We hope that everyone is enjoying this parallelogram season.
The first quarter of 2023 did not fail to surprise. Without delay, below are the main points for this strategy update.
Strategy Update Highlights
- We are likely approaching the end of the interest rate hiking cycle. Two reasons for this are slowing inflation data and the probable reverberations from the SVB (Silicon Valley Bank) collapse across small and mid-sized US banks.
- Our bond portfolios are very conservatively positioned, currently focusing on Government of Canada and Canadian Bank Bonds. We are still seeing some bond yields over 5%, as well as tax-efficiencies, and will buy where appropriate.
- We have continued slowly increasing equity exposure but are still underweight. Much of our equity exposure is focusing on dividend growers and value equities, and underweight growth equities.
The good news is we anticipate the historic interest rate hikes experienced in 2022 to slow considerably and maybe pause in the USA or pause in Canada by the end of 2023, if not much sooner.
These rate hikes did reveal some gaps in US Banking regulatory oversight and US Banking regulatory powers.
The impact on US regional banking caused by the SVB (Silicon Valley Bank) collapse is nothing like the system-wide credit-driven problems global banks faced in 2008. What happened with SVB is that they invested funds from short term liquid deposits into longer term secure government investments. SVB could have avoided this using short-term (30–90-day) Treasury Bills to satisfy their required cash on hand obligations to meet customer withdrawal requests. SVB got into trouble when they bought 7-to-8-year US Treasury Bonds before US rates shot up 4.75% from .25% to 5.00% creating a recipe for disaster.
This is not rocket science, folks. SVB executives should have known better. The problem for SVB is that there was no mechanism to rapidly correct this negligence. Had there been a way for the US Regulators to come in and give the original cash back, let’s say 2%, for everyone’s troubles, SVB would not have collapsed. After all it would have been the US government giving cash for their own bonds anyway. Then the regulators could be empowered to fire SVB’s CEO, CFO, and executives, and remove their board and place the regulator in charge. Better still, claw back all their compensation and face US legal and/or civil penalties for their reckless actions. The US regulators have quite a bit of experience taking over banks in the short-term from the great financial crisis.
Canada’s banking system is considerably more regulated, as we have only 6 major banks compared to the US with over 4,000 banks. I was on a conference call after this crisis happened and learned that one of the major Canadian Banks had $130 on hand for every $100 of required regulatory cash on hand.
Fixed Income:
Bond markets rallied off their lows in the first part of this quarter and then had a small pullback. We continued buying short-term government and Canadian bank bonds; however, we did edge back into some global bond mutual funds and ETFs. We still anticipate this stepped move back into fixed income alternative mutual funds and ETFs as rates rise.
We are still buying bonds that are trading at a discount (i.e., below $100 par value) that still have very attractive returns/yield to maturity. As mentioned in our last few strategy updates, interest bearing bonds purchased at a discount to par in taxable accounts give a higher after-tax interest equivalent return than bonds trading at par ($100) who’s yield to maturity are the same as the discount bonds we are buying. This is because interest paying bonds bought at a discount to par mature to $100 have a return containing interest and capital gains. Please remember for taxable accounts only 50% of capital gains are taxed.
Short-term bond yields are not likely to rise significantly more from here. Also, bond managers will now be able to generate higher returns in some areas of the fixed income market. It is for these reasons that we will now start buying back into specialized bond funds and fixed income ETFs.
Equities:
While our balanced growth portfolios’ equity weighting increased to about 47% (from purchases and portfolio appreciation) since our September 33% equity weighting, we are still underweight our longer-term target.
I believe these dramatic interest rate hikes should cause, at the bare minimum, a mild economic slowdown and negatively impact interest rate sensitive sectors and earnings. As we have seen, negative earnings surprises usually cause a share price correction.
We added some Canadian bank positions for clients underweight Canadian banks after the SVB collapse. As a reminder, we had reduced Canadian bank exposure near their 52-week highs last year before financials had sold off.
We are comfortable with our current exposure as we wait for more clarity on earnings, economic data, and the direction of interest rates. Eventually we will look to move up to 57% equities and ultimately move close to our balanced growth equity target of 63%. As we mentioned before, we are getting paid to wait as short-term interest rates have risen.
