Category: Canada

The market has long since baked in the upcoming drop in interest rates.

As a result, anything “yield-y” have been bidded up substantially.

I note the REIT sector, which at one point earlier this year was mostly negative year-to-date is now, with a couple exceptions, up solidly.

We have the go-private transaction (99% sure to succeed) for Melcor (TSX: MRD) repurchasing the minority interest in its REIT (TSX: MR.UN) – the fact that MR suspended dividends some time ago should have given a clue as to its financial condition, but apparently they have some assets on the balance sheet that’s worth paying a healthy 60% premium to market for.

The larger REITs, e.g. REI.un, AP.un, CAR.un, etc. are all up roughly 25% over the past three months.

This is purely due to the quantitative effects of interest rates dropping. I will question the economic fundamentals of such price moves.

We also look at other (restaurant royalty) income trusts, including KEG.un, AW.un, BPF.un, etc., and they are all up. I will also question the economic fundamentals of such price moves. Do lower interest rates cause more people to go to restaurants?

While high prices are great if you are already holding and intend on selling, returns on investment drop with higher prices.

It’s getting pretty tough out there. As cash yields less and less, investors will be compelled to march up the risk spectrum to make the same returns that investors are fighting for.

The good news, however, is that having a slate that is cleaner than it has been since 2008 gives some mental clarity. I am not going to force cash to work for the purposes of increasing yield. It does hurt in some manner, knowing that every day cash erodes in purchasing power.

Despite government-published CPI statistics showing that inflation has moderated, anybody with a functioning eyeball will know that cost escalation is still significant and ongoing, especially with goods and services that people actually require. Costco is an excellent barometer for this.

The deflation you see are for goods that nobody needs. Take a look at Craigslist ads for furniture and you can explore a market that is besieged by deflation. Do you want somebody’s discarded Roomba? That can be had for $50 or $60.

There is also another metric to determine how much purchasing power has declined and that is to measure the portfolio value not in dollars but rather ounces of gold – gold as measured in Canadian currency is up almost 25% year to date, which is more than my own year-to-date performance this year. Just in case if I wanted to pull off a “Scrooge McDuck” and cash everything into one ounce gold coins and go swimming in the vault, I’d have less today than I would have last year!

Interesting times always lie ahead. The environment today is a lot more difficult than it was in 2020-2022.

The whole financial sector of the country knows that the Bank of Canada dropped interest rates by a quarter point a few days ago (from 5.00 to 4.75%). Those holding floating rate debt will see a little bit of alleviation of expenses, and those holding CASH.TO and the like are seeing their risk-free rate drop – nudging the capital further right along the risk spectrum.

However, the overall picture of the inverted yield curve has not changed –

It is still deeply inverted, with a 125bps spread between short and long term yields.

The transmission rate of dropping interest rates (or raising them) and the impact on the real economy is a very slow process – the literature cites around 12-18 months before the full impact of rate hikes and drops come into play. Entities look at their cost of capital and decide to invest or not in projects (e.g. residential strata condominiums or chemical factories) that have a five year development cycles and when the decision is made, the economic impact occurs well into the future. It is not like you can order one of these on Amazon and get it shipped in a day!

You can infer this by looking at employment statistics. Why is construction labour down about 34,700 jobs year-to-year? Major capital projects are running off the ledger (e.g. TMX is finished, Coastal Gaslink is nearly done, etc.) and the decisions to do residential construction occurring in cities were made in 2021 when rates were at rock-bottom and these projects are just completing now. The only sort of capital projects are are hitting the “buy” button are government works – except these are all running into massive cost overruns (e.g. using some BC examples, the Site C dam, the Metro Vancouver sewer plant, any hospital project, the Broadway Skytrain project, etc, etc.). Only government projects are allowed to have any amount of money thrown at them for completion – and this of course attracts contractors like a moth next to the flame. When your competition is able to spend infinite amounts of money, what makes you as a private developer, able to compete for those services? No chance at all – hence cost inflation. With your cost of capital is still relatively high, there’s no avenue for profit.

