Category: Canada

Bank of Canada governor speech

Tiff Macklem gave a speech today in Halifax, trying to rationalize getting blindsided by inflation. Key quote:

At the time, we assessed that the effect of these global forces on inflation was likely to be transitory. Historical experience has taught us that supply disturbances typically have a temporary effect on inflation, so we tend to look through them. A year ago we expected inflation in goods prices to moderate as public health restrictions were eased, production ramped up and investment in global supply chain logistics picked up. In hindsight, that turned out to be overly optimistic.

I’m surprised his speechwriters haven’t sanitized the word “transitory” out of his vocabulary yet.

The forward-looking payload of his speech is on the “Inflation Expectations” sub-heading. Essentially the Bank of Canada is on a mission to target inflation expectations, rather than inflation itself because the key risk is entrenchment of expectations:

That’s why we are so focused on measures of expected inflation. We use a range of surveys and market-based measures to assess expectations of future inflation, and they show us that near-term expectations have risen. Survey results also indicate that consumers and businesses are more uncertain about future inflation and more of them expect inflation to be higher for longer. So far, longer-term inflation expectations remain reasonably well anchored, but we are acutely aware that Canadians will need to see inflation clearly coming down to sustain this confidence.

They will keep raising rates until they’ve triggered this sentiment, which is likely to happen when the labour market has transformed into one where people are grateful for employment (read: no more upward wage pressure) and the economy goes into the tank.

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.

Recall that interest rates only started to rise on March 2, 2022. It typically takes a year for these decisions to permeate into the economy (capital expenditures cannot start and stop on a dime unlike interest rate futures).

By the end of the first quarter of 2023, things will have gone sufficiently south that people will be begging and pleading for a stop to the torture. There will obviously be a decline in discretionary demand by this point. The question is whether this will actually impact inflation expectations. I’m not so sure – expectations is also a function of public confidence and the question is whether we have seen anything to actually restore confidence – I don’t see anything on the horizon in this respect.

The litmus test is the following – say somebody handed you a stack of $10 million dollars and gave it to you a 10-year rate fixed at the current prime rate (5.45%) (which is a luxury only investment grade corporations would get at the moment). What would you do with it?

Probably most of you reading this would say “invest it in XYZ”, but say I put a future condition on the loan, which would be that you actually had to invest it in a physical capital project involving machinery and equipment and the like (and not through the construction of yet another self-storage facility either!). What would you put your money into?

Bank of Canada – raising rates and NOT killing kittens

Right on the front of the Bank of Canada website:

A lot of press was made about this, and the distraction phrase here is “cash”. Yes, they did not print cash, but they sure as hell injected a bunch of money into the system in the form of bank reserves!

The logic is as disingenuous as writing the following:

“#YouAskedUs if we killed kittens to finance the federal gov’t.

We didn’t.”

The original inception of the central bank is that it is supposed to perform independently of the government to fulfill its mandate (which is set by the government and is currently to maintain inflation at a level of 2%). Independence is supposed to give the central bank credibility, but since we are now in the era of the politicization of everything, the central bank is now playing politics, which certainly won’t help its credibility.

Anyway, back to the present, the Bank of Canada raised 0.75% today, largely on expectations.

Key points in the release, with my comments:

* consumption grew by about 9½% and business investment was up by close to 12%.

It is very easy for consumption to increase this level when inflation is 7.6%! This is a lagging indicator.

* Given the outlook for inflation, the Governing Council still judges that the policy interest rate will need to rise further.

October 26: 0.25% increase to 3.5% unless if something really, really terrible happens in the next seven weeks (say, a stock market crash). The non-market consensus outlook that I’m putting some probability towards is that they will continue to raise 0.25% each meeting until there is the obvious break in demand.

Implications and thoughts

It has been a very long time (about 15 years) where short term interest rates were at these levels, just before the 2008 economic crisis. The risk-free rate is a relevant parameter for most financial calculations. Right now, you can lend the Government of Canada your money for a year and receive a 3.75% guaranteed (nominal!) return. When going out to the corporate bond market, this represents an effective floor on an investment – why bother lending your money to Nortel or Shopify at 3.75% when you can just do it with the government for zero risk?

One reason could be that the corporate world will give you a return for longer than a year – and indeed, a 5-year government bond now yields 3.3%. The question of where long term interest rates go from here is a fascinating one, but if we ever return to the zero-rate environment again, a guaranteed 3% return is golden.

It is instructive to look at the progression of quantitative tightening. December 22, 2021 was the peak of Bank of Canada holdings of government bonds, approximately $435 billion. There is also a (relatively) small amount of provincial and mortgage debt on the books, but we will focus on the bonds. As of August 31, 2022 the Bank of Canada holds $381 billion ($54 billion or 12%). We have data on the “Members to Payments Canada” (bank reserves held in the Bank of Canada) – a reduction of $78 billion there. There’s a $24 billion gap there. What happened?

