In this commentary:
Scott Blair, CFA
Chief Investment Officer
A year ago, we wrote an article titled, COVID-19 winners and losers in the market which mentioned a colleague who experienced an unusually long delay in receiving a pair of Adirondack chairs they’d ordered. It took eleven months, to be exact. That story highlighted how record demand for the chairs, hitting up against reduced supply due to COVID-19 protocols, affected a factory in Ontario.
Early in the pandemic, these issues seemed very unusual. How could a huge recession lead to record demand for a “nice to have” item like patio furniture? The answer, of course, was that this was like no recession we’d ever seen. On average, incomes and savings rose due to generous government programs, while the outlets to spend those dollars fell as travel and other services were – and still are – limited.
Port pains – more than just a nuisance
We’re now eighteen months into the pandemic and supply chain issues are no longer just a nuisance – they’re starting to impact our recovery. Recently, a company we own in our U.S. portfolio shared that one of their chartered containerships was denied entry into China because a crew member tested positive for COVID-19. The ship had to go back to Indonesia and change the entire crew before it could return to China. The result was a delay of more than two months from the original timeline.
Stories like these highlight the complexity of running a port during a pandemic. Not only have ports been ill equipped for the increase in demand, but they’ve also had to deal with worker shortages and increased complexity due to the implementation of social distancing. Occasional COVID-19 outbreaks have also caused delays. The result has been significant disruption leading to ships having to spend a lot more time at ports, and the cost of shipping (freight rates) skyrocketing.
As of mid-September, there were 61 ships anchored off the two major U.S. west coast ports. In normal times, even five is considered too many. Not surprisingly, freight rates are through the roof. It used to cost $1,600 to transport a container between Shanghai and Los Angeles. Today, the price is closer to $11,000 (Figure 1).
Figure 1: Supply chain bottleneck
Early in the pandemic, companies had inventories they could draw from to cushion the supply chain disruptions. In effect, inventories act as a shock absorber. Those inventories are now at near record lows in many categories and industries, while manufacturing facilities continue to be impacted by COVID-19. Our double whammy of surging demand for goods and reduced production capacity continues.
Short-term impacts on companies and consumers
In the short-term, the major impact is a significant increase in transportation costs. This ultimately leads to higher prices for consumers, and potentially lower profits for companies if they can’t pass on the price increases.
While the short-term picture might look concerning and the impact from supply chain disruptions is real, we view this as a transitory issue that will get resolved. With vaccination rates increasing and stimulus running off in the U.S., ports are likely to be able to hire more workers which is a first step in eliminating some of the bottlenecks in the global supply chain.
Things are looking up in the long-term
Looking past the supply chain shock, we’re seeing strong consumer demand backed by unprecedented savings, intention to increase CAPEX spending by corporations, and the need to rebuild the inventory levels. All this should provide a boost to economic activity over the next 12 to 18 months.
Of course, the biggest wild card in looking at the future continues to be COVID-19. The delta variant was a significant drag on what should have been an exceptionally strong summer of economic growth. It appears today that the delta wave is ebbing. Also, news of a new pill from Merck that might cut the risk of death or hospitalization from COVID-19 in half could be a game changer for the recovery.
As investors, we’re taking the longer view. Global recovery is still strong and we anticipate robust economic growth well into next year, which should be positive for the markets. Investing in companies with reasonable leverage and resilient businesses provides good protection against all the bumps along the way.
Gil Lamothe, CFA
Senior Portfolio Manager, Canadian Equities
After a torrid first half of the year, the Canadian equity markets took a breather in the third quarter with the S&P/TSX Composite index gaining 0.17%.
One of the more notable performers was Nutrien. The stock was up around 10% in Q3. Nutrien is a fertilizer producer and retailer. There are three essential fertilizers used in agriculture: nitrogen (in the form of ammonia), phosphorus, and potash. Nutrien produces all three of these and acts as a distributor and retailer. Global prices have been trending higher for these products (Figure 2). The underlying fundamentals are also strong, with supply constraints in potash, and the world’s largest buyer, China, drawing down their fertilizer inventories and looking to prevent their producers from exporting product. This could increase demand for Nutrien’s products.
Figure 2: Rising fertilizer prices around the world
The COVID-19 delta variant has had a material effect on the speed and nature of the global recovery. Chemicals such as potash and methanol are enjoying high global prices, whereas the base metals and gold are struggling. There’s strong demand for consumer goods globally, yet the ability to produce and ship those goods has been impeded by a lack of labour and the necessary pandemic distancing measures – neither of which are conducive to efficiency, whether producing chips or loading ships.
