Canadian interest rates

The Bank of Canada dropped their target interest rate from 0.75% to 0.5% today.

Canadian currency has taken a plunge in response. In addition the Federal Reserve Chair has pledged to start “normalizing” US interest rates by the end of this year which also puts downward pressure on all non-US currencies.

cdw

While I rarely have strong feelings on currencies, the “perfect storm” for the Canadian dollar is brewing (lowering interest rates, lowering GDP, lowering commodity prices, lowering external trade with China/USA, political uncertainty over the October 19 election) and it appears more likely than not that we’ll start approaching the point where we’ll see some sort of floor on Canadian currency (simply because the news could not get worse). I’m going to guess it will be around 72-74 cents, but we will see. I’d also expect this low to be reached around October and I may make a significant policy change on my CAD-USD holdings at this time given valuation levels.

My working theory is that the US economy is going to have extreme difficulties adjusting outside of a zero-rate environment and the process of deleveraging will be a painful business when hedge funds can no longer obtain money for free (Interactive Brokers, for example, will happily lend you USD at 0.63% for more than a million and 0.5% for more than $3 million). Paradoxically if the 30-year treasury bond decides to spike up from 3.2% to around 3.5% yield levels, I would suspect that purchasing long-term treasuries are going to be the winning play over the next period of time – not any equity fund. Debt levels incurred by the US government are hideously high and with every quarter point increase that they face will be a disproportionate amount of interest expense going out the door.

This also does not factor in other entitlement spending (e.g. social security, medicare, etc.) that serves to effectively ramp up the net expenditures for public debt purposes.

Right now I am mostly cash (or near-cash). Some of my efforts to find a place to park cash have mysteriously yielded results that are relatively low risk and I’ll be able to realize a modest single digit percentage at the cost of a little bit of liquidity, but in the event there are better investment opportunities on the horizon I will be in a very good position to pounce.

Canadian Housing Financing Market

There are three companies that come to mind that are directly related to Canadian residential housing financing: Genworth MI (TSX: MIC), Home Capital Group (TSX: HCG), and Equitable Group (TSX: EQB).

I’ve done extensive research on all of them in the past and I am research-current with all three companies. I do own shares of MIC from the summer of 2012.

The first, which should be no surprise to regular readers here, deals with mortgage insurance. The second and third deal with direct financing of home mortgages (both first-line and refinancing). If a mortgage is required to be insured (which is usually the case for higher ratio mortgages and refinancings) then CMHC and Genworth MI get involved and charge a premium in exchange for the lender being able to give out a lower rate of interest.

HCG today announced that its mortgage originations were down from the previous year and its stock price cratered roughly 15% as of the time of this writing.

Genworth MI is down about 4% in sympathy, although Equitable Group is in the “white noise” range for the markets (i.e. relatively unchanged).

A downturn in mortgage originations will materially affect HCG and EQB’s profitability, while this has more of a muted effect on Genworth MI as cash proceeds from mortgage insurance are not accounted for as revenues until they are recognized according to prior experience (net of expected default losses).

The takeaway to this message is that if Genworth MI gets disproportionately trashed in the upcoming days, it is likely unwarranted as the fundamental profitability in Genworth MI is not through volume, but rather the solvency of the lenders in question. Genworth MI also has the advantage of being able to run off its insurance book and still receive a boost in market value as it is trading below book value, while HCG and EQB are trading above book value.

Option implied volatility does suggest that institutional interest suspects further volatility. Tread carefully as always!

General market overview

The past two weeks in the markets have seen the S&P 500 go down a whopping 3% from its rough highs of 2120.

While I do see some signs of margin selling, it is still quite light and I am still not interested in dipping my toes further in the market.

I would love to see evidence of large-scale margin liquidations in illiquid securities. That makes me salivate financially, but we are another 100 points away from the S&P descending further before this may happen.

A few other points:

* 30-year US treasuries seem to have peaked at 3.2% and are now trading at 3%. The 3% gain you would have lost in the S&P 500 you would have gained by investing in long-term treasuries.

* The Canadian currency has also been hacked to death and BAX futures are hinting, but not fully pricing in, the notion of another interest rate cut to 0.5%. If the Canadian currency slips further I will likely convert some USD to CAD, likely around the 76 cent level. This seems to be directly correlated to the drop in oil prices.

* If the technical glitch on the NYSE was determined to be caused by hackers, I am curious how this would be priced into the markets.

Positions:

Happily majority cash.

Genworth MI repurchases shares

Genworth MI (TSX: MIC) recently disclosed that they repurchased 1,454,196 shares in mid-May for roughly $34.38 per share, a repurchase representing $50 million.

The buyback algorithm they employed was less than subtle, mainly the repurchase of 137,210 shares per day for 10 days and 82,096 shares for the last day. As 57% of the shares outstanding are owned by Genworth (NYSE: GNW), they supplied 57% of the liquidity for these transactions. 620,818 shares were taken out of the public float.

This repurchase was executed at slightly less than book value, which means it will be mildly beneficial to book value per share – my estimates are that based off of end of Q1-2015, the transaction would add 3 cents of book value per diluted share.

Of course, the transaction will be hugely accretive to earnings – the buyback represents 1.56% of shares outstanding, which means this will add a couple pennies a share to the quarterly EPS figures. In addition, the buyback also means that the company will not have to give out an extra $2.3 million a year in dividends.

At the end of Q1, the company had $200 million in surplus of its own internal buffer, which is 220% of the minimum capital test required to operate. The company reported 233%.

As the company typically book about $90 million in income a quarter, the buyback likely represents a “cash neutral” policy of balancing dividends (est. $36 million in this upcoming quarter) and share buybacks, at least with its current market value. If their market value remains suppressed below book value and they keep executing buybacks on a quarterly basis, I foresee higher equity prices in the future.

Long-time readers here will remember that I disagreed strongly with management’s decision to repurchase shares at $40/share back in 2014. May 2015’s repurchase I completely agree with – a shame they could not execute it in March, but still, they (and shareholders) will receive good value for this $50 million repurchase.

I continue holding Genworth MI shares since mid-2012.