Canadian Stocks
Productivity is bad & inflation has been staying higher than wanted. We should probably be in a pretty bad recession already... which should in turn cause worse damage and rate cuts, further damaging the currency... causing more stagflation etc etc etc....
But we're not... and honestly the same reason we're not is why we might not. Population growth.
People want to blame population growth for stress on the housing market and rental affordability. The reality is they're bailing out a financially sinking (because of increased rates) property owner. The fact is... and many people need to hear this... despite the averages "Top 10% salary can't afford the average house!!! (*with no trade up equity and average heavily weighted by most expensive markets... but let's avoid talking about that*)" and what you hear about Canada, Toronto and Vancouver. You can still buy a brand new 3 bedroom, 2.5 bathroom house for 450k (USD$330k) near Calgary, Edmonton, Regina, Saskatoon, Atlantic Canada etc. That's because despite the "immigration making housing unaffordable," when builders can build, prices follow the cost of production. As a reminder, this is EVEN AFTER a decade where "low interest rates made housing unaffordable." In my opinion, at 2.5% interest, $1800/month as a mortgage payment on such a home is affordable. Immigration is obviously not the problem... but it does amplify what the actual problem is. The actual problem being the time, cost and difficulty of building. Also, it's crazy how many people will complain about affordability but when given 5 affordable options, look down on those locations in some form. The averages are warped by people's perceptions about frankly what's not Ontario & B.C. Another issue the MASSIVE take governments reap from inflated land transfer taxes and other such costs. The problem is almost entirely artificial and self induced. Population growth is bailing out our economy from home made stupidity. It's 'easy' to point the finger but it's not the problem. Same with "low interest rates."
Recession or Not
I don't know if we enter a recession. GDP growth has sucked for 6 months & could easily slip negative. On the other hand with adding 25k jobs per month (probably hurting productivity) we've already added 0.5% to our unemployment rate. By year end, that could easily be 1% off the lows without a recession. If we had 0 job growth, unemployment would rise 0.2% per month which would be a similar pace to the GFC. If you believed that inflation was caused by tightness in the labor market... this sounds deflationary... even adding 25k jobs per month sounds deflationary. Also, if we're going to look at wage growth with immense fear "omg still 5.2%" well, I believe we are about to witness some favorable base effects in that regard.
In the last 8 months January to August, wages went from 33.01 to 33.47. In the last few months of last year, wages went from 31.67 to that 33.01 in January. That's a 1.34 increase that gets lapped vs a 0.46 increase over the majority of this year.
In any case, recessions are transitory. Plus, most of the time by the time everyone agrees it has arrived, the market is looking past it.
We're already in a non-recession... recession.
Believe it or not, I started this not really wanting to discuss macro factors. I wanted to talk about some stocks. I did however want to make an important point. That is, in the discussion about Recession... economic collapse... bubble bursting etc. It's important to realize that the pain & stress is already being felt. We are adding growth potential... companies are adding long term value... the economy is stagnating for now but adding potential. We're not growing but in suffering this (higher rates and higher unemployment) without collapse... we gain the potential value of;
What if yields normalize at inflation +50bps...
What if more people find jobs... eventually
That could mean higher growth, higher cashflows, higher valuations.
I don't like the near term Canadian economy... and think there are real risks there but also think... to use a horrible cliché... what doesn't kill us, makes us stronger... now the key of course is... not dying. (Or suffering permanent damage). I think we need to look South... and West... if the Fed can be done and investment in Oil can bail out our currency we could be surprisingly ok. If the Fed presses onward and our currency gets caught between a rock and a hard place it could push a bad situation towards a very bad situation.
Banks
Ok so... housing bubble... inverted yield curve... possible recession... economic stress etc... who in their right mind would go out and want to buy bank stocks? That's a valid question that many are probably asking. I don't have a good answer... or I should say wouldn't have a good answer if we were talking small 1/10000 banks at full price with marginal equity cushions.
