no longer being done by U.S. regional banks. This is another potential long-term secular tailwind for alternative asset managers.

Tom: That's fascinating, Nick. Thanks so much for that.

Nick: Thanks for having me, Tom.

Tom: I'd like to thank all our listeners. Again, this is another edition of On the Money. On behalf of all of us at Dynamic Funds, we wish you all continued good health and safety. Thanks for joining us.

Mark Brisley: You've been listening to another edition of On the Money with Dynamic Funds. For more information on Dynamic and our complete lineup of actively managed funds, contact your financial advisor or visit our website at dynamic.ca. Thanks for joining us.

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