One factor is that the Government of Canada has been raising more money than expected. Their net cash position with the Bank of Canada rose $30 billion in the prevailing time period. On the fiscal side of things, there is much less pressure on the financial markets to raise debt capital simply because tax revenues have been skyrocketing – this is one of the effects of inflation – everything is valued with nominal dollars. This fiscal cushion gives monetary policy some extra runway before having adverse effects on the longer term interest rates. The government will continue to roll over its debt at higher rates of interest, but they have a very large cash cushion to work with, and if the indications suggest, they will be reporting a significantly lowered budget deficit when they do the fiscal update this November (just in time for more spending to “alleviate the cost of living”!).

What will this mean for the equity markets and asset markets in general? Tough times! It is much, much more difficult to make significant sums of money in a tightening monetary policy environment. Instead of the customary multiple boosts, returns (if any!) will likely be much more correlated to traditional metrics, such as net income and free cash flow, and any gains in corporate profitability will likely be offset to a degree by the P/E multiple compressing due to the risk-free rate rising. Be cautious.

Short term interest rates

Exciting times in Canadian government interest rates – finally seeing some yields again (2 year Canada government bond chart below):

Short-duration bonds are yielding higher than they were before the 2008-2009 economic crisis. The one-year bond is at 3.67% currently, and the two-year at 3.53%.

I’ve talked about this before, but one theory in finance is regarding the term structure of the yield curve in that the total returns is invariant to the term one invests in – e.g. if you invested in 1-year government bonds 10 times, the net result will be the same as if you invested in 1 10-year bond. Of course, practice is different than theory, but if one were to take this theory and apply it with the existing rate curve, it would suggest that the target rate is going to rise significantly higher than the so-called “neutral rate” which, according to the monetary policy report, is between 2-3% nominal. I’ll leave it up to the reader to decide on the validity of these financial theories.

In the monetary policy casinomarkets, the 3-month Bankers’ Acceptance Rate is currently at 3.46% and has crept up slowly in anticipation of September 7, 2022’s expected rate increase – the September futures indicate a 3.89% 3-month rate. I am not sure if this translates into an expectation of 50 or 75bps for the September 7 meeting, but either way short term interest rates are going up. The next meeting of the bank on October 26 is anticipated to have a 25 basis point increase as well.

All of this means that money is coming harder and harder to come by. Governments will find it much more expensive to borrow money, so I would look carefully at your portfolio for entities that are government-dependent.

The big risk continues to be that interest rates will rise further than the market anticipates – and it likely will if inflation does not reach the magical 2% target.

First quarter review of oil and gas – and a look at Suncor

This is a brief review of the companies that have reported their quarterly results to date in the oil and gas space – specifically the ones in the Divestor Canadian Oil and Gas Index. (ARX, CNQ, CVE, MEG, SU, TOU, WCP have reported).

When your spot commodity exposure charts look like this, you know things are looking good:

The amount of bullishness out there in the previous week was a bit nuts and ripe for a correction. When markets ascend for this much time for this duration, there is a natural process where momentum and technical analysis players get cashed out, regardless of any fundamental underpinnings.

The financial market moves much, much, much faster than what goes on at a glacial pace in reality. While the amount that has evaporated out of my portfolio in the past week is impressive, it goes with the nature of finance that things will indeed be volatile, but the intrinsic value of the portfolio remains intact, reflected by real-world economics instead of financial economics.

All of the companies in the oil and gas index have been reporting record free cash flows, but most notably all of the players have been quite tight on growth capital in the sector – the free cash flow for the most part has gone into debt reduction, dividends and share buybacks. Now that most of these companies have reached their leverage targets, they are now continuing to deploy more cash into share buybacks, or (in the case of TOU) special dividends.

The financial mathematics of companies giving off sustained free cash flows (key word being ‘sustained’, noting that fossil fuel extraction is a cyclical industry) is interesting to analyze. I will use Suncor as an example.

Suncor guided in Q1 that their income tax payments will go up from the lower $2 billion range to $4 to $4.3 billion (note that income tax is a function of operating income minus interest expenses and after the removal of royalties, which is another huge layer of money given to the government!). Suncor does not have a material tax shield so they will be fully paying cash corporate income taxes. The Canada and Alberta corporate tax rate combined is 23%, and they have other operations in other provinces and overseas, so we will assume 23.5% as a base rate, which puts Suncor at $17.7 billion in pre-tax income ($13.5 billion after-tax).

Those with an accounting mindset will ask whether net income translates directly into free cash, and Suncor’s capital expenditures are roughly in line with depreciation. My own on-a-paper napkin free cash modelling also corresponds roughly to this $13.5 billion amount in the current commodity price environment.

Suncor has 1.413 billion shares outstanding as of May 6, 2022, so the upcoming year of income is $9.55/share. Suncor trades at $44/share as I write this, and has an indicated quarterly dividend of 47 cents per share ($1.88 annually). Although management has hinted this will go up over time, for now let us assume it is a static variable.

Deciding between debt reduction, dividends and share buybacks usually are a dilemma, but when the math is this skewed it is not.

Suncor’s debt currently costs them about 5.25%, or 4% after-tax. A share buyback not only alleviates the company from paying out the 4.27% dividend, but is also purchasing a 21.7% return on the equity.