What was once the well-oiled and functioning globalization trade machine, now has some gears with broken teeth. The good news is that demand is strong, and this will fuel the rebuilding of the trade machine as the pandemic eases over the coming months. On the M&A front, there have been a few developments in the quarter. The CN Rail and Canadian Pacific (CP) tussle over the purchase of the Kansas City Southern railway, which would allow access into Mexico, turned abruptly into CP’s favour.
The U.S. regulator, the Surface Transportation Board, ruled against CN establishing a trust in which to hold the acquired railway. This is a necessary element to any deal approval, and as CP’s trust proposal had already been approved, they were essentially the only viable bid. We’ll be monitoring closely how much value CP can extract from this acquisition.
It’s now clear that the global supply disruptions related to COVID-19 are expected to extend well into 2022. That said, equity markets continue to move steadily higher, as it appears that persistently strong demand is also likely to continue. This may be a recipe for increased volatility as news regarding either the supply or demand side, in the form of economic statistics or actual events, makes headlines.
As long-term investors, we see this disruption being just two to three quarters, which makes it a short-term event. As such, weakness related to this, whether market wide or company specific, should be seen as an opportunity.
One potential area of concern in Canada has been the recent federal election result, where the Liberal Party had campaigned on a platform which included a surtax on the major banks and insurance companies. The OSFI restriction preventing these companies from increasing their dividends, put in place in early 2020, has resulted in very strong capital positions in this sector. The expectation was that the restriction would be lifted this fall, and the banks and insurance companies would play catch-up with their dividend increases. Our concern now is how that may play out with the possibility of a future surtax.
Oil prices have been strong recently. Again, the supply side is constrained after years of low prices resulting in very little investment in production. We do have some direct and associated exposures to stronger oil prices in the portfolio and expect to maintain those as this unfolds.
We’ve recently added three new stocks to the portfolio. CGI Inc was added in the information technology sector. The company provides IT services in the form of data storage and access to companies who are looking to outsource some or all of their IT needs. The value proposition is that the need to maintain and upgrade data servers and expertise is reduced or eliminated, allowing companies to operate with smaller IT departments. CGI has grown through acquisition and operates internationally. Management has proven itself with successful integrations as well as increasing margins.
Another recent addition has been Fortis. Fortis is an electricity generation, transmission and distribution company operating largely in North America. The addition of Fortis helps diversify our utilities holdings in the portfolio. We like the stability that the company brings to the portfolio, with a consistent and growing dividend underpinned by diverse, high-quality assets.
Late in August, we also added Waste Connections (WCN) to the portfolio. WCN is a waste collection and disposal services company operating throughout North America. They provide this necessary service on a contract basis to both municipalities as well as industrial customers. The company has been growing through acquisition and focusing on regions with fewer competitors, allowing them to operate with the industry’s highest margins.
In addition to these new names, we’ve been adding to some of the positions that have been under pressure this quarter. The chip shortage hurting the auto industry is temporary in nature, making Magna a good long-term buy in our view. We think Agnico Eagle’s recent proposal to merge with Kirkland Lake Gold could be a very good move. The stock’s price has come off along with all of the gold producers through the quarter, and we’ve added to the position after this announcement.
The third quarter of 2021 started on a positive note. Stellar performance in both July and August was helped by another strong reporting season, where a record number of companies beat earnings expectations by a significant margin. However, with the quick spread of the delta variant towards the end of summer, sentiment changed and equities declined by more than 4% in September. U.S. equities ended the quarter up slightly.
Recent economic data disappointed and the U.S. CITY economic surprise index, which measures the degree to which economic data is either beating or missing expectations, is currently in negative territory. Supply chain disruptions and their far-reaching impact was a hot topic throughout the past three months, with the two biggest impacts being a significant increase in transportation cost and delays in product deliveries. More companies are warning about the negative impact this could have on near-term earnings.
Finally, towards quarter end the Fed hinted that it might start reducing its bond buying program in October or November, and we could potentially see rate increases as early as in 2022, which also put pressure on market returns.
From a sector perspective, the returns were mixed with half of the sectors in negative territory and the rest finishing up in Q3. Cyclical sectors suffered, being heavily dependant on the global economic recovery and China. Consumer Discretionary also lagged with Amazon being a big drag on the sector. Leading sectors this quarter were Financials, Health Care and Technology. Financials were helped by an increase in interest rates towards the end of the quarter. Growth outperformed value with large tech companies performing well.
We acknowledge that inflation pressure and growth constraints from the supply chain disruptions are real, but don’t want to lose sight of the big picture. While these will impact both the economy and corporate earnings in the short term, we continue to see strength in both consumers and corporations. The government transfer payments and decreased spending on services during the pandemic has resulted in households amassing more than $2 trillion of excess savings. That’s roughly 15% of annual consumption.
