Canada – Page 4

The effort it takes to get a coal mine going

Headline: Ottawa says no to Glencore’s Sukunka open-pit coal mine project in B.C.

I don’t think anybody should be shocked these days that opening up a new coal mine in British Columbia is next to impossible. It will be killed at the environmental regulatory process.

Glencore has been at it since 2013 and halted in 2016 and 2018 to obtain more data on cariboo and water quality and perform further consultations with various First Nations bands. Interestingly enough, one of the identified impacted First Nations bands, McLeod Lake Indian Band, issued a letter in support of the project. The various reports made for fascinating reading.

On this post, I am not making judgement on the environment assessment process or to determine its efficacy or whether it was a good decision made or not; however, I will point out the obvious that this is not the only project to be bludgeoned on the entrails of the environmental ministry and it will not be the last. What this does, however, is provide a huge layer of incumbency protection on the existing projects (especially looking at Teck).

Practically speaking, there are two coal miners in British Columbia – Teck and privately-held Conuma Resources. Looking at their transparency reports (Teck, Conuma) it is like the proverbial elephant and mouse in terms of their contributions to the government.

The last (to my knowledge) issued environmental assessment certificate given to a coal miner in BC was to HD Mining in 2017 for their proposed 6 million ton a year metallurgical coal mine project near Tumbler Ridge, BC. While there was a very colourful story to this company almost a decade ago, today it is pretty obvious that the project is still dormant.

Considering that Teck got rid of its interest in its Quintette coal mine (for a not insubstantial $120 million) to Conuma very recently, there is still obvious economic value in these residual interests even if they are dormant.

However, developing a new mine from scratch in BC is going to be very difficult to clear through the government regulation. Incumbency protection is very significant.

Bank of Canada raises interest rates

Bank of Canada link.

I was expecting a 25bps raise, but they did 50bps instead, which wasn’t entirely out of the realm of possibilities. The short-term bank rate is now 4.25%, while 10-year government debt yields 2.78% – extreme inversion.

The second to last paragraph of the relatively terse Bank of Canada announcement says (with my bold-font emphasis):

CPI inflation remained at 6.9% in October, with many of the goods and services Canadians regularly buy showing large price increases. Measures of core inflation remain around 5%. Three-month rates of change in core inflation have come down, an early indicator that price pressures may be losing momentum. However, inflation is still too high and short-term inflation expectations remain elevated. The longer that consumers and businesses expect inflation to be above the target, the greater the risk that elevated inflation becomes entrenched.

This “entrenchment” of inflation expectations is the key variable. As long as people believe in inflation, demand will continue to be high. Run through this thought experiment – if you think the purchasing power of your money is going into the toilet, what do you do? Buy more stuff while you can.

Also, we’re in the tail-end of what I will call the “covid effect”, namely after suffering from two years of lockdowns and general malaise, people are spending money because they haven’t been spending for the previous two years. This Christmas is probably going to be the end of it. In early 2023, I’m expecting a sobering-up period and this will probably be sharper than most expectations.

The last paragraph:

Looking ahead, Governing Council will be considering whether the policy interest rate needs to rise further to bring supply and demand back into balance and return inflation to target. Governing Council continues to assess how tighter monetary policy is working to slow demand, how supply challenges are resolving, and how inflation and inflation expectations are responding. Quantitative tightening is complementing increases in the policy rate. We are resolute in our commitment to achieving the 2% inflation target and restoring price stability for Canadians.

The “will be considering” is a very different change of language than “will need to rise” to describe the next interest rate action.

Finally, quantitative tightening is a slightly misleading term at the moment simply because there is only a billion dollars of Canada Mortgage Bonds due to mature on December 15, and then the next tranches of maturities is not until February 1st (with a $17 billion slab of near zero-coupon debt due for maturity). Reserves at the Bank of Canada continue to be around the $200 billion level and have not moved for the past 6 months or so:

Those banks are very happy to keep their money at the Bank of Canada and earning 4.25% – you’re certainly not going to give a sketchy customer a leveraged unsecured loan at 6%! The reserves will get bled out as QT resumes in February and concurrent with the Federal government doing what it does best – deficit spending.

My prediction for the January 25, 2023 announcement is a 0.25% rate increase to 4.5%. The expectations for retail sales during Christmas season might be even better than expected – especially given that we still aren’t very good at mentally adjusting the “same-store-sales” numbers down 10% to account for inflation!

2022 Edition: TSX Tax-Loss Selling List

The TSX has made quite a surge up this quarter, and year-to-date it is only down about 6%. That said, there are plenty of stocks deep in the red for the year. Some of them will have equity investors so underwater in them that unlocking capital losses will push prices even further down.

2022-11-21-TSXTaxLossSaleList (Excel version)
2022-11-21-TSXTaxLossSaleList (PDF version)

Attached is a spreadsheet that contains in rank-order, the year-to-date losers of the TSX, with an arbitrarily set market cap floor of $50 million and everything under 25% year-to-date.