In the energy sector, the recent sell off was short lived as crude oil is now back over $80/barrel. At these levels the price of oil will provide a lift to earnings per share over the short term. In the medium to long term, I am a little less optimistic as we continue to shift to greener energy sources.
Our smaller allocation to growth stocks remained at the same number as last quarter. That said, I do believe that some of larger growth equities might present a better buying opportunity in the next 6 to 9 months.
We have been very fortunate that our portfolio volatility has been quite low due in part to reduced equity exposure. The drop in markets last year was the result of asset repricing to reflect the regime change in interest rates, as we ended a decade plus of ultra-low rates. Now it will be earnings per share that will be the focus. As mentioned, we will eventually move back to our portfolio targets. When this happens our portfolio volatility will increase but so should our returns. I have said many times before that picking the exact bottom or the exact top will never happen. The pendulum swings both ways but the best medium- and long-term hedge against inflation is to have equity exposure. If we wait for things to massively improve then we may miss some excellent opportunities.
Conclusion:
We wish everyone a happy and healthy tax and parallelogram season.
As always, we appreciate and value your trust. Please do not hesitate to contact if you need anything. We are currently available to meet by phone, Webex, or in person.
** Here’s the fine print and there’s a lot of it…
Currency can add return when the Canadian dollar goes down but reduce returns when the Canadian dollar goes up for non-currency hedged US and international investments. Also, please remember that your US accounts report values in US dollars.
Securities or investment strategies mentioned in this newsletter may not be suitable for all investors or portfolios. The information contained in this strategy update is not intended as a recommendation directed to a particular investor or class of investors and is not intended as a recommendation in view of the particular circumstances of a specific investor, class of investors or a specific portfolio. Options, and other strategies mentioned, may not be suitable for all investors. You should not take any action with respect to any securities or investment strategy mentioned in this newsletter without first consulting your own Portfolio Manager or in order to ascertain whether the securities or investment strategy mentioned are suitable in your particular circumstances. This information is not a substitute for obtaining professional advice from your Portfolio Manager. The commentary, opinions and conclusions, if any, included in this newsletter represent the personal and subjective view of Daniel Kelly who is not employed as an analyst and do not purport to represent the views of RBC Dominion Securities Inc. The information contained herein has been obtained from sources believed to be reliable at the time obtained but neither RBC Dominion Securities Inc. nor its employees, agents, or information suppliers can guarantee its accuracy or completeness. This report is not and under no circumstances is to be construed as an offer to sell or the solicitation of an offer to buy any securities. This report is furnished on the basis and understanding that neither RBC Dominion Securities Inc. nor its employees, agents, or information suppliers is to be under any responsibility or liability whatsoever in respect thereof. The inventories of RBC Dominion Securities Inc. may from time to time include securities mentioned herein. Investment Trust Units are sold by RBC Dominion Securities Inc. There may be commissions, trailing commissions, management fees and expenses associated with Investment Trust investments. Please read the prospectus before investing. Investment Trusts are not guaranteed, their values change frequently, and past performance may not be repeated. (Keep reading, there’s only 7 more sentences to go.) This commentary is based on information that is believed to be accurate at the time of writing and is subject to change. All opinions and estimates contained in this report constitute RBC Dominion Securities Inc.’s judgment as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. Interest rates, market conditions and other investment factors are subject to change. Past performance may not be repeated. The information provided is intended only to illustrate certain historical returns and is not intended to reflect future values or returns. RBC Dominion Securities Inc.* and Royal Bank of Canada are separate corporate entities which are affiliated. *Member-Canadian Investor Protection Fund. RBC Dominion Securities Inc. is a member company of RBC Wealth Management, a business segment of Royal Bank of Canada. ®Registered trademarks of Royal Bank of Canada. Used under licence. ©2023 Royal Bank of Canada. All rights reserved.
Investment portfolios are not guaranteed, and past performance is no indication of future returns. In addition to these portfolios not being a guaranteed investment, there can also be significant fluctuations in the value of the portfolio. Did anyone read this far?