McMurtry Investment Report & Model Portfolios

McMurtry Investment Report – July 2022

July 2022 –  How do Financial Stocks perform in a recession?

As the probability of an upcoming economic recession has recently risen to over 40% or higher, investment strategists are switching their rhetoric from fighting inflation to worrying about an economic downturn. While cyclical sectors tend to outperform the overall market 3-6 months pre-recession, they perform worse in the midst of a global economic meltdown.

The US Federal Reserve is now entirely focused on controlling inflation before it gets totally out of hand. In this regard, interest rates are expected to continue to rise until the peaking of inflation is more clearly apparent. At the moment, there are some signs of a peaking in inflation, but it is still too early to be absolutely certain of this belief.

Many investors have a false sense of security owning financial stocks through both upturns and downturns. The above graph clearly indicates how an equal weight US Financial sector ETF performed substantially worse than the overall market over the last recessionary period of 2008. These percentages are absolute price movements only and are not total return numbers.

Currently, the financial sector represents 31.8% of the TSX Composite index and 10.8% of the S& P 500 index. It is obvious that how you weight this sector relative to the overall benchmarks will materially affect your investment performance, especially during a recession.

It is still too early to predict how severe an economic recession we will experience. However, differing from 2008, the upcoming recession is likely to be less severe, especially for the financial sector. Nevertheless, it does not pay to be overexposed to this group and this is why I am going from an overweight position to an underweight one.

Currently US bank stocks are trading at a cheaper valuation than Canadian ones are. In both countries, bank capitalization ratios are currently in very good shape and are much better relative to where they were before the 2008 recession.

We all know that rising interest rates are positive for net interest margins. They are also a tailwind for insurance companies with the present values of their long-term liabilities lower from the rising rates. However, this factor is clearly only one of many and should be properly taken in context with all the other variables.

In an economic downturn, loan losses start to rise once again which is a real negative. Secondly commercial and consumer loan growth collapses. This can be seen today by the significant drop in mortgage applications in this period of rising rates. Thirdly, investment banking tends to fall off sharply in the midst of an economic recession. Lastly, investment fees earned from managed portfolios drop off sharply in a period of falling equity valuations. Credit card delinquencies also rise sharply in an economic recession.

A housing sector meltdown brought on initially by higher rates normally has a devastating effect on the banks’ overall profitability.

Many investors are told to ignore these short-term movements of equity markets and economic activity and only to focus on the dividend income they receive. This is a major mistake. While there has only been one incident of a domestic bank cutting their dividend, the now-defunct Bank of BC, there have been many instances of US banks cutting their dividends in a recession. However, during the recession of 2008, the Canadian financial regulator did not permit dividend increases until the capitalization rates were materially increased. This took several years as we all know. US regulators required the same criteria before any dividend increases were permitted.


I am reducing the Financial Sector exposure from overweight to underweight. It is very important at this time to focus on quality in terms of high capitalization rates. Banks that can limit their overall loan losses as a percentage of their total loans will perform much better than ones that don’t. It is important to keep in mind that it is the trend in actual loan losses that matters the most and not simply the trend in loan loss provisions, which is purely an accounting estimate.

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