This is a no-brainer decision from an optimization standpoint – every penny after regular capital expenditures, should go into a share buyback. The dividend should be brought to zero and shares should be bought back with that amount instead, until such a point where the return on equity goes below a particular threshold (my own personal threshold if I was calling the shots at management would be 12% or anything below $80/share in the current price environment!).

However, there are other variables to consider.

One is that the commodity price environment might not (and indeed is very unlikely to) last forever. There is a pretty good case to made that this particular price environment will last longer than most (instead of spending on capital expenditures like drunk sailors, companies across the grid are shockingly being very disciplined about limiting the amount of growth in production), and also the margin of error of the price level itself is quite high – West Texas Intermediate is at US$100 and even if it goes down to US$75, my models still have Suncor making around $8 billion in free cash. My $80 threshold price for share buybacks would drop to $47/share in this scenario – very close to the current market price.

So the argument to reduce debt is not out of financial optimization, but rather reducing the brittleness of the financial structure of the company. Hence the decision to allocate the residual 75% of free cash minus capital expenditures and dividends to debt reduction, and the other quarter to share buybacks. Although it is not financially optimal if you assume the current environment exists, it is a safe decision. They will do this until they go to under a $12 billion net debt position, which will happen at the end of Q3/beginning of Q4. (Note that Suncor introduced a new conservative fudge factor by adding in lease liabilities into this definition which inflates the net debt number).

After they reach the $12 billion net debt figure, then 50% gets allocated to debt and 50% to the share buyback. At the current commodity environment and share price, they will be able to complete nearly the 10% full buyback with this regime. After they get down to $9 billion in net debt, then the debt reduction goes to 25% and share buyback will go to 75%. I just hope that management has the prudence to taper the buyback and increase the dividend if their share price gets too high.

The other variable is the dividend. While the tax inefficiency of dividends are well documented elsewhere, it does provide a “bird in the hand” component to the stock, and also gives the buyback itself some metric to be measured against. While other people consider a dividend to be very important, I am agnostic about a particular dividend level, except in context of alternatives.

Obviously if a company has capital investment opportunities, you do not want to see a dividend. You instead want to see them deploying this capital in productive ventures. However, in the fossil fuel industry, there is a very good argument to be made to just keep things as-is and just go on cruise control – this is exactly what is happening for all of these companies. They are paying down debt and allocating cash to dividend and share buybacks, especially when all of them are giving out 20%+ returns. There is no reason not to.

The ultimate irony here is that in such an environment where cash flows are being sustained, it works incredibly in the favour of investors that the market value of these companies remains as low as possible, to facilitate the execution of cheap share buybacks.

This leads me to my next point, which is that it does not take a CFA to realize that on paper, many of these oil and gas companies are perfect candidates for leveraged buyouts. Only the perceived toxicity of fossil fuels and ESG has prevented this to date, and I am wondering which institution will be making the first step in outright trying to convert a leveraged loan (even in the elevated interest rate environment, they can get cheap debt) to buy out a 25% cash flowing entity. It is inevitable at the current depressed market prices.

The first warning shot on this matter (which is cleverly disguised as a strategic performance improvement scheme) comes from Elliott Investment Management’s Restore Suncor slide deck. They can’t outright say what they’re thinking – let’s LBO the whole $60 billion (market value) firm!

Needless to say, an investor in this space makes most of their money “going to the movies”, as Warren Buffett said about one of his earlier investment mistakes (selling a company too early). I think this will be the case for most of the Canadian oil and gas complex.

Size of Bank of Canada Quantitative Tightening

The Bank of Canada, effective April 25, will now let its portfolio of government treasury debt mature.

Over the next two years we have the following maturities, in billions rounded to the nearest $100 million (MBS = mortgage-backed securities):

2022 – total 56.9 (+1.3 MBS)
May – 12.6
June – 3.1 (+0.3 MBS)
August – 16.8
September – 6.8
November – 17.6
December – 0.0 (+1.0 MBS)

2023 – total 88.5 (+1.3 MBS)
February – 17.4
March – 10.8
May – 16.9
June – 6.0
August – 9.1
September – 23.9 (+0.6 MBS)
November – 4.6
December – 0.0 (+0.8 MBS)

Total portfolio – 423.2 (+2.6 MBS)

Observations

Below is the chart of the cash the Government of Canada (their asset) has at the Bank of Canada (their liability):

There is around $98 billion for them, which suggests that liquidity will not be a concern with maturing government debt.

We examine Budget 2022, Table A1.7:

Note the $85 billion cash requirement (despite the $53 billion accounting headline deficit), which the government will have to raise through the fiscal year in addition to the rolling over of near-term debt.

How much will the government raise in gross debt in 2022-2023? Around $212 billion according to this projection:

What a coincidence – May, August and November correspond with when the major components of the QT maturities are arriving this year. Instead of the primary issuers buying the debt and then the Bank of Canada immediately scooping them up, now those institutions will have to actually purchase the government debt with the knowledge that the BoC will not be backstopping it.

How much can the treasury market take before it starts to vomit? We will see!