Lions Bay Q1 2026 Commentary — Defense While Risk Reprices

For the first quarter of 2026, the Lions Bay Fund returned +2.86%.  Since inception, Lions Bay has generated an annualized rate of return of +14.81%.

During the first quarter, our core portfolio investments were not immune to the broader sell off, and these positions were a drag on returns for the Fund for Q1.  Despite this, we were able to generate significant realized gains through our hedging portfolio as well as a number of profitable active trading positions, which more than offset the declines in the long portfolio. 

Q1 Review: Volatility Roars Back

Following a 9-month long melt up in equities from the April 2025 lows, volatility has returned to financial markets in a big way, with global equity and bond markets selling off violently in March.  There were three principal drivers of this.

1. Growing risks in the $3 trillion private credit market, with multiple large managers gating redemptions and marking down the value of their holdings
2. Fears of AI disruption risk across a wide variety of industries, and the negative consequence for labour markets
3. Geopolitical risks emerging, as in the space of three months the United States conducted a military operation to abduct and depose the leader of Venezuela, threatened to take over Greenland, and engaged in a full-scale war with Iran, sparking a global energy crisis

Any of the above issues taken in isolation would likely be enough for the market to stomach. All three occurring at the same time poses risks to the financial system that we think are still underappreciated, with the potential to bring about a bear market if they aren’t resolved quickly.

It’s All Connected

We initially discussed the first issue, private credit, in our Q3 2025 commentary.  In September, the first cracks started to emerge in the industry with the bankruptcy of two businesses in the automotive sector.  Things got much worse this quarter, driven by fears around the exposure of private credit managers to software businesses.

Credit crises emerge through issues of solvency or liquidity.  Existential threats to business models, fraudulent activity and/or an excess of leverage present a solvency challenge (as in the case of the automotive businesses we profiled) while liquidity issues, in the case of asset managers, tend to rise from redemption cycles and the asset/liability mismatch that emerges when they offer a level of liquidity to their investors that doesn’t match the liquidity of the assets they’ve invested in.  It is clear now that private credit managers are facing both, creating the conditions for a potential credit crunch.

The second issue, AI Disruption, came to dominate the financial news cycle in February.  The launch of new AI tools from companies like Anthropic threatened the business models of many software companies, driving a -24% sell off in the iShares Software ETF in Q1.  Of course, the threat of disruption from AI is not limited to software companies, as evidenced by the sell-off in sectors as diverse as shipping/logistics, real estate brokerage and financial advisory firms, just to name a few.

Private credit has been a major lender to software companies in recent years, and the risk of solvency issues leading to a crisis has increased.

ISHARES SOFTWARE ETF

While there’s no easy fix for a solvency issue, liquidity issues are normally resolved by central bank intervention.  As the central bank lowers rates, or in the case of 2020, actually intervenes directly to improve the functioning of the corporate bond market, financial conditions improve and investor appetite for riskier debt returns.

This is where the third issue comes into play.  The conflict in the Middle East has led to a surge in inflation expectations driven by a spike in energy costs.  Financial markets entered this year expecting major central banks such as the Federal Reserve, the Bank of England and the European Central Bank to cut rates this year.  As shown in the chart below, these expectations have completely reversed following the sharp move higher in petrochemical prices.  The traditional central bank response mechanism to a credit crisis is not there while the conflict in the Middle East is ongoing, and this is extremely concerning.

NUMBER OF INTEREST RATE HIKES OR CUTS PRICED BY YEAR-END

The Psychology of a Sell-Off

The drawdown in the market we experienced in the first quarter was remarkably orderly.  Despite 5 straight down weeks for the market, and the worst month for the S&P 500 since 2022, the largest daily decline it faced in March was a paltry -1.79%.  The highest close for the VIX index was 31 in March, and it logged just 2 closes over 30 all quarter – very tame compared to the most recent energy shock in Q1 2022, which saw the VIX close over 30 on 16 occasions. 

We think the explanation for this resiliency has to do with a psychological phenomenon known as recency bias.  The psychology of risk in the market is heavily influenced by recent events.  This cognitive bias means that episodes that have occurred more recently carry more weight in investors risk taking calculus than might be reasonably justified. 

Were it not for the powerful rally that markets staged following the tariff crash last year, we think markets would have been much lower last quarter.  The greatest level of fear we saw expressed by market participants was a fear of missing a de-escalation rally.  We read countless pundits saying things like “The President won’t let the market sell off before mid-terms”, reflecting a deeply ingrained belief that the financial markets are operating with an embedded put option where they are immune to a meaningful decline. 

This type of thinking will only have been reinforced by the powerful rally at the start of Q2.  It makes us deeply nervous, as this is the type of thinking that must be in place for a truly devastating bear market to take hold. 

Prior to the housing market crashing in 2006, it was widely believed that you couldn’t lose money in real estate.  In 1999, investors were so optimistic about the runway for growth ahead for tech stocks that they believed valuations no longer mattered.  Today, investors believe that the White House will rescue them from any correction.  Unlike 2025, the issues facing the market presently cannot be resolved in an instant with a social media post. 

Even under the assumption that we’ve seen a total cessation of hostilities in the Middle East, it will take quarters, not weeks, to restore energy supply chains to health.  The fact that equity markets are essentially back to pre-war levels means there is considerable downside risk in the event that the recently announced ceasefire fails to hold.  Either way, inflation and interest rates are likely to remain higher for longer. 

Current Positioning:

The fund got very defensive halfway through Q1, primarily through raising cash and trimming several large core holdings.  In a highly volatile market, the ability to stay flexible and adjust exposure rapidly is critical to risk management. 

Our net exposure throughout the year has fluctuated at various points from flat to slightly net short, and we haven’t yet felt the conditions were there to deploy capital in a meaningful way.  We have been adding to some large, highly liquid positions on sell offs, which allows us to increase our exposure while maintaining our focus on liquidity.  This type of long exposure is also very easy to hedge as we encounter binary risks in the weeks ahead such as a geopolitical ‘deadline’ or a meaningful economic data release.  The ability to easily dial risk up or down in this type of market is extremely valuable. 

We are focused intently on what matters most to financial markets: interest rates and the oil price.  Despite the early Q2 relief rally in equities, both are still at levels which present a challenge to the growth outlook.  We’d be willing to overlook these risks if we felt they were priced in by equity markets, as was the case in the fall of 2022, but with equity markets down less than 1% on the year at the time of writing, we are a long way from there.  The table below outlines how some of these key factors have changed since the Iran conflict started.

At current levels, we think equities are ignoring the enduring risks to the economy presented by the tax of higher rates and higher energy prices.  We view the massive rally we’ve experienced to start the second quarter as a sell-the-news event, and an opportunity to re-initiate portfolio hedges that were profitably monetized during the March sell-off.