Every day I hear similar questions and comments from clients about the state of economy, the direction of markets, and the positioning of investment portfolios. My response has been consistent for the past many months – I focus on leading indicators to assess the health of the economy, banks can provide valuable insight to consumer and business trends, Covid-19 has created significant changes to market leadership, and the historical correlation between economic activity and market performance provides us with a roadmap.

Canadian Banks

The major Canadian banks all reported third quarter earnings this past week and the results were impressive once again. Revenues, earnings, funds set aside for bad loans, and regulatory capital reserves were all better than analysts and markets had expected. The 12-month share price performance of the banks certainly reflects the strong financial position they are in currently. But where do we go from here?

Much of the rise in earnings and resulting share price has largely been driven by the release of credit loss provisions. Recall that banks had to set aside billions of dollars of capital early in the Covid-19 pandemic to potentially protect their balance sheets against business and consumer loans that would not get repaid. Since then, the majority of these loans have been serviced by the borrower, and therefore, the capital set aside has been freed up. This release of provisions cannot be the driver of future earnings going forward.

The onset of Covid also brought the end to dividend increases and share buybacks for the Canadian banks by regulators. This has created record level of capital ratios for most of the banks and an expectation that the next step in share price performance will be driven by these funds getting paid out to shareholders. The three major uses of this capital are i) dividend increases; ii) share buybacks; and iii) increased lending activity to customers, each with their own benefits. We would welcome both i) and ii) as a form of returning money to shareholders, and iii) would reflect a strong economy and strength for households and businesses. We will be watching closely over the fall for news of all three initiatives.

Our three favourite positions currently are Royal Bank, CIBC and TD Bank. Royal has a dominant market position in most of its business units, including retail banking, capital markets, commercial banking and wealth management. CIBC offers a dominant position in consumer lending with its credit card and auto loan businesses. TD has a significant U.S. banking operation and is one of the banks most sensitive to higher interest rates. It will benefit most with an increase in short-term interest rates.

Technology Industry

As the end of calendar second quarter earnings reporting period comes to a close, I think paying particular attention to the technology sector is worthwhile. Much has been made of the sector’s influence and weighting for index and market performance, and there had been plenty of speculation that the end of the sector’s impressive run is near. The earnings results show the continued strength and in many cases, the dominance of these business’ products and services in our everyday lives. It was the commentary from these companies and their management, however, which stood out to me as reason to not expect anything less than more of the same going forward. The Covid pandemic shifted the development and adoption of many of these businesses ahead 3-5 years, and some even more. These changes are not expected to be temporary, as the business of e-commerce, secure communications, network security, digital documents and signatures, global logistics, data storage, and many others will remain an important and growing part of how consumers and businesses exist.

Our client portfolios continue to hold the large, dominant names in the technology space as well as some companies in new and emerging parts of the industry. I continue to be mindful of the threats and risks for the sector, and for individual companies within it. The pace of growth is likely to decline over the coming period as the pandemic-driven benefits wane and more normal growth takes over. Cost pressures are building with supply chain issues presenting a challenge over the intermediate term. As well, the threats of rising interest rates and increased regulation both present the potential for sector headwinds that may come and go over time. However, I believe technology will remain one of the most influential industries in the global equity markets, and portfolios should maintain appropriate exposure and proper diversification.

Economic Outlook

Our domestic economy along with many of the economies of other developed countries have adapted to this pandemic. While everything has not returned to pre-pandemic levels, some pockets of the economy continue to struggle, and new Covid cases are flaring up in many regions, but consumers, households and many businesses have figured out how to get by and in some cases, thrive. Vaccinations have certainly helped. Much of this is attributable to a decline in hospitalization and death rates from the virus, and markets have changed their focus to industries and companies that can operate instead of those that cannot. It is safe to say the glass seems half full, not half empty.

Economic growth has recently shown signs of slowing, although the pace of growth was to inevitably fade with a reversion to something more normal. The initial decline in economic activity and subsequent bounce back were both so strong last year, but the growth rate shown through the first half of 2021 was destined to fade. The slowdown in growth rate is approaching a level more sustainable as global economies move towards full potential.

I expect more of the same for the remainder of 2021. Pent up demand from consumers, excess savings among households and businesses, and continued accommodative government fiscal and monetary policy should provide the support necessary for most economies to continue to improve. There will always be events and threats that cause volatility and elevated risks for the markets, such as inflation data, geo-politics, and rising Covid infection rates, but the current outlook remains constructive.

Projecting economic activity on to market activity is an important exercise, and it doesn’t need to be complicated. The following two charts summarize the correlation between a growing economy and rising share prices.

Source:  RBC Wealth Management Portfolio Advisory Group

Source:  RBC Wealth Management Portfolio Advisory Group