Category: Finance

Most of financial media is designed to get you to trade around your positions. There is always attention deficit disorder-inducing information about some minute development that tries to nudge you to getting in or out of positions.

Such actions are most typically very destructive for performance and also the disposition of securities destroy long-term benefits of tax deferrals on non-registered accounts.

There are times to pounce and there are times to just twiddle your thumbs and spend 10 bucks on a Netflix subscription and catch up on the soap operas. (I’m trying to make a modern-day version of a phrase Warren Buffett used to describe himself about “going to the movies” instead of taking an action in the market that he later regretted).

Right now is one of those times.

The Bank of Canada is going to raise interest rates on October 26, quite likely 0.5% to 3.75%. Then the Federal Reserve is going to raise interest rates on November 2, quite likely to the 3.75-4.00% range.

In both cases, QT continues concurrent to rate increases. The Bank of Canada has $370 billion in federal government bonds, and $17.6 billion goes off the books at month end. The US Federal Reserve peaked at $5.771 trillion in treasury securities at the beginning of June and is now at $5.629 trillion – and is mandated to drop $0.06 trillion a month.

While liquidity levels are ample, it is decreasing. The cost of capital is rising – while you can still get capital, it is a lot more expensive than it used to be.

Laying in the financial bushes and stalking targets is the mode of the day. In the meantime, cash is offering a dividend level not seen in well over a decade.

Things in the real economy are going to get a lot worse. You will see this with a lot of lagging indicators, especially unemployment. Come January and February 2023, the unemployment rate will rise a lot higher than the reported 5.4% for August.

The financial economy tries to predict these changes in advance and indeed, some of this has been already priced in. There are typically two areas where the market does not anticipate very well – when it over-extrapolates a trend, and also the failure to predict second and third order impacts of economic developments. The ability to predict these contributes to a lot of alpha for portfolio managers – worthy of a separate post.

At the end of the day, however, equity markets have some semblance of valuation on the basis of residual profits of the various entities which are given to shareholders. There is never an equilibrium price achieved, it is always fluid and subject to anticipation of changes.

When the so-called “risk-free” rate increases like it has, the comparisons become more competitive as there is always a risk premium between risk-free and risk-taking.

A concrete example of this is looking at a relatively stable equity versus a government bond.

We will use A&W Revenue Royalties Income Fund (TSX: AW.UN) as our example. It is nearly a universally recognized entity in Canada. The business is stable. The debt leverage employed is not ridiculous. While there are some complexities (the controlling interests have somewhat of a conflict with the unitholder trust), all you need to know for the purpose of this post is that the business skims 3% of the revenues of all A&W franchise sales across Canada. After interest expenses and taxes, the cash is passed to unitholders.

Right now this trust yields unitholders 5.4%.

Contrast that with a 1 year government bond, yielding about 4%, or a 10 year government bond yielding 3.1%. If you’re dealing with retail amounts of money and want to put it into a GIC, a 1-year GIC earns 4.53%, while a 5-year GIC earns a cool 5% – that’s a larger rate of interest than it has been for a very, very long time. Savers are finally getting rewarded for a change.

In contrast with units of A&W, you’re not receiving a lot of compensation for your risk. As a royalty business, you are less concerned about profitability and more about gross sales – your incentive is that the business operate rather than thrive. For some reason, the market warrants the risk spread (to government debt) of about 1.4 to 2.3%, depending on time horizon, is deemed to be sufficient. One can argue this is too high or too low, but right now it is what it is.

If interest rates continue to rise from here, it is only logical that the equity risk premium rise as well. In other words, if 1 year rates go to 5%, and 10 year rates go to 4.1%, then all things being equal, the equity should be priced around 6.4% – or the equity should take a 15% price haircut from the current point.

The equity risk taken is absurd especially in light of other perpetual investments that offer a seemingly higher margin of safety than A&W. An example would be in preferred shares of Pembina Pipeline, say PPL.PR.A, which gives you around a current 6.9% eligible dividend (much better tax treatment than royalty income) with a gigantic margin of safety. However, in rising rate environments, many of these entities are extremely leveraged with debt, which may result in credit risk deflating the value of your shares.

There is also the overall market liquidity risk – when liquidity continues to decline (central banks are tightening up the vice with QT as we speak), valuations across the entire market will compress as the marginal dollar does not have the ability to sustain high asset prices.