Finally, I will observe that the progression of quantitative tightening, albeit very slow, is still progressing – the following chart is the “Members of Payments Canada” line item on the liabilities ledger of the Bank of Canada:

The last slab of QT took the “Members of Payments Canada” line item (which is a measure of reserves the financial institutions have with the Bank of Canada) below $100 billion for the first time since the Covid-19 pandemic. As the current $248 billion stack of government bonds, mortgage bonds and provincial bonds get bled off of the Bank of Canada balance sheet, there will be a corresponding drop in bank reserves held at the Bank of Canada. This is not a fast process – $15 billion is scheduled to mature in the remainder of 2024, while $32 billion is slated for maturity in all of 2025. While QT is still ongoing, it is at a glacial pace – hence, “a little bit of QT”.

My reading of the tea leaves makes me suspect that the Canadian currency is going to get pushed down further in relation to the US dollar. Canadian exporters should benefit from the upcoming shift. I also do not view this as beneficial for the domestic economy. There is not a lot of safety out there and cash continues to earn a very good risk-free rate while patiently waiting for the capital values of various entities out there to implode in some sort of panic (the last one being 4 years ago with Covid, although I am not anticipating anything with that magnitude happening again in my lifetime).

The only question that remains is whether we will see a bounceback in inflation. Given the million+ increase in demand for housing in urban areas without a corresponding increase in supply, I do suspect that the most heavily weighted component of the CPI will continue to exhibit an increase. A lower Canadian dollar will also result in costlier imports. Finally, labour inputs are also increasing – wage growth provisions in contracts are rising and here in BC, minimum wage is now $17.40/hour – and correspondingly, your “extra value meal” at a fast food joint is now at least $10, and that’s with a coupon! The wage-cost spiral is a very difficult one to break without a deep recession.

It is difficult to passively wait, but I don’t see the risk/reward for moving up the risk spectrum that good right now. Even the oil and gas sector in Canada with current commodity prices are trading at valuations that are “blah” rather than being a great value.

Any sectors out there getting your attention?

The issuer market for Canadian TSX-traded debentures has been very muted. In past times, issuers would typically roll over debt with 6-12 months remaining in maturity by issuing new debt and calling the soon-to-mature issue. Today, these rollovers have been exceedingly rare, presumably because everybody and their grandmothers have been waiting for lower interest rates!

We have the following issuers that have maturities coming in less than three months, coupled with some point form notes:

AD.DB – Alaris – Likely to mature for cash, paid for with room in the company’s credit facility
AFN.DB.F – Ag Growth – Likely to get rolled over with a new issue – AFN.DB.J (3.7 years out) is 16% away from the money and is trading at 108, it is likely they can get an acceptable coupon price… AFN.DB.G is not further away with a year-end maturity and both might be done with a $150 million or so debt offering (disclosure: I own some shares here).
AI.DB.C – Atrium MIC – will likely mature and be paid by the bank line of credit
ALC.DB.A – Algoma Central – will mature for sure, the question is how much will get converted to equity? (they are 2% in the money at present)
EFN.DB.B – Element Fleet Management – will be converted to equity (conversion is well in the money at present)
TF.DB.C – Timbercreek Financial – will be paid off with the secured credit facility

With the possible exception of Ag Growth, all of these debentures will vanish from the TSX and be absorbed.

When examining the overall debt market (and also the preferred share market), very little strike me as potentially interesting. The price inflation in relation to potential risk is quite unattractive to me at present – the companies trading at low prices are generally doing so for very good reasons. They are also competing against risk-free cash at around 5%, which does not make their relative valuations look good – why aim for a risky 7-8% when you know that the liquidity associated with that 7-8% will be crap when there is a real market crisis, when you can just sit on your rear end with a safe and liquid 5%? I’m not reaching for yield – not being paid enough.