With strong pent-up demand – especially in certain areas – we expect at least some of these savings to be spent in the next 12 to 18 months. Wages are also rising which should further boost consumer confidence and spending. As for corporations, balance sheets are in great shape with cash balances near record highs, and interest coverage (interest payments/earnings) the lowest it’s ever been (Figure 3).
Figure 3: Inventory levels near record lows
Another factor that makes us optimistic on the economic recovery is the current level of CAPEX and inventories. Both are close to all-time lows. The COVID-19 pandemic caused many disruptions in the inventory cycle that are taking longer than usual to resolve. However, we expect that once bottlenecks in the supply chain get resolved we’ll see businesses rebuilding depleted inventories. This, coupled with companies’ intention to ramp up CAPEX spending in the coming years, should support the economic recovery in 2022 and 2023 (Figure 4).
Figure 4: Upward trend in CAPEX spending
We think we might continue to see earnings surprising to the upside. During the first two quarters of 2021, we had huge earnings surprises with the market underestimating the recovery of the earnings substantially. With economic data being disappointing lately, we saw upward revisions in earnings stalling. With expectations already reflecting current headwinds, we could see a continuation of earnings surprises into the second half of the year, which should be positive for markets.
During the quarter, the U.S. portfolio performed in line with the S&P 500. While we’re aware of the quarterly numbers, we don’t give much importance to short-term numbers and instead focus on executing on our investment process to enhance the portfolio for the long run.
We exited a few of our positions wherein our thesis either played out or had less probability of materializing in names such as DaVita, CMC Materials, Bank OZK, Centene and Kraft Heinz. We redeployed the capital in several high-quality businesses that were trading at attractive valuations and offered compelling risk/reward.
Some of the names that we initiated during the quarter are Apple, Walmart, Disney, and Amazon. Our thesis on these names is based on continuation of revenue and earnings growth which is not yet being priced in by the market.
Amazon deserves special mention as it’s a stock that we’ve stayed away from in the past, mostly due to valuation. With the pandemic, there’s been a pull-forward demand for its products – e-commerce and cloud business. This pull-forward, which we deem sustainable, led to earnings growth while the stock has done little in the last year, resulting in an attractive entry point for this high-quality business. We also added capital to existing names where execution has continued and valuation was still favorable.
In our U.S. portfolio, we focus on long-term investing in high-quality companies with strong returns, healthy balance sheets and stable cash flows. Staying truthful to our process, we continued to deploy capital in such businesses whenever risk/reward was in our favor.
The past few months have been very eventful in China. One of the more notable events has been the unraveling of Evergrande, one of its largest property developers. Evergrande recently announced that it will not be able to pay interest on its USD bonds due in September, due to lack of cash.
Evergrande is the most indebted company in the world and its inability to repay its debt surfaced in 2020. The company carries net debt of $64 billion. It also carries another $148 billion in its account payables, which can also affect other Chinese companies.
Its current problems were exacerbated after China announced its “three red lines” for the property sector, which formulated new financing rules for companies that want to refinance or increase their debt. Given that Evergrande was in breach of all the red lines, it couldn’t continue borrowing, so to generate cash it attempted selling assets and selling houses at steep discounts.
Given Evergrande’s high debt and its struggles to raise cash, the market has been calling its potential demise China’s “Lehman moment” that could spill over into a broad financial downturn.
Another sector that was in the news recently is Macau’s gaming sector. The government recently issued a consult document prior to legislating a new gaming law. The last law, enacted in 2001, must be updated given the significant changes in Macau over the past 20 years.
The document stipulates nine points, of which the following are of particular interest:
- Dividends will require government approval
- The government will monitor daily activities
- Higher taxes
Experience has shown us that “Lehman moments” rarely, if ever, are on the front page of the newspaper ahead of time. Evergrande now occupies the attention of all policy makers in China. The central bank provided liquidity to the banking system several times and though the government stated that it will not bail Evergrande out, it has asked state-backed property developers to conduct due diligence on some of its assets for a potential purchase.
If regulators are worried and it’s in the news, the market is already discounting it. As such, we’re less concerned about a financial crisis and more concerned with trying to understand potential fallout.
We don’t own Evergrande but are particularly interested in determining how its issues may impact our holdings in two Chinese banks (ICBD and CCB). The banks provided loans to Evergrande but won’t disclose their size. As such, we gathered data to figure out how much exposure the banks have to their largest customers.
Among its largest 10 customers, ICBC has none that operate in the real estate sector. CCB’s 2nd largest customer does operate in that sector. Digging deeper, we know that the size of the loan is RMB38.4 billion. However, we also know that CCB has reserves of RMB615 billion for loan losses – more than enough to cover this loan even if it goes to zero – which real estate loans rarely do.