There are some aberrations here and there that you will have to adjust for (dual class stocks, Dorel performing a massive special distribution, etc.) but for the most part there is a lot to go with here for research crusades.

I was floored by the number of companies on this list – 209 – and 81 stocks went down more than 50%.

There is a very obvious split between these companies. Most of the severe losers do not make money (and consequently do not give out dividends), while the second half of the list (between 44% and 25% losses for the year) approximately half the companies do exhibit a trailing 12 month positive EPS characteristic and more than half of them gave out dividends. Some of these companies are quite credible.

Screening these companies for value is an interesting exercise. The whole market environment from 12 months ago has completely transformed – specifically interest rates have gone from 0.25% to 3.75% with a very probable rise on December 7, technology companies have been completely murdered (witness the rise and fall of Shopify, down 73% for the year and no longer a top-10 component of the TSX Composite… they’re 11th) and instead of marijuana companies and gold mining companies being pervasively on this list, we have a much broader spectrum of sectors represented.

Some of the IPOs have exhibited extremely poor performance, especially in the software sector – for example, Vancouver companies Copperleaf (TSX: CPLF) and Thinkific (TSX: THNC) are down 83% for the year. Those option grants aren’t getting exercised in my lifetime. Both of these companies have a ton of cash on the balance sheet, have little debt, are losing money, but their market caps are still considerably above their book value. Will all of that software R&D (expensed and hence not on the asset side of the balance sheet) be realized in the form of profits sometime?

With this much breadth there are a few prospects I’ve been eyeing, but just like a tiger waiting in the bushes, there is a right time to pounce.

Anything on this list that catches your attention?

Bank of Canada will lose money for the foreseeable future

It is ironic that one victim of higher interest rates is the Bank of Canada itself.

After engaging in a massive amount of quantitative easing, as of October 26, the Bank still has about $400 billion of government bonds on their books. They collect interest income from these bonds as payments are made (a journal entry from the Government of Canada to the Bank of Canada). You can view the holdings and come to a calculation of approximately $5.9 billion a year in interest income that the Bank will earn from their “investments”. The Bank stopped publishing exact details of their $11.8 billion provincial debt holdings in 2021, but if we just model it at 25bps higher than the federal government, we get another $200 million in interest income, for a total of $6.1 billion a year.

This modelling is not quite correct – the above calculations used strictly the coupon rate for the government debt securities, and not the more appropriate measure of using the market yield to maturity as the basis for the revenues earned for government debt. Using this metric, the calculation bears less revenues – the 2nd quarter report of the Bank of Canada indicated $1.163 billion in interest revenues, which equates to about $4.65 billion annually. The $6.1 billion estimate above is too generous.

Pay attention to a typical interest rate announcement. The first paragraph is the following:

The Bank of Canada today increased its target for the overnight rate to 3¾%, with the Bank Rate at 4% and the deposit rate at 3¾%. The Bank is also continuing its policy of quantitative tightening.

If you are a member bank and wanted to borrow money from the Bank of Canada for a day, you would pay the Bank Rate. Conversely, the Deposit Rate is the money the Bank of Canada gives you for parking your money in reserves.

However, in our world of quantitative easing, a significant portion of the government debt purchased by the Bank of Canada got converted into two primary liabilities – the Government of Canada account, and the reserves of member banks (“Members of Payments Canada”).

When QE was going on, these liabilities resulted in insignificant payments – the deposit rate was 0.25%. However, interest rate increases have significantly increased the deposit rate to the 3.75% we see today.

As of October 26, 2022, the Bank of Canada held $282 billion in reserves held by banks and the Government of Canada. With the deposit rate now at 3.75%, the Bank of Canada now has to pay off $10.6 billion and this only offset by roughly the $4.6 billion a year received from the Bank of Canada’s bond portfolio on an annualized basis (and subtracting amounts that get quantitative tightened over time). The Bank of Canada also has an operating budget (to pay for staff, office space, IT, etc.) which annualized, is around $720 million.

My quick paper napkin calculation suggests that at a 375bps rate, the Bank of Canada will be losing around $1.6 billion quarterly as long as they have the roughly $282 billion in deposits on their books (currently $96 billion held in the Government of Canada’s name, and $186 billion held in member bank reserves). If the Bank of Canada stops paying the Government of Canada, this number goes to about a $3 billion a year loss. This number gets reduced in 2023 if the Bank of Canada continues its QT program, but such stemming of losses would be potentially offset by further interest rate increases. The number only swings back to profit when the Bank has eliminated the reserves on its liability book, or if it chooses to decrease the deposit rate.