So how does one survive as an investor in a rising interest rate environment? There are very few escape valves.

One is cash, or very short-term cash equivalents. While you take the inflation hit, your principal will be safe. You will also be the recipient of rising rates when you rollover your debt investments into the like.

However, many do not have the luxury of holding cash (funds are restricted from holding over a certain amount).

Preferred shares in selected companies are another possible escape route. While they do not offer great returns, many of these firms that obviously will be solvent and paying entities are trading at reasonable yields. Your opportunity for capital appreciation is likely to be very limited, but at least you’ll be generating a positive and tax-advantaged return. (I will once again lament the upcoming redemption of Birchcliff Energy’s preferred shares (BIR.PR.C) as being the last redeemable preferred share left on the Canadian marketplace (R.I.P.).)

However, many do not have the luxury of holding fixed income products.

So say there is a gun pointed to your head and you are forced to wade into the equity markets.

The problem is that anything with a yield is sensitive to increasing interest rates. Companies trading at high multiples will have P/E compression and this will kill your equity value.

The formula is that you need to invest in a company generating cash at a very low multiple (well beyond a 2-3% spread from the risk-free rate), the cash flows are sustainable, AND the company can either repurchase its shares at such a low multiple or give out cash to shareholders at a yield well beyond the risk-free rate.

There are not many companies like this that trade. Ideally one day you would find a royalty company trading at a 15% yield. Then you would pounce on it with full force.

There are very few moments where you see this happen, and when it does, it can be very profitable. February 2009, Q1-2016, Christmas 2018, and March 2020 were some recent times where you had a gigantic rush for liquidity in various names.

Execution on the trading is also not easy – before a royalty company reaches a 15% yield, it will have to trade through 8%, 10%, 12%, etc. At these valuation points, it will increasingly look more and more attractive. Back during the economic crisis of 2008/2009, I remember purchasing long-dated corporate debt in Sprint (the telecom) for a 20% yield to maturity and feeling a bit resentful when at one point it was trading at 25% YTM before it slowly made its way back to the upper single digits YTM a couple years later. A similar situation with equities and some distressed debt will likely happen over the next 12 months, so plan accordingly to reduce resentment of not catching the absolute bottom – markets are most volatile at their bottoms and tops. I do not think we are at all close to seeing the peak in volatility for this cycle yet, which is surely a ‘down’ cycle.

By far and away, the largest surprise for many has been the relative strength of the US currency to the exclusion of others:

Since most international trade is denominated in US currency, it means that for foreign countries engaging in commodity purchases and most other imports, the trade currency becomes that much more expensive to transact. This has an effect on their cost inputs (in addition to the core commodity prices themselves being relatively inflated). For example, when Europe wants to import LNG, not only do they have to pay an extremely bloated premium to doing so, but right now they are dealing with record lows of “99 Euro-pennies” being equal to one US dollar.

The US Federal Reserve as well is raising interest rates, so holding cash (or liquid short-term treasury notes) is no longer a zero-yield option: indeed, you can lend your money to the US government for a year and get 3.3% for it. Cash is once again becoming more valuable.

It was widely anticipated that with inflation and the US government printing massive deficits that the currency would sink like a stone – indeed, it has gone in the opposite direction as people are demanding US dollars, especially as asset markets depreciate, and credit stress becomes apparent.

The future course of action appears to be that there will be some sort of crescendo event where the US dollar will gain so much strength and then when things break somewhere, the US dollar will be sold off. I don’t know when this will be.

All I know is that being levered long in this environment is dangerous – especially as the existing consensus is that the fed will drop interest rates again in 2023 – what if they don’t because inflation is still running well above 2%?

Prices are formed on the basis of the sentiments of the marginal bidder and marginal seller. In the event that there is an instantaneous drop in demand and consistent supply, prices will drop and they will drop quickly. As interest rates rise and central banks continue to pull capital out of the bond markets, it is like taking oxygen out of the room. Initially, nobody notices. Then there is a point where people actually feel better, despite the fact that the oxygen level gets below where it can sustainably maintain your cognitive function. We’re probably at that point in the markets. Then finally, you start to lose your functionality entirely before losing consciousness.

