Canadian Interest Rate Expectations

Today, the Bank of Canada announced it was keeping the target short-term interest rate steady at 1%. This was not a surprising announcement. The big concern on the minds of the bank is the escalation of household credit. It will blow up eventually (especially whenever interest rates rise again) but in the meantime, conditions continue to be very ripe for future borrowing.

I guess the financial tip of the day is to make sure to start deleveraging before everybody else does!

Month / Strike Bid price Ask price Settl. price Net change Open int. Vol.
Open interest: 651,369 Volume: 128,687
March 2013 98.715 98.720 98.720 0 87,081 3,000
April 2013 0 0 98.705 0 0 0
May 2013 0 0 98.720 0 0 0
June 2013 98.750 98.760 98.760 0 117,907 18,450
September 2013 98.800 98.810 98.800 0.010 140,414 30,685
December 2013 98.810 98.820 98.810 0.010 126,676 26,022
March 2014 98.790 98.800 98.790 0.030 85,272 21,108
June 2014 98.750 98.760 98.750 0.010 53,319 16,547
September 2014 98.690 98.700 98.690 0.030 17,236 8,173
December 2014 98.610 98.620 98.610 0.010 13,242 2,706
March 2015 98.520 98.540 98.530 0 5,555 1,051
June 2015 98.430 98.450 98.440 0.030 1,559 566
September 2015 98.340 98.350 98.350 0 1,723 149
December 2015 98.250 98.280 98.270 0 1,385 230

BAX Futures state that rates are not going to rise again for the remainder of 2013, and there is the expectation of a chance (but not certainty by any means) of a quarter-point hike around March 2015.

Canada Airlines – Westjet, Air Canada, Transat

The words from Warren Buffett resonate within my mind when I recall him saying that the cumulative retained earnings out of the airline sector is negative.

This brings us to Westjet’s (WJA.TO) and Air Canada’s (AC.B.TO)’s relative good performance over the past year – shareholders are up 150% and life is good:

wja

acb

I won’t examine Air Canada because there are a whole bunch of other messy variables to take into consideration (pension liabilities, special government regulatory business, the fact that it is Air Canada, etc.) but we will take a very superficial look at Westjet.

Looking at their year-end results, the corporation has an existing market capitalization of $3 billion, $1.46 billion in cash, $739 million in debt (thus enterprise value of about $2.3 billion) and delivering about $452 million in free cash flow to its investors – a multiple of about 5 times free cash flow. What is not to like about this?

The profits were generated through high seat loading factors (Westjet did 82.8% of seats filled in 2012) and fare rates being sufficiently high, in addition to fuel costs being moderate through the year.

In other words, everything is going quite well for Westjet and they had a banner year. It looks like this is continuing in 2013 – in February they announced a load factor of 86.1%.

An investor will ask – what is the upside from here? The only upside I see is through sheer trading momentum – this is why I would not want to short the stock at present. The higher the stock price goes, the more tempting the short case may seem under the inevitable basis that eventually competition will eventually catch up to the airline and there will once be some overcapacity in the industry. Until then, there is no reason for the stock to not go higher – they could reach $30 or even $40 a share and you could make a “numbers” case for the company’s valuation just based off of free cash flow. The lack of solvency risk (i.e. cash higher than debt at present) is also another bullish case.

Interestingly enough, Air Transat (TRZ.B.TO) has not exhibited the same trajectory, so some inferences can be made on the vacation destination market vs. regular North American travel.

Market musing while being inactive

I hate to sound like a broken record, but I’ve still been doing nothing other than research but nothing worth investing in at the moment except for one illiquid play mentioned in an earlier post.

Here is a series of miscellaneous observations:

* I note that Apple (AAPL) continues its slide down to the point where I am wondering if they are pricing that the company is not going to be able to keep its premium pricing strategy. On paper, they are still massively profitable, but if competition continues to chip away at their product line (mainly through Samsung on the phone front and a variety of other realistic competitors on the tablet front), they might run into revenue growth problems. The company in their last fiscal year (ended September 2012) made $156.5 billion in revenues and this year the analysts are projecting an average of $182.8, which is a $26.3 billion increase year-to-year. This is a huge amount of growth and the law of large numbers will likely be catching up to Apple in short order.

* CP Rail (CP.TO) is trading at absurdly high valuations at present. They performed a change in management and the market is giving the new CEO a lot of credit, but the railroad business is very mature and I don’t have a clue why they are giving the equity such a huge premium at the moment. I’d be a seller at this price range (the C$130 mark).