In Canada we have maybe 10 worth a look... 6 that every Canadian has hear of... all heavily regulated and capitalized like a GSIB ( Global Systemically Important Bank) most of these have been adding to their PCL (Provisions for Credit Losses) aka reduced earnings and is at a P/B multiple comparable to COVID or mid GFC. So yes... we may see the implosion of the Canadian economy through gross incompetence... but a normalization of bank performance over the next 5 years could generate something like a 25% IRR... from owning the big banks. That would mainly require enough population growth to avoid a Recession.
The Canadian banks have been around for many years:
Bank of Montreal 206
Bank of Nova Scotia 191
Royal Bank of Canada 159
Toronto Dominion 68 [merger of Bank of Toronto (would be 168) and The Dominion Bank (would be 154)]
Canadian Imperial Bank of Commerce 62 [merger of Canadian Bank of Commerce 156 & Imperial bank of Canada 150]
National Bank of Canada 164 (or 43)
Not to mention Laurentian Bank which has achieved much less in their 177 year history.
The point being that these banks survived the great depression and the GFC along with 20% interest rates and many difficult environments. That's not to say that they're invulnerable... but they are pretty resilient.
Canada doesn't have the same MBS problem that the US had in 2008. We also regularly have 1/5th to 1/10th the mortgage delinquency rate of the US. Further, a large percentage of mortgages are insured or have a large equity cushions. Then remember we've already seen some decline in construction as prices don't satisfy return thresholds for new supply.
What I think happens is somewhere in the middle. A few years of reduced earnings before gradual improvement. I don't think dividend cuts are likely so when I run through some possibilities it's an area that looks interesting from a DCA, collecting a few shares perspective. Particularly because my portfolio is light on the yield. I don't like buying things exclusively for their yield but I think that in a few years those dividends will return to growth in that environment I think there's relevant capital appreciation potential.
Oil
There's a lot to like about Canadian oil. (...but)
Maybe OPEC extends cuts or is near their production limits... maybe the Permian has peaked... maybe the Canadian dollar falls apart. I honestly have no idea... but with a bunch of these companies continuously saying they can make money at $45 oil... I continuously wonder why they aren't putting even more capital to work at $70+
In Q2 we had 10.4B of capex... that was the third most of any quarter since the big oil collapse of Nealy a decade ago. Plus, now their balance sheets are much stronger. Capex is still at roughly half of last cycle. Frankly as a Canadian & someone with significant investments in Alberta, I hope the capital keeps going in. The alternative is basically worse on all fronts.
The problem from a stock perspective is that the volatility of earnings and the depletion type of business isn't necessarily a good long term idea. Now they can grow assets and long term value quickly but that won't always be the case. Investments currently pay back quicker and leave income streams beyond that so it makes sense to invest... and leave the company with more residual value when it no longer makes sense to. This won't remain the case forever because it's a cyclical industry. That's why for energy companies I think one metric that you can't lose sight of is book value. If an oil company trades at 2x book (it's more so asset value than book but...) it might be possible to put a fresh $1B to work and have it be worth $2B. Eventually someone will do that. Whether that's capex from an existing company or a pool of investors putting their dividends to work or a management team with their buyout proceeds... it doesn't matter someone will eventually do it and make a ton of money. Doing it sooner will allow you/your company to make more of the excess profits... doing it later is more likely to miss some excess profits...that's the only difference. Maybe the company can quadruple it's long term value first... maybe more or less is lost to taxes, maybe it takes 1 year, maybe 10... maybe price goes high enough to reduce demand... maybe price is flat... I have no idea but eventually the investment gets made... and at a company level it makes much more sense to do it early.
The stocks are probably a decent hedge for more pain in Canada but too much pain here or globally can backfire in many ways. I like the sector and think there's a lot of profit left to be had in Canadian Oil. I don't think it's as cheap as some nor am I a believer in sustained $100+ oil. But I think the sector is well positioned especially for as long as Saudi wants to give up market share.
Rails
One area of interest for "permanent capital" in Canada might be an investment in one (or both) of our two railroads. Ideally an entry point with a mid teens multiple starts getting quite interesting from a long term perspective. Both rails have been around nearly 100 years and stand a shot of being around for another hundred.
