2023 March CAD

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-0.11% MTD

-4.44% YTD

Bad Banking is Bad for Business

“The worst loans are made at the best of times, and the best loans are made at the worst of times.”

- Howard Marks, Co-Founder, Oaktree Capital Management.

Dear Partners,

For the Month of March, the Caravel Capital Fund was down 11 basis points. The breakdown of where we did well and where we suffered is quite simple. We materially exited the portfolio’s fixed-income holdings just before the banking crisis in the US unfolded. We still profited from the trade but left about 90% of our expected return on the table, which I refer to as spilled milk, and therefore don’t spend any time lamenting over it. The portfolio generated positive returns from our oil equity exposure, which were somewhat reduced by a hedge we had in place as a risk-dampening short overlay position on crude. Our merger book profited from the closing of the Shaw Cable purchase by Rogers Cable. All of this was overshadowed by a complete giveback on the gains we had generated from our holdings of Onex Corp. We wrote about the investment in the previous letter. More on that below. The net result was a disappointing flat month.

We believe the collapse of the three US regional banks in March could have a gargantuan impact on economic activity over the next 12-18 months. Let us explain. We know the US Central Bank is trying to engineer a slowdown in the economy and fight inflationary pressures by tightening the money supply and raising the cost of money simultaneously, which we have been watching for the past 12 months.

While the Fed was trying to slow the economy down, we got a banking scare. In our previous letter, we discussed the impacts of losing depositor confidence. This letter focuses on a key knock-on effect of bank failures: credit tightening. All shareholders of bank stocks saw what happened to Silicon Valley Bank and want to avoid the same fate. The executives working for these shareholders and the regulators meant to protect them are on the same page (for now). This will likely result in a significant tightening of lending standards across the US Banks and possibly the global banking system. Specifically, banks are likely to recall riskier outstanding loans where they have the right to do so and impose stricter conditions for new loans. This better insulates the banks’ equity (or “tier-one”) capital in the event of future adverse shocks like the one we saw last month. The downstream effect of this conservative shift is that small and mid-sized businesses, representing more than half of US economic activity, will suffer. Imagine if the federal reserve eliminated access to new loans for 50% of the economy and demanded repayment of existing loans from the same clients. It would be a disaster. So why have we not seen the stock market collapse? The impact of banks withdrawing from making new loans takes time. We believe we won’t see the effects for a few months after the Fed hikes overnight rates in three weeks to 5%. We remain very cautious. Eighty percent of this year’s US stock market gains are attributable to 5 stocks.

We have built up our merger arbitrage book as spreads have widened, increased our market-neutral spread trades, and added to our alpha conviction names like Onex (see Feb letter). We continue to keep our powder dry as we wait for more clarity.

“The market is never wrong; investors are either early or late.”

-      Jeff Banfield, April 22, 2023.

If you would like to discuss anything or just say hi, we love catching up with our partners any time.

We thank you for your continued confidence and capital,

Jeff and Glen.