I’ve used the market rally that began in July to pull out the weed-wacker and trim the portfolio a little bit and raise cash. If things rise from here, I’ve got plenty of skin in the game. However, the suffocating effect of rising interest rates is increasingly apparent. It will be very difficult to generate excess returns at present.

All of the resource companies that have reported to date are guiding costs upwards, due to inflation.

For instance, Teck is now guiding unit costs on copper up approximately 6%. Their major capital project at the moment (QB2, a massive copper project which is nearing completion) just ramped up their own costs once again and is signalling that production will not begin until early 2023 instead of 2H-2022 as expected.

Cenovus’ 2022 projected capital costs are going up 10%.

The rest of them will be roughly similar to this – rising costs everywhere.

The impact of inflation will be permeating through the entire economy. Just because companies are going to be making good cash on a high commodity price environment does not make them immune on the cost side.

Commodities are a price-taking industry, the producers more or less sell at whatever the market is willing to give them.

Companies that are price-making (e.g. SaaS like Microsoft) have a lot more power in this environment, but there is an element of elasticity depending on exactly what you’re selling. Those companies that have wide moats will do very well in an inflationary environment.

It is well known that inversions in the yield curve signal bad economic times coming ahead.

Why? Typically credit is extended by financial institutions that make their money by borrowing short and lending long.

When the yield curve is inverted, financial institutions will find it more difficult to make money since the interest spread capture is narrower.

JP Morgan, for example, has announced in their last quarter that they are suspending their share buyback program. Their politically correct wording was: “In order to quickly meet the higher requirements, we have temporarily suspended share buybacks which will allow us maximum flexibility to best serve our customers, clients and community through a broad range of economic environments.”

Just remember, they’re suspending share buybacks for your safety!

Certainly when JPM is deciding to go into capital preservation mode, I get suspicious. Indeed, when I look at the Canadian banks, I think most of them have a good chance of going back to the pre-Covid levels. Second-grade financial institutions (e.g. Equitable, Home Capital, etc.) are offering GIC rates of around 4.4-4.5% for two-year money, which is the highest I’ve seen in a very long time. If they have to pay that much for their short-term capital, good luck on the duration match when they are also charging 4.59% rates for a 5-year mortgage!

Presently, I’m looking at one of the weirdest interest rate outlooks I have ever seen. The markets are predicting an increase on the July 27th Federal Reserve meeting, and another rate increase in September. However, in 2023, rates are expected to drop again, presumptively modelling this economic slowdown and recession nearly everybody and their grandmother is talking about at this point.

It is the oddest recession on the planet where you have low unemployment rates (5.1%, which is about as good as it gets here), commodities are booming, governments are raking in record corporate income taxes, etc, etc.

The Canadian rate curve has a similar trajectory – September 2022 3-month Bankers’ Acceptance Futures are trading at 3.85%, while a year later (September 2023) they are at 3.30%. Right now that rate is at 3.18%.

Since this rise in rates in 2022 and the drop in rates in 2023 is all baked into existing futures pricing, it leads one to the question – where might this actually go?

A few scenarios:

1. We get our recession, but inflation persists – banks likely have to stand pat on a relatively low rate of interest (2-2.5%) and real rates will continue being negative for the foreseeable future.

2. We get a massive recession (e.g. the asset deflation scenario with QT and everything), inflation busts out due to demand evaporation (supply chains normalize, etc.) – banks will crank rates down likely to the zero bound and you can dust off your post-Japan 1989 playbook for another couple lost decades.

3. The economy is actually fine, capital gets invested, etc. – rates will steady and possibly rise even further as this would probably be inflationary in the short-run.

Since a lot of the inflationary phenomena involves psychological expectations, it is very difficult to predict how this is going to resolve itself.

Cash (take a mild amount of duration risk for a net 370bps YTM with TSX: XSB!) might be trash, but it might be less trashy than the alternatives. Perhaps taking the real rate loss and being able to purchase assets for 20-30% of a discount from present is a possible scenario for those that are patient. Quantitative tightening has just barely begun and the typical real world economic impacts of interest rate increases will take a year to permeate – we’re now four months from the initial March 2, 2022 quarter point increase. Perhaps when the collective amounts of all of the Covid handouts have been spent, there will be a significant belt-tightening process. There are many lines of speculation about the future.