Overview
With another year recorded in the books, once again there are all sorts of lessons for investors to glean from those past 12 months. While some events from 2022 carried over into 2023, there were new developments that are certainly worth looking at and analyzing in greater depth.
Whether it was stubbornly high inflation or the Israel-Hamas conflict, amidst these events are nuggets of wisdom waiting to be uncovered. So, let’s try to uncover what those are.
March: A Bad Time to Be a Bank
After a relatively quiet start to 2023, three months into the year the financial and economic world was violently shaken. Why? In just under a week, three U.S. banks were shut down in rapid succession: Silvergate Bank, Silicon Valley Bank (SVB), and Signature Bank.
A fourth U.S. financial institution, First Republic Bank, also shut down a few weeks later, which ended up being the second-largest bank failure in U.S. history.
Their collapses were largely due to clients performing a “run on the bank”, that is, a large number of withdrawals happening in a very short period, reaching a point where the federal government needed to intervene to ensure clients were able to withdraw their funds.
The specific reasons why these bank runs occurred varied. In the case of Silvergate Bank and Signature Bank, their collapses were largely due to their exposure to the cryptocurrency business. As for SVB and First Republic Bank, they were brought down due to the high interest rate environment they, and every other bank, found themselves in.
Approximately a week after the flurry of U.S. bank closures, Swiss investment bank Credit Suisse found itself on the brink of collapse and was saved thanks to swift action from its competitor UBS. Interestingly, the reasons for its failure weren’t the same as the ones for the U.S. banks.
Amidst all these bank failures, SVB received the lion’s share of attention. Why? It was the second-largest bank failure in U.S. history at the time it collapsed (just weeks before First Republic Bank eventually took that spot). Because SVB’s collapse happened so suddenly and posed a serious risk to the U.S. financial system, markets were very quick to react to this bad news (1, 2, 3).
Given the scale and severity of these events, there are multiple key lessons for investors to extract here.
First, this rapid succession of bank closures is a grim reminder that disasters can strike in the blink of an eye, and there will be times when investors will get caught off guard, forcing them to think on their feet.
The bank runs that happened to Silvergate Bank, SVB, and Signature Bank happened in a matter of days, so it’s unsurprising that investors and markets alike immediately resorted to panic. During circumstances like this investors will need to know how to quickly process what’s going on while staying as rational as possible, which again highlights the importance of investors keeping their emotions in check.
This leads us to our second insight, which is investors can find themselves being the victims of “collateral damage” of a major event, even if they have no connection to the event that took place. Following the collapse of SVB, Canadian banks lost $19.7 billion in market value, despite the fact they weren’t directly impacted by SVB’s woes. Even a couple of months after this crisis Canadian banks were still being impacted.
Investors who had Canadian bank shares in their portfolios would’ve experienced these losses as well, even if they had no investment relationship with SVB whatsoever. Frustratingly, this is a reality investors will need to deal with, and many times is something that’s well beyond their control.
Finally, the third lesson we can glean is that external, uncontrollable forces can lead to some very tangible consequences. From 2022 – 2023, benchmark interest rates were at all-time highs to try to keep inflation in check.
As interest rates go up, bond prices go down, which proved to be a very big problem for SVB in particular because a large portion of its portfolio was tied up in government bonds, and the prices of those bonds cratered. As for First Republic Bank, it failed to properly navigate this high interest rate environment, leading to a 2,040% year-over-year surge in its interest expenses, which ultimately was the catalyst for its demise.
Continued Interest Rate Spikes and the Continued Fear of Recession
One of the major headlines in 2022 was the record-breaking inflation that took place around the world. In an attempt to contain this inflation, central banks responded in the usual manner: raising benchmark interest rates.
As benchmark rates continued to soar, and with inflation showing no signs of slowing down, many people and businesses began to wonder if a recession was on the horizon due to decreased economic activity.
Entering 2023, inflation remained stubbornly high, interest rates continued to climb higher, and the possibility of a global recession was still a major concern. Fortunately, despite weaker-than-normal economic activity around the world the fears of a widespread global recession largely went unrealized, with the U.S. and Canada in particular narrowly avoiding it.
In 2022’s recap, we talked about how interest rates can adversely affect investors due to their ability to dampen economic activity, thereby affecting the investment merit of some holdings. Additionally, we also talked about how just because people are saying a major economic event is going to happen (in this case, a recession) doesn’t automatically mean that it will.
These lessons still largely apply to 2023, with interest rates remaining astronomically high and with people already predicting that the long-awaited recession will be in full swing in 2024, which we will find out if it truly does materialize in next year’s recap.