Grocery Stores
Grocery stores are another Canadian oligopoly that's been moreso in the news recently. On one hand I believe they're very stable business and probably have some upside with population and GDP growth longer term. That said, I've continued to be skeptical that the recent pace of growth is realistic. These are very low margin business. That means they do and must pass on price increases quickly. So any nominal price increase that's not their fault results in earnings growth. The hilarious irony of our current government blaming grocery stores for higher food prices is that their very carbon tax has pushed the cost of food higher... and... higher nominal prices mean more profit (although a similar minimal margin). Then the government threatens 'take prices down' (they can't) "or we tax them more." Which could arguably push prices even higher. Before I turn this into a political commentary I'll move on.
The good news is that 'whatever' the factors that pushed food prices this high, globally, food inflation is fading HARD... at least... good news for us, perhaps less for food stores. Supply has responded to higher prices. Part of this feeds in to why I suggest inflation is likely less of a concern than some suggest. Food inflation at 7.8% YoY is roughly 1.2 of the 3.3% add in 0.8 from mortgage interest cost... both of which should quickly roll off should more than offset some rebound in some other components. In fact most other components that went up as quickly as food eventually saw negative YoY numbers. Then figure that if inflation was deemed to be under control, and rates were reduced, that +0.8 could flip to negative too... then new development makes sense and rents don't need to increase anymore... more inflation gone.
Reflexivity. If we believe inflation is gone it will be (with some time). If we keep creating our own inflation it'll stick around. (Higher rates = inflation + need for higher prices = inflation= taxes = higher prices = inflation= rate hikes = inflation.
I got slightly off topic in my attempt to say that food price inflation disappearing will likely mean slower growth for supermarkets. But with reasonable valuations I think the outlook is fine.
Utilities
The utilities and pipelines are another interesting sector. They have been double hot by the rise in interest rates. The highly levered utilities now face a wall of more expensive capital upon maturity. They also face the fact that with higher rates and the availability of yield on GICs, there's less value/demand for high dividend stocks. This is a similar challenge for real estate. Both may now be in a position to reset with a new baseline of assumptions which they can perform against... in other words, if rates peaked and decline, you get the revaluation higher & improved cashflow fundamentals from lower refinancing cost. I think we're somewhere in the repricing. I don't think all of them have fully priced in higher rates persisting but I think most are in the process of slowly assuming that maybe rates will remain a bit higher for a bit longer. I don't think they should fully price in higher rates (that view comes from my personal opinion on rates). The more that they do price in, the more asymmetric the investment. The companies are mostly fine but the appeal of the price of years ago wasn't what investors hoped. There will probably be a stretch of less growth while debt is managed. It's a place where there's probably some time but may be worth picking up some long term holdings over a few years.
REITs
Real estate is in a weird spot. From a price to book/NAV perspective, it's extremely cheap. (There's a rather significant discrepancy between public and private prices.) From a 'I can get a 6% GIC' perspective... less so.
The two things that matter most are interest rates and NOIs. If rents/incomes keep rising then existing debts can incrementally be retired and long term values can be fine. If occupancy or rent falls then we have a more complicated situation... especially if funding becomes more expensive.
We haven't seen yields like this out of REITs in many years. It is possible that they stay here... or are cut. It's complicated and can't be answered with blanket statements. I suspect with catch up rents and incremental deleveraging, the new set of expectations is probably pretty low. The discount to NAV simply means they are much cheaper then their private/I traded alternatives. They may or may not be extremely cheap... it depends where interest rates settle.
Miners
At the risk of repeating myself, mining is a difficult business. While not apparent in the same way as for REITs and Utilities, miners are similarly worth less in this kind of environment. Inflation = cost inflation too. And interest rates make the capital more expensive.
On the other hand, and this is something I've been mentioning for a while but goes directly against traditional economic thinking... in commodity -like capital heavy industries, capital is your most. It's not a great moat and it will be overcome eventually but it is some moat. This is because you need (Risk free rate +) for the investment to be worth it. The more capital costs, the bigger that number needs to be. Higher rates need higher prices to get the same returns... and higher rates mean even higher still prices are needed to justify taking the same risk.