Given that the market is concerned about contagion, we checked the banks’ exposure to real estate loans. Both banks’ non-performing real estate loans (2.96% for ICBC and 2.03% for CCB) are in line with the bank’s corporate loans average (2.46% for ICBC and 2.49% for CCB). The banks have sufficient reserves to cover substantial losses, and because most of these loans are collateralized (sold to others), losses should be relatively small.
Bottom line, we believe the banks we own in our portfolio have small and manageable exposure.
Moving to Macau, we believe that the market’s concerns are overblown. The focus of the government is employee welfare and, most importantly, investments so that the industry will continue contributing to employment and the financial stability of Macau.
- The government will not forbid dividends, it just wants them to be reasonable to withstand crises and to invest in the community.
- The government already monitors daily activity, especially in the count rooms. Further monitoring will likely be through a board membership, which is nothing unusual in China.
- Higher taxes are not part of the consult paper, so it’s not part of the discussion. For this reason, we’re not concerned about it.
Considering these points, Galaxy is the best positioned company in our view in our portfolio. It’s Chinese, so there are no issues with its concession. Its owners’ relationship with the government is very good and it has one of the best products on offer in Macau.
Galaxy’s current earnings are only about a fifth of what it had prior to COVID-19. As the pandemic recedes, we believe that most restrictions will be lifted and earnings will recover. Additionally, there’s a large project coming online in 2022, plus two other potential development opportunities.
The Chinese banks valuations have declined due to Evergrande’s troubles. Figure 5 compares the Price to Book Value of ICBC and CCB to a Canadian bank (TD). TD is trading at 2x the Price to Book Value of the Chinese banks, which is a huge divergence that we’ve taken advantage of by increasing our weight in both names.
We also took advantage of the volatility in Galaxy by increasing our weight in the name as well.
Figure 5: Significant divergence in bank valuations
Ric Palombi, CFA
Director of Research, International Equities
Inflation is, once again, top of mind for fixed income investors. After the U.S. Federal Reserve meeting in late September, Chairman Powell announced that tapering would begin in earnest starting in November and likely be completed by mid-2022 – a full six months ahead of expectations.
The response from fixed income investors has been swift, pushing up 10-year yields above 1.50% and 30-year yields above 2%. More importantly, inflation expectations are, once again, beginning to heat up.
Figure 6 tracks U.S. investor expectations for inflation 5 years out. After bottoming in July at 2.2%, it’s now at 2.42% – the highest it’s been in over three months.
Figure 6: Inflation expectations ramping up
A similar story can be seen in Canada. Figure 7 shows the breakeven of a 10-year Government of Canada real return bond. Simply stated, the breakeven is an investor’s expectation of compensation for holding an inflation-protected investment.
For example, the current breakeven for a 10-year real return bond is 1.80%. So, if inflation averages more than 1.80% over the 10-year period, the real return bond outperforms a traditional 10-year fixed rate bond. Conversely, if inflation averages below 1.80%, the fixed rate bond outperforms.
Figure 7: Breakeven points are trending higher
Whether you believe this latest bout of higher inflation is transitory or not, what’s undeniable is that central banks, like the U.S. Federal Reserve and the Bank of Canada (BoC), have never been in a better position to achieve their inflation policy goals. We know the BoC has an explicit target of achieving 2% inflation over the long run. As fixed income investors, it’s critically important to understand, and not underestimate, the BoC’s resolve to achieve this mandate. Why? Because inflation has a devastating effect on purchasing power. Taking the best-case scenario, which is that the BoC simply meets its 2% target, the purchasing power of $10,000 over 10 years erodes to almost $8,000 if left unprotected.
PEPP is an acronym we use which stands for Protect and Enhance Purchasing Power, and it’s at the heart of our fixed income investment strategy. We’ve seen that nothing erodes purchasing power more, or is more destructive to future savings, than inflation. Our Diversified Fixed Income Pool (DFI) is designed to enhance PEPP over an economic cycle. We accomplish this by building a portfolio that can thrive through any economic cycle.
This is done through an active management strategy which helps protect your assets while letting you benefit from higher inflation. Looking at the current composition of DFI (Figure 8) through an inflation protection lens, we note that over 50% of the fixed income investments either protect or have a direct positive correlation to higher inflation.
Figure 8: Diversified Fixed Income pool composition
Here’s a quick, real-life example of how we take advantage of these investment opportunities. In the discussion above on breakeven points, we mentioned that the current 10-year breakeven is 1.80%. We also mentioned that the BoC long run inflation target is 2%, and that there’s a high probability of the BoC achieving their target.
The final piece to this investment puzzle is that real return bonds do better than fixed rate bonds if inflation runs hotter than a 1.8% breakeven. We believe that the BoC will indeed achieve its 2% target, so the protection and risk/reward offered by a real return
bond at this level is very compelling. As such, we’ve been increasing our exposure to real return bonds in DFI.