Section 27 of the Bank of Canada Act is the mechanism where the Bank will remit proceeds over a certain amount to the Government of Canada – essentially sending its profits to the government. The legislation does not work in the other direction – it is implied that the Bank of Canada will always be making money! Some minutiae of the Bank of Canada states the following:

At 31 December 1955, the statutory reserve had reached the maximum permitted under the Bank of Canada Act of five times the paid-up capital. Since then, all of the net revenue has been remitted to the Receiver General for Canada. Following an amendment to section 27.1 of the Bank of Canada Act, the special reserve was created in 2007 to offset potential unrealized valuation losses due to changes in the fair value of the Bank’s investment portfolio. An initial amount of $100 million was established at that time, and the reserve is subject to a ceiling of $400 million. Effective 1 January 2010, based on an agreement with the Minister of Finance, the Bank will deduct from its remittances an amount equal to unrealized losses on available-for-sale assets. Prior to 25 March 2020, this category includes Other deposits.

The government has generously allowed the Bank of Canada to deduct its losses from the 2008-2009 economic crisis, which was not really needed because the Bank did not engage in wholesale QE during that era (less than $40 billion of reverse repurchases, which is a drop in the bucket compared to the numbers we see today – and they were settled in 2010).

However, this time is different, and the Bank of Canada will be facing significant losses as long as interest rates continue to remain at elevated levels. Their Q3 report will show a loss, and their Q4 report will show a big loss. It will blow through the $400 million reserve in short order.

I can imagine the upcoming hilarity that is going to occur on November 3, when the government announces the fiscal update which will likely include more “anti-inflationary (deficit) spending”. Part of this hilarity involves the government having to draft legislation to permit the Bank of Canada to incur losses and beg for money to keep operating. Just imagine the political backlash when Canadians learn that the Bank of Canada will be one more fiscal lead anchor that the public has to subsidize and also the sight of Tiff Macklem going to Finance and begging for money from the government to maintain the payroll.

Canadian Monetary Policy – Interest rates will continue to rise

Back on October 7, I wrote the following:

Until things blow up, my nominal trajectory for Canadian short-term interest rates will be:

October 26, 2022 – +0.50% to 3.75% (prime = 5.95%)
December 7, 2022 – +0.25% to 4.00% (prime = 6.2%)
January 25, 2023 – +0.25% to 4.25% (prime = 6.45%)
March 8, 2023 – +0.25% to 4.50% (prime = 6.7% – think about these variable rate mortgage holders!)

Note that the Bankers’ Acceptance futures diverge from this forecast – they expect rate hikes to stop in December.

We might see the Canadian 10-year yield get up to 375bps or so before this all ends, coupled with the Canadian dollar heading to the upper 60’s.

This October 26 prediction was a non-consensus call, with the markets generally pricing in a 75bps increase and me sticking my neck out with 50bps. I nailed it.

The 10-year government bond yield did eclipse 3.75% on October 21, but I am not claiming victory here – the intention of my post is that it will be occurring later in the future when it dawns into the market that short term rates are not dropping.

The Canadian dollar clearly hasn’t gone into the 60’s yet, but it should happen.

I get the general sense that the market is pricing in a change in the second derivative of the interest rate trajectory. The pattern looks very elegant – 25bps, 50bps, 50bps, 100bps, 75bps and now 50bps, and they expect another 25bps in December and then it’s done. Since the light can be seen at the end of the tunnel, party on, start playing the low interest rate trade since surely the Bank of Canada and Federal Reserve is going to loosen policy again and send everything skyrocketing.

It will not be this simple. Long term bond yields will rise and markets will fall when they come to the realization that inflation has not subsided.

Recall that inflation is not increased prices, but rather the expansion of money supply against a fixed amount of goods and services. Increased prices are a consequence of inflation.

The reason is that this assumption that market participants believe that central banks will come to the rescue in the event the economy tanks is what is causing the rates to continue increasing. It will only be when people are begging and pleading for relief that the central banks will relent, and likely bail out the entire populace with the introduction of a centrally administered digital currency.

The key metric to watch out for is employment. Although full employment is the mandate of the US Federal Reserve, it is something that the Bank of Canada will be paying attention to, albeit a lagging indicator.

We need to see unemployment rates climb before the psychology of inflation gets stabbed in the chest.

Until then, every item purchased at Costco and Walmart, every restaurant meal, every hotel and airline ticket, represents an element of aggregate demand which the supply is clearly still not expanding to.

There are signs that the tightening monetary environment is having an effect. Monetary aggregates have barely budged over the past year (M2++ is up 1.4% from January 1 to August 1 this year when the typical trendline is around 5%). But we are in a waiting period where corporations and individuals need to burn off their reserves before engaging in the real difficulty of belt-tightening that comes after some very poor fiscal and monetary decision-making.

Using a physical analogy, we have been eating daily at a buffet for the past two weeks and the 10 pounds of excess weight that we have gleefully put into our stomachs need to get worked off. Although the food has been taken away relatively quickly (rising interest rates), the fat on the waist is still showing (we still have a huge surplus of liquidity from the 2020-2021 fiscal/monetary actions).

Until we see signs of unemployment and, in general, “pain”, interest rates will slowly climb until we see people lose jobs. The Bank of Canada governor is slowing things down for political reasons more than anything else – he doesn’t want to be seen as the guy crashing the economy – and you can be sure that politicians of every political stripe, whether red, blue, orange, light blue or green, will be sharpening their knives and polishing their talking points.