Canadian Banks Increasing PCLs
Continuing our discussion of record-high interest rates, while they certainly have an impact on economic activity, there is another thing they can significantly affect: loans.
Most banks earn the bulk of their revenue from the interest they charge on their loans. While higher interest rates mean banks can earn more interest revenue, this also means their borrowers are now on the hook for heftier interest payments. Because of this increased strain, a greater portion of these borrowers may be unable to repay their loans in full and on time.
Indeed, banks recognized this possibility and acted accordingly, at least the ones in Canada.
Banks that offer loans understand that not all of their loans will be repaid (i.e. some of their loans will become “impaired”). To prepare for this, they earmark some funds to offset the losses brought on by these inevitable impaired loans. These earmarked funds are known as the Provision for Credit Losses (PCLs).
In quarters one, two, and three, Canadian banks increased their PCLs in anticipation of more impaired loans due to the record-high interest rates their borrowers faced.
Although this may seem like a problem limited to a bank’s operations, there is a subtle yet powerful lesson here for investors.
PCLs are standard practice for many banks, yet it is something that can easily be overlooked by investors when performing their analysis. After all, it’s something that’s usually tucked away in annual and quarterly reports and isn’t as prominently reported as other metrics such as earnings, P/E, and the efficiency ratio.
However, changes in PCLs can signal how a bank feels about its loan portfolio and can be a sign of increased (or decreased) interest revenue in the future. Investors who pay attention to these changes when assessing investment merit can pick up on potential weaknesses in a bank’s operations, or capitalize on a possibly bright future.
Indeed, other types of businesses have niche metrics that only apply to their specific industry/sector but can prove to be highly invaluable when trying to assess investment merit.
There are many metrics and numbers investors must take into account when assessing investment merit, but there are some that can easily be overlooked yet can provide additional insight that can directly influence an investor’s decisions. PCLs are one such example.
Israel-Hamas Conflict
One of the major global events that transpired in 2022 was the Russia-Ukraine conflict. While many people hoped that this would be the only major conflict the world would need to worry about, unfortunately, 2023 had other plans, and the Israel-Hamas conflict soon erupted in October.
As we know from the 2022 recap, the Russia-Ukraine conflict had a noticeable impact on financial markets before and after it started. Record-high oil prices and equally high benchmark interest rates dominated headlines that year and part of the reason for those could be attributed to this war.
So, when the Israel-Hamas conflict broke out, similar concerns were immediately brought to mind, namely a jump in oil prices. Naturally, markets reacted to this and investors were rightly concerned about how this conflict would evolve (1, 2), but for the most part, investors’ fears largely went unrealized.
At the end of 2023, the conflict still rages on but hasn’t exactly spread to surrounding regions, oil prices hovered around 70 USD by year’s end, and financial markets around the world have or more less resumed regular operations without any wild spikes in volatility.
So, what can investors learn from all this?
The initial fear in the days following the conflict and the relative calm months later is yet another example supporting Benjamin Graham’s adage in The Intelligent Investor, where he states that “in the short-term, the market is a voting machine. In the long-term, it is a weighing machine”.
Indeed, at the start of the conflict emotions were running high, but as time went on and the true scale of the conflict was better understood, markets returned to their usual form. Time and time again investors fall into the cycle of “panic now, think later”, and how investors responded to this conflict was, unfortunately, no different.
In addition, wars have the potential to affect the world in various ways, but not all of them will do so to the same extent.
The Russia-Ukraine conflict had a direct influence on the eye-watering oil prices that dominated most of 2022 and also played a role in the record inflation (and subsequent interest rate hikes) that was also witnessed that year. The Israel-Hamas conflict, however, didn’t have the same impact on global economics.
Major conflicts cause most investors to worry, and rightfully so given that it’s very difficult to predict how they will evolve. That being said, it would be quite naive to think that all conflicts will have a widespread impact to the point that they will directly impact individual portfolios.
Paying attention to major global events is important, yes, but not all of them will have an impact on investment portfolios.
Wrapping Up
2023 presented an interesting mix of both new and ongoing issues, teaching investors new lessons while also reminding them of previous ones.
High inflation, high interest rates, and the constant fear of a recession weighed heavily on people’s minds throughout 2023. However, the string of bank failures that happened in March, the Israel-Hamas conflict, and Canadian banks constantly increasing PCLs during the year gave investors new issues to worry about as well.
Some of the biggest questions that remain are how long will this inflation last, will interest rates ever drop to near-zero anytime soon, and will the dreaded recessions that everyone is worrying about finally hit? These are questions that can only be answered as time passes.
