I hope everyone had a great holiday break. Now, let’s get on with looking at some portfolio advice.
Strategy Update Highlights
- Jerome Powell’s (US Federal Reserve chair) comments in early November 2023 caused a year-end global market rally. Over the next two quarters we expect to expand portfolio equity exposure towards our long-term target. This will occur if interest rates stay level and/or begin to drop closer to the summer.
- Fixed income strategists are debating the range of likely rate cuts expected later this year and into 2025 (currently expecting 4 - 6 rate decreases, i.e., 1.00%-1.50%). Even if rates only drop 0.5%, we could experience 7-8% fixed income bond portfolio returns over the next year. If rates decrease 1.5%, we could experience double digit returns from some fixed income products.
- I expect that recessionary pressures may cause short term equity market volatility eventually resulting in a rally in dividend growth equities (banks, utilities, and telcos) later in 2024.
Fixed Income:
We spent the last two years thinking about where interest rates may top out and it seems that we are now there. Strategists believe that we are now looking at rate decreases, some saying as early as this March. However, the main consensus is that later this year we may see anywhere from 4 to 6 interest rate cuts resulting in a 1-1.50% US Federal Reserve rate decrease over the next 18 to 24 months. The belief is that Canadian rates will experience a similar decrease. Inflation (CPI) and the labour market are two things being watched very closely – more moderation/weakness seen in those indicators will lead to more and quicker rate cuts.
I would argue that Canadian mortgage holders are worse off than American mortgage holders. Many American homeowners remembered the 2008 crisis. Instead of relying on variable rate mortgages Americans opted for 30-year mortgages at rates in the 3% range or lower. Many Canadians have mortgages coming due that were locked in at 1.8% three, four, and five years ago and are now facing renewal at possibly 6% rates. Individuals with floating rate mortgages have already felt the pinch. Canadians have had a greater negative impact from rising rates than Americans have as we have more floating rate mortgages and shorter-term mortgages. It is for this reason that any rate decreases by the Bank of Canada will have a more immediate and positive impact on the Canadian economy.
Given that we are expecting interest rate decreases I have begun buying back into global fixed income investments like ETFs, mutual funds, and trusts. These investments can access global fixed income markets much more easily and are able to manage their portfolios such that they create not only returns from interest but also potentially significant capital gain returns.
Additionally, I have begun to buy back into the preferred share market using 2 ETFs – Horizons’ HPR and Dynamic’s DXP. Over the next year, these two ETFs could provide fixed income returns of 12-15% consisting of dividends and capital gains. Previously, our last purchases of these two ETFs were mid-2020. On average this preferred share exposure gave 27-30% returns as we bought after the dramatic preferred shares sell offs resulting from the 2020 COVID outbreak.
We deflected much of our bond portfolio drops resulting from the interest rate increases throughout 2022 and 2023 which caused some of the worst fixed income returns ever. We have now started selling some of our shorter-term bonds after making particularly good returns for other fixed income investments that should make even more.
If rates stay at these levels and don’t decrease, we may not receive the double-digit fixed income returns we hope for, but we will still make good fixed income returns from the bond yields and interest.
Equities:
If rates drop later rather than sooner, equity markets will likely not rally significantly until the back half of 2024. We have flexibility to buy as we expect continued volatility directly resulting from what direction interest rates take. I believe that some of the sectors that experienced the largest sell offs from interest rate hikes, like banking, utilities, and telecoms, will provide very good dividend yields in the short run no matter what the pace of rate decreases will or will not be. I am less enthusiastic about real estate investment trusts in the short run given the challenges in certain sub-sectors of commercial real estate.
Last quarter, I mentioned that we reduced our overall bank exposure before the banks sold off significantly in 2022 and into 2023. I also said the higher dividend paying equities were looking more appealing. So much so that in the past quarter I increased our bank exposure to BMO, TD, and RY along with another financial services company EFN (Element Fleet). I may further increase our bank exposure over the next 2 quarters. Additionally, I also added Manulife (MFC) into our US dollar accounts.
We are still under weight our equity targets with an eye to increasing our equity exposure over the first half of 2024. On average, we are currently protecting about 30% of our Canadian equity portfolio from a drop greater than 6% using index put options. We are also assessing insuring part of our US equity portfolio.
While we wait to see where rates go, how geopolitics play out, and how equity markets progress, you are getting paid very well to wait. We will continue to selectively add positions or take profits.
Conclusion:
We have begun to reposition and take advantage of market changes over the next several quarters. Our conservative stances deflected bond and equity market drops in 2020 from COVID and from the unprecedented rate hikes that started in 2022 and went well into 2023. While 2022 was a terrible year for bonds and equities, our clients weathered 2022 and did quite well in 2023. Our team will continue following our conservative investment process as we navigate the ever-changing equity markets, interest rates changes, inflation, and the geopolitical environment.
As always, we appreciate and value your trust. Please do not hesitate to contact us 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 license. ©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?