Harbour Monthly. Strategy Q The Harbour Group of RBC Dominion Securities. All For One: You. RBC Dominion Securities Inc.

Transcription

1 RBC Dominion Securities Inc. The Harbour Group of RBC Dominion Securities Harbour Monthly All For One: You An Exclusive Newsletter for Our Clients and Friends APRIL 2015 Main Reception: Toll-free: RBC Dominion Securities Brookfield Place Bay-Wellington Tower 181 Bay Street, Suite 1520 Toronto, Ontario M5J 2T3 Peter Coward, hba Vice-President & Director, Investment Advisor Graeme MacGregor, fcsi, cim Vice-President & Director Portfolio Manager & Wealth Advisor Christopher Newall, fcsi, cim Vice-President & Director, Portfolio Manager John Grant, cfa, mba, msc Associate Portfolio Manager & Wealth Advisor Robin Gullason, cfa Vice-President, Lead Strategist Private Wealth Management Putting you first, every time, to help you navigate the complexities of managing your wealth. All of our team members, all of our resources, all of our collective insight: All for one: you. Strategy Q As we have seen for the entire post-crisis era, central banks continue to dominate asset prices around the world. The European Central Bank (ECB) has undertaken extraordinary monetary policy while the world waits to see when the Federal Reserve will raise interest rates. The U.S. economy has suffered another soft patch over the winter, which we think is temporary. Longer-term indicators suggest a healthy labour market and favourable demographic trends at play. The Canadian economy is adjusting to life without $100 oil, and this has been felt in the currency market in particular. The lower Canadian dollar helps cushion the blow but does not eliminate it. Barring support from higher oil, the path of least resistance continues to be lower. While the timing is uncertain, we are preparing strategies to position portfolios for higher interest rates. Rate-sensitive business models, commodity exposure, strong dividend growth and certain preferred shares should act well when rates rise. We think equities are fairly valued in the context of depressed energy earnings, low inflation and low interest rates. A large portion of the TSX has had a strong correlation with oil that we expect to continue in the near term longer term, sector-specific fundamentals will win out. Continued on page 2 THE HARBOUR GROUP OF RBC DOMINION SECURITIES

2 Strategy Q continued from page 1 Central Banks Continue to Dominate the Narrative If there is one theme that has dominated the first quarter of 2015, it is the actions of global central banks. Consider the following - the ECB (finally) engaged in quantitative easing (printing money to buy bonds), leading to a significant outperformance of European equities in local currency terms. The Bank of Canada shocked market participants by cutting interest rates without warning, leading to significant turbulence in the Canadian fixed income space and taking the Canadian dollar down another notch. And not to be forgotten, the extreme focus on when the U.S. Federal Reserve will achieve liftoff from its near-zero interest rate policy. Market participants engage in an incredibly active debate as to whether this will happen in June, September, or later our main concern continues to be the if, not the when, as history shows we typically see a reaction in equities, interest rates and currencies around the time the Fed goes on a tightening campaign (as seen in our March Market Note). Timing of the when continues to be a mug s game, with expectations shifting with each weak or strong economic data point in the United States. What is clear to us is that the Federal Reserve wants to get off of zero, and the message they are sending is that it should happen sometime this year. U.S. Suffers Another Winter Slowdown- We Do Not Think It Is Anything Worse Similar to 2014, we have seen a weak patch of economic growth in the U.S. and this is clearly seen in the economic surprise index in Exhibit 1. We note that these indices tend to be cyclical after a weak patch of data, economists cut back their expectations, and it doesn t take much of an improvement for the economy to start outperforming again. Given another nasty winter and the effects of the west coast port strike, we will give the U.S. economy the benefit of the doubt for now, as we do not see recessionary precursors on the horizon. Exhibit 1 U.S. Economic Surprise Index Continued on page 3 2 RBC DOMINION SECURITIES INC.

3 Strategy Q continued from page 2 We also wanted to highlight a couple of indicators that don t get as much play in the media. The number of job openings (Exhibit 2) has accelerated in the past year and now sits near a record for the series. This is an alternative measure of labour market slack, and with a near record number of jobs going unfilled, it suggests to us that the U.S. jobs market is healthy. This has some negative longer-term implications as employers will have to eventually pay higher wages and benefits to lure employees. That should lead to a pickup in inflation, but for now the market is equating higher wages with economic progress. Exhibit 2 U.S. Job Openings In Exhibit 3, we have presented U.S. household formations, which after a significant drop during the financial crisis had been rather stagnant. As economic conditions have improved, many young people who had delayed going out on their own are now doing so. We take this as a tangible sign of confidence in the economy many surveys simply ask people how they feel about the economy. It is one thing to answer a survey with a positive view, but quite another to take on a significant change in lifestyle and expenses. This should be an encouraging sign for the U.S. housing market, which is still mired at levels that in previous cycles were considered bad. Exhibit 3 U.S. Household Formations Continued on page 4 3 RBC DOMINION SECURITIES INC.