I want to be clear, I'm not saying higher rates are purely Inflationary... they remove capital availability too (that's deflationary) what they do is make people poorer and life less affordable.
Gold, I don't have a strong view
Silver is roughly fair value
Copper, I'm bullish on demand longer term but think price is higher now than bulls give it credit for & has two way risk short term. My history has taught me that you really only need to buy these when the metal has been flushed.
Lithium there's very little on the TSX but I'll say. Lithium price was ridiculously too high, it's now decently high. It's demand longer term is pretty obvious but I'm less sure how much that translates into price from here. Most companies can make their projects work with prices at half of current levels, so the odds are pretty good that eventually prices fall by more than 50%. Maybe the stocks make 1000% first, that I don't know.
Exporters
One area that I think has more potential is export companies. In the Oil segment, I mentioned in passing that maybe the CAD falls apart. A weakening currency would be a tailwind to companies that cost in CAD and sell in USD. It's funny actually, the other day, prior to a discussion that got to this point, I saw someone tweet a weird boast. They said they converted a bunch of CAD to USD at 0.65 back in the day but that's good because now they have USD investments that give them USD cashflow. I immediately thought... ok... why not just own Canadian businesses that sell into the US (oil qualifies) if you want protection against a falling CAD. It's hard to find many pure-plays of this as most have diversified operations as well as sales. Still, at present it's a more interesting area because A: you don't have to deal with struggling Canadian clients... B: if the currency sucks more, you're hedged as margins should improve.
That said, I don't know if I've ever gotten a currency related trade right... there's always more to it or expectations than what I imagine and I have no idea how to measure prices or what the market is saying. There's economic strength, rates, trade, inflation and so on already built in and evolving, most of the time I just figure, currencies go up, currencies go down... I'll never know why. Even still, there are times when I appreciate a more global sales exposure & other times when being regional is nice.
'Cheap'
On a price to earning basis... as well as a price to book basis in many places... the Canadian market looks cheap. Or at least, cheap relative to recently or relative to the U.S. That is however, not the be all end all of security analysis (despite what some may say). It's the market's message that current earnings or asset values are in danger. Maybe that's transitory earnings capabilities, margin normalization, pending recession-related losses, maybe end of cycle pricing...etc
This pessimism may or may not be misplaced. I would suggest that, commodity companies and tech stocks shouldn't trade at similar multiples. Asset heavy businesses have growth constraints that other companies don't. Being that capital and balance sheet capacity is often the limiting factor, the risk for such business is often tied closely to marginal changes in the economy. I mention this because Canada has a lot of asset/balance sheet heavy businesses. First and perhaps most relevantly when looking at Canadian stocks... the banks... then oil etc.
I think that a lot of Canada is set to perform well at some point but I think things need to point in the right direction first... or at least stop pointing in the wrong direction. This can be especially annoying because some things are moving in the right direction but sentiment is not and has capped them. There's a lot of torque in the Canadian market's earnings. With bad things happening they can easily fall a lot more that the US and that what central banks keep trying to cause. If we could get past that to an actually good economy like the late 90s or mid 00s the entire picture can flip. What is now '20% discount to book because of losses coming' can become '2x a 40% higher book' the difference there may be 2 or 3 x in earnings multiples (more in some cases) but 300% in stock price. We could be at the start of a decade of outperformance or the start of a multi year brutal underperformance. I think the current expectations are skewed to the pessimist side, but I also think at these rates, our economy is in an awful position in the short term.
Bonds
Bonds are tricky too.
I think short rates need to move lower... but I don't know if they will. (Yes you heard that right)
I don't think the long end needs to go lower... but I can't bet on the front end going lower without thinking the same event would push the long end lower.
I also don't know when or how much because the whole thing isn't a bet of what should happen or what makes sense, it's a bet on the choices of parties that seem completely illogical.
