Are Banks the True Risk Here?  Watch Out for Falling Demand

Many took the March collapse of the Silicon Valley Bank and Signature Bank as a sign that the 2008 global financial crisis would repeat. But the U.S. Federal Reserve (the “Fed”) quickly doused the flames by guaranteeing deposits and allowing banks to put their underwater bonds to the discount window and receive 100 cents on the dollar. These events, followed by the brokered sale of First Republic Bank to JPMorgan Chase & Co. by regulators in recent days, suggest that a problem in the economy will likely not come from the financial sector. We think it is far more likely to come from a persistent decline in demand.

The economy appears like a perpetual growth machine where employment gains power final spending, which in turn causes more employment gains. Yet the Fed has to hit demand before it can begin to ease. In our view, that may not take much longer. Financial stresses are building and the case for deposit and money rates falling sharply, perhaps back to 1%, is strong. To sustain current levels of spending, households have run down more than half the $2.2 trillion savings built by their COVID stimulus checks and they will likely spend the remainder by summer. They have also borrowed sharply over the past two years, increasing outstanding credit card debt by over 22%. The average interest rate on unpaid credit balances now exceeds 20% according to the Fed, and borrowing cannot be sustained at these rates. Retail sales are falling, and home mortgage applications are off over 60% since the beginning of 2022. For a company like Macy’s Inc. (M), whose credit card revenues provide 50% of its operating profit, late fees are now 50% of credit card revenues so time is running out; the implication of a collapse in spending would severely reduce profits but also reduce interest rates sharply. Our portfolio reflects these expectations.

Healthcare stocks underperformed in the first quarter, giving us the opportunity to buy stocks which reflect the fastest growing sector in the economy at good value. The S&P 500 Health Care Sector Index, which captures most of the defensive managed care and pharmaceutical stocks, fell 4.3% in Q1, logging its worst performance relative to the S&P 500 Index in 30 years, while the SPDR S&P Biotech ETF fell 8.2% for the same period.

We see two levels of opportunity in healthcare. First, we continue to build positions within medical technology and hospital companies as signs point to normalization of industry supply chains and improvements in labor costs. Surgical procedures left undone during COVID times are growing again and high-cost pressures due to inflated travel nurse contracts are beginning to reverse. These trends bode particularly well for our investments in healthcare facilities, which includes exposure to ambulatory surgery centers (“ASCs”). ASCs generally offer lower costs than surgery within hospitals, with similar outcomes, and so have taken share from traditional hospitals. We’re seeing attractive value opportunities here, and also in the behavioral health category where better positioned operators stand to benefit within an industry with strong, secular trends for mental health services.

Secondly, we see pharmaceutical and biotechnology stocks as the cheapest way to buy technology in the marketplace. Higher interest rates and the failure of Silicon Valley Bank, which funded many venture-backed and newly publicly traded companies, led to declines in many biotech issues during the first quarter, providing an excellent buying opportunity for long-term performance. Performance has turned up recently, and we think this turn may finally be underpinned by the resurgence of a mergers and acquisitions market and the reopening of broader capital markets. Several recent acquisitions performed by large-cap pharma underscore our argument that pharmaceutical companies must buy product pipelines. Public market investors are valuing strategic assets far below what desperate buyers will pay for out-year earnings.