4 continued from page 3 Canada: Loonie at Financial Crisis Levels What s next? While the Canadian dollar put in its post crisis peak in 2011, it didn t start to move significantly lower until 2013 (Exhibit 4). Once oil broke down in 2014, we saw the foreign exchange market react swiftly, taking the currency to the $0.80 range where it currently resides, in line with the lows seen in 2008/09. With the Federal Reserve set to raise interest rates before the Bank of Canada, the outlook for the Canadian dollar continues to be negative barring a sudden rise in oil prices. RBC s forecast is for the loonie to hit $ by the end of June, bottoming at $ at the end of Q3. After that, they see the Canadian dollar gradually gaining ground to end 2016 at $0.7752, still below today s level. Exhibit 4 Canadian Dollar The CAD has historically been driven by commodity prices and interest rates, and those two factors have recently become much more strongly linked. With oil prices largely holding above $80/bbl since 2011, expectations for the Bank of Canada played an outsized role in the currency. With the departure of Mark Carney and ascension of Stephen Poloz at the Bank of Canada, the outlook for interest rate increases diminished, leading to the first leg lower in the loonie despite oil prices sustaining high levels. Exhibit 5 Canadian Dollar - 1 Year This was followed by the sharp drop in oil prices through the fall and a surprise interest rate cut from the Bank of Canada in January, ostensibly to help offset oil-related weakness. With the January cut, the Bank of Canada tipped its hand, indicating that more cuts are likely if the price of oil fails to rebound later this year. Conversely, should we see a recovery, expectations should rapidly adjust to a view of no more rate cuts, and perhaps hikes in 2016 once the Federal Reserve is underway. If oil prices were to remain at depressed levels for a considerable period, the economy should eventually rebalance and the Bank will be able to act on fundamentals, but likely from the point of a lower Canadian dollar. Currencies tend to run in long cycles (5-years or more) and if we assume that the current downtrend started in 2011, this trend is about 4 years old. After such a violent and move to the downside, we certainly cannot rule out a corrective bounce on a rebound in oil (which we are seeing as we write this Exhibit 5), but the risk over the medium term is that the Canadian dollar continues to head lower as oil weighs on the economy and the Bank of Canada lags the Federal Reserve s rate hiking cycle. 4 RBC DOMINION SECURITIES INC.

5 continued from page 4 How to prepare for (eventually) higher rates? The risks posed by higher interest rates continue to be top of mind for investors. While it appears low rates will be with us for some time, we do not want to make a one way bet that this condition is going to persist forever. The low rate environment has been a boon for bonds of all types and equities that look like bonds i.e. a high dividend yield with not a lot of growth. In recent years, however, we have seen dividend growth become a more important factor in generating returns for client portfolios. Exhibit 6 Annualized Return from 24 July July 2012 Consider Exhibits 6 & 7 In both exhibits, we look at the returns of various sectors, two representing dividend growth (Consumer Staples and Industrials) and two representing dividend yield (Telecom and REITs). As seen in Exhibit 6, from 2009 until 10-year Treasury yields bottomed on July 24, 2012, performance had a high correlation with dividend yield as investors preferred a bird in the hand as we exited the crisis. Fast forward to the period after the 10-year yield put in its generational low and we see that dividend growth has significantly outperformed. Companies with high yields continued to pay them out, but as interest rates stopped falling, investors turned to securities with growing cash flows. When we see rates start to move higher, this trend should continue as static dividends will face competition from higher yields on safer securities like government bonds, while a growing dividend should serve to blunt this risk somewhat. This doesn t mean all high yielding stocks should be liquidated, but investors who prize income above all else should be prepared for the risk that the growth in their capital may lag or worse in the event that interest rates rise. Exhibit 7 Annualized Return since 10Y Treasury Yield Bottomed* Traditional interest rate sensitive sectors such as life insurance companies should do well in a rising rate environment. Though they have diversified away some of their interest rate risk, markets would still look favorably at these companies as rates go higher. Given just how low interest rates currently are, we think banks would also benefit from rising rates, though not as much as the life insurance sector. Rising rates should lead to higher net interest margins, which have been under pressure in this era of depressed rates. Depending on the reason for higher interest rates, commodity stocks could once again have their day in the sun if rate rise due to inflation concerns. We note that the 5 RBC DOMINION SECURITIES INC.