I don't believe low rates are bad. I think there's a massive "back in my day rates were" bla bla bla ... "those were the good ol' days of 11% unemployment and 10% interest rates when we nuked our own economy because of an exogenous oil shock," out there by people in positions of authority. When you get into logic of how rates actually helped anything be better back then, the arguments fall apart... they turn into "well if nobody could afford it and everyone was struggling then things would be better for everyone." The honesty of the matter is most people should just say "I want to make 5% on my money for taking no risk; because I have money."
The problem is, with today's taxes, costs, demographics etc I don't think the country functions at +3.5% interest rates. I think it leads to very bad things, economically, socially, politically etc. I also think that things are comparatively fine at 2% interest. We could have great growth and prosperity without problematic inflation.
Any prediction needs to be a mix of will and should... so if I were going to make one it would be something like: YoY is probably almost 4 before October data... so they may panic and do one more hikes before realizing in ~March that inflation is falling very quickly and by ~April that they're way too restrictive. Then they start cuts around then... probably (as I mentioned above), once they start cutting there's probably a long way to go. Probably +250bps of cuts over many quarters because they'll stay concerned about a rebound. However, this basically assumes they act like headline chasing trained monkeys. If thought goes in to other data, they could easily move the timeline up 3 months... I mean if they really were concerned with data they could move the timeline up 8 months... but evidence suggests that's unlikely.
Wrap Up
When I talk to people, many seem to think we are in a lose lose situation. For lower rates, they believe we need a recession. A recession has historically meant catastrophe earnings felines/losses by sensitive companies. In other words it is believed that companies need to do poorly in order for the pain & unsustainably higher rates to end. I don't know if that's accurate. It does seem to be what the market is looking at in a few places. I think Canada is buffered by the ability to export to the US... and simultaneously at added risk because of Currency on imports. Buffered by population growth and at risk because that masks the true pain some are experiencing. This might mean no recession or a very mild one... or cause the BoC to go massively overboard and do severe damage. I do think that there is a tremendous amount of pent up demand in some of our more rate vulnerable areas. The incremental relief at some point could do wonders.
Everything is to a large degree... interest rates. So far that has been a running shock. In some ways the economy handled it well, in others we've handled them terribly. Led by our debt and mortgage resets I think that rates are already too high for much of the country. I've given up on believing that what should happen will or that there's consideration of factors beyond headline inflation. There was plenty to suggest that we should have stopped before 4%... it seemed insane to resume after the pause at 4.5... they did. So yes, I think we've gone far further than necessary. If food reverted to global averages and we excluded Mortgage Interest Costs we'd have BELOW target inflation... I digress. Other parts of the country/economy are completely survivable and doing fine. The yield curve also matters, what discount rate is used? 5% or 3.5%. The higher a number you can make work, the better the odds of success.
That said, if you're asking my opinion of what eventually happens.
Let's look at it this way. The people who currently own the 10 year bond at 3.65% probably think that short end rates are going lower (if not they'd roll short treasuries). When that happens they believe that long rates will go lower and long bonds will become more valuable. In other words, they expect long rates to drop and short rates to drop to an even lower level than that lower long end level. So a 3.65 10 year is probably a suggestion that the short end may go to 1-1.5% and the long end would be 2-2.75% or something. This is basically what bulls of the 10 year are thinking. If that happens, real estate and other supply can react, affordability can improve and the economy can function properly. The one thing preventing us from getting there is patience (inflation). I say patience because, there are no signs of a wage price spiral, the economy is incredibly clearly not overheating... so what we need is time for the volatile/incentive prices to roll off and stability to return to the supply side. You know, it's ironic that central banks claim they want to achieve price stability yet their actions are essentially trying to crash some prices thereby creating volatility.
We're clearly not overheating... we may be stagflating but I think at some unknow point the Bank of Canada will regain sense and stop intentionally hurting the economy. On a lag from that point there are a lot of companies out there that to varying degrees are pricing in the pessimism that I spoke about. I don't know exactly when the point of peak pessimism will be but keep trying to look beyond that at the 'next cycle' and think we're starting to see some interesting longer term prices.
Canada may not be in a great place right now... but you really can't find many people that think it's doing too well... and it shows.
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