* Anybody remember the big scare about rare earths a couple years ago when China started restricting the supply and most of those stocks went crazy? The big play here, Molycorp (MCP) has continued to slide into the gutter now that the market reality of the perceived shortage has completely gone away. The substitution effect is very powerful and MCP shareholders are holding the bag.

* Likewise, most other fossil fuel commodity companies, including my favourite company that has been so overrated by many, Petrobakken (PBN), are continuing to suffer. It is similar to how most gold mining companies are not faring nearly as well as the underlying commodity – it costs an increasing amount of money to extract the resource, so even if the commodity price is increasing, if your costs are increasing, you are not going to make much money. Even Crescent Point Energy (CPG.TO) is starting to lose its lustre.

* The other commodity market that is continuing to get my curiousity up is currency trading – the US dollar has continued to outperform most of the other global currencies. The only way that I play this is that I try to hedge my portfolio by having some US-denominated securities rather than using leveraged speculation.

* The two Canadian Real Estate financing proxies, Home Capital (HCG.TO) and Equitable Group (ETC.TO) warrant a further look. HCG has faded somewhat off of its 52-week high, but Equitable is still there. If people are still hyper-bearish on the Canadian real estate market, these two companies should be the first on anybody’s short selling list. Non-performing loans are still around the 0.3% level and currently still do not show any real signs of distress in the market. I am still riding the wave on Genworth MI (MIC.TO) and believe there is still a reasonable percentage gain to be realized from current price levels. The loan companies, however, are hugely leveraged and I’m finding it difficult to see value there when book values are so significantly below market prices.

* Long term interest rates have also taken a nose dive – the Canadian 10-year bond was skirting at the 2% yield a month ago, but now they are back down to 1.8%. The world is awash with capital and there are few places to deploy it where you’ll generate yield at an acceptable risk level. Eventually the leverage party will end and the fallout is going to be very brutal. Whether this happens in 2013, 2014 or later, nobody knows. But there will be fallout, and figuring out how to brace yourself for the fallout will be a big financial challenge over the next decade.

Inactivity is my friend

The only transactions being performed so far this year has been the accumulation of relatively illiquid warrants (over the past two months I have single-handedly been about 30% of the volume in this market) that give you the right to purchase the underlying shares at a strike price significantly in-the-money and the current market value of such securities is still trading under the tangible book value of the corporation (i.e. I expect further and significant price appreciation). In other words, the warrants are a leveraged free-ride compared to the common shares and the history of its management has been appreciation through buybacks rather than dividends.

My leverage fraction is somewhat higher than I am normally used to, but despite the scare tactics that the market will be employing over the next little while to shake soft money out of equities, the trend is indeed up. Too much cash out there is chasing an inadequate amount of yield, and fund managers will need to continue taking more risk in order to reach their required levels and this means equity investment.

With US 10-year bond yields at 1.85% (Canada is 1.94%), pension managers will not be getting these returns out of AAA-rated securities. They must take more and more risk to get their yield.

The most damaging thing I can do at this point is exit. There will be a time to exit, but it is too early. Sentiment is still very damaged by the US fiscal situation and people still think bonds are a safe investment, which they are not.

Ally acquired by RBC

Ally Canada (which was formerly General Motor’s financing division before the parent company went into bankruptcy proceedings) was a competitor in the Canadian high interest savings market. They had a fairly decent product a couple years ago where they offered 2% on a fully liquid savings account. They reduced that to 1.8% last year when they presumably received enough capital from their customers, but it still was in the top tier out of their competitors.

However, Ally was acquired by RBC late last year and now RBC announced they are closing down most of Ally’s accountholders and are encouraging you to open up an account with RBC.

I received in the mail a “special offer” from RBC to open an account with them for a 1-year GIC at 1.8% or redeemable GIC at 1.5%. I laughed as I dumped it into the paper shredder.

Somebody has been kind enough to maintain a site that has a compilation of various high interest savings banks that can be accessible by most Canadians. I’m generally not interested in going through the paperwork hurdles for the privilege to accumulate a less-than-inflation rate of interest. Unfortunately the new economic reality in this extended low-interest rate environment is forcing people to find cash alternatives in the marketplace to find low-risk yield. There are not a lot of opportunities left in this space anymore.

I even notice my standby US-dollar short-term ETF, the 1-3 year iShares bond fund (NYSE: SHY) is giving out a paltry 40 basis points of yield. At least in Canada the floor is 1% – the Canadian ETF equivalent is (TSX: XSB) and they give out 1.48% albeit at some interest rate risk – their average term of maturity is 2.80 years.