6 continued from page 5 commodity sectors are immensely distrusted by investors, and a rally here would be a surprise for many. Exhibit 8 S&P 500 Sector EPS Estimates We are also seeing opportunities to benefit from higher interest rates in non-traditional places. Floating-rate preferred shares have traditionally been a way to play higher rates but rate-reset preferred shares are rapidly becoming a play on this theme as well. The interest rate cut by the Bank of Canada has thrown the rate-reset preferred share market into a state of disarray, as many issues are likely to reset their dividends at a lower rate than previously thought. The market has started to apply this sort of pricing for many preferreds that have years left until reset, which we think is irrational unless one is of the view that interest rates stay at today s levels for a prolonged period of time. As new issues come to market with higher reset spreads, the existing issues sell off as investors prefer a higher reset spread all else equal. In an odd twist, we think many rate- reset preferred shares will now be positively correlated with interest rates as higher bond yields imply a better yield on the preferreds when they are reset. Given the dearth of yield available in traditional fixed income in Canada, we think discounted rate reset preferred shares present an interesting opportunity to lock in tax effective yield and potential leverage to higher interest rates. All of the above comes in the context of interest rates (in Canada in particular) that remain at severely depressed levels and imply the Bank of Canada cutting rates further (which is certainly possible) and leaving them there for a prolonged period. If that does not happen, we think normalization should start to take place once the initial shock from the oil decline wears off, leading to total return prospects for high-quality bonds that will have difficulty surpassing coupon income, with the risk being outright negative returns. All Things Considered, Equities Are Fairly Valued We would argue that equities, while no longer cheap, are fairly valued at current levels. Going into the first Federal Reserve rate hike we would expect the market volatility we have seen over the past six months to continue, but do not feel that is a reason to significantly alter asset allocation. The probability of timing a correction right (selling high and having the stomach to buy low when there are scary headlines everywhere) is very low, and investors are likely to incur unnecessary taxes and lost dividend income. 6 RBC DOMINION SECURITIES INC.

7 continued from page 6 Earnings expectations for the S&P 500 in 2015 have slowed somewhat, but much of that can be blamed on an energy sector that has seen its earnings stream decimated by the drop in oil prices (Exhibit 8). Taking into account low interest rates that are likely to persist, low inflation and higher quality economic growth (the previous cycle was driven by a housing bubble in the U.S. and commodity boom in Canada, neither of which are in place now) we feel the equity markets are fairly valued and look for earnings growth and dividends to drive returns. Exhibit 9 TSX and Crude Oil Year-to-Date Bottom Line We expect a broad swath of the TSX to have a strong correlation with oil in the near term (Exhibit 9), as the market has essentially been divided into three parts commodities, banks, and everything else. For the first few months of this year, investors clamored for everything else as commodity stocks became toxic and concerns over banks earnings growth and energy exposure caused investors to shy away. In recent days and weeks we have seen this reverse somewhat the banks which had been left for dead are now trading near their 2015 highs while as we write this the oil price is attempting to break out of a bottoming pattern. We have long viewed the TSX s unnaturally high commodity weighting to be a deficiency and this has not changed. If and when commodity prices recover, this strategy may underperform, but over the long term we believe our strategy of owning high quality businesses that pay and grow their dividends will succeed in providing strong risk-adjusted returns. This commentary is based on information that is believed to be accurate at the time of writing, and is subject to change. All opinions and estimates contained in this report constitute RBC Dominion Securities Inc. s judgment as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. Interest rates, market conditions and other investment factors are subject to change. Past performance may not be repeated. The information provided is intended only to illustrate certain historical returns and is not intended to reflect future values or returns. This information is not investment advice and should be used only in conjunction with a discussion with your RBC Dominion Securities Inc. Investment Advisor. This will ensure that your own circumstances have been considered properly and that action is taken on the latest available information. The information contained herein has been obtained from sources believed to be reliable at the time obtained but neither RBC Dominion Securities Inc. nor its employees, agents, or information suppliers can guarantee its accuracy or completeness. This report is not and under no circumstances is to be construed as an offer to sell or the solicitation of an offer to buy any securities. This report is furnished on the basis and understanding that neither RBC Dominion Securities Inc. nor its employees, agents, or information suppliers is to be under any responsibility or liability whatsoever in respect thereof. The inventories of RBC Dominion Securities Inc. may from time to time include securities mentioned herein. RBC Dominion Securities Inc.* and Royal Bank of Canada are separate corporate entities which are affiliated. *Member-Canadian Investor Protection Fund. RBC Dominion Securities Inc. is a member company of RBC Wealth Management, a business segment of Royal Bank of Canada. Registered trademarks of Royal Bank of Canada. Used under licence RBC Dominion Securities Inc. All rights reserved. 15_90451_L4B_022 (04/2015) 4 RBC DOMINION SECURITIES INC.