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Counsel Views – Episode 26: North of the 49th

A closer look at the state of and outlook for Canadian markets

Counsel Views, hosted by Stu Morrow, Chief Investment Strategist, RBC PH&N Investment Counsel, is an audio series aimed at bringing insights to clients from thought leaders and experts across Canada’s leading wealth management firm.

Episode guests: Irene Fernando & Sarah Neilson: Vice Presidents & Senior Portfolio Managers, RBC Global Asset Management Inc. (RBC GAM)

In this episode of Counsel Views, Stu welcomes RBC Global Asset Management Inc. (RBC GAM) Vice Presidents and Senior Portfolio Managers Irene Fernando and Sarah Neilson. The Canadian equity specialists discuss the challenges and opportunities facing Canadian equities today, while also providing their considerable insights around the impact of soaring commodity prices on the country’s energy sector. They also share their views on rising interest rates, and their impact on the broader economy and the Canadian financial sector.

Irene started with RBC GAM in 2007, and has gradually progressed to more senior roles at the firm over the years, moving from Research Analyst to Associate Portfolio Manager to Senior Portfolio Manager. Sarah joined the firm in 2004 and, like Irene, she has also since progressed to more senior roles within RBC GAM. Sarah also leads the RBC GAM North American Equity Team’s integration of ESG into their investment process. Together Irene and Sarah co-manage the PH&N Canadian Equity Value Fund and the RBC Monthly Income Fund, which make up about $10 billion in assets under management.

View transcript

Stu Morrow:

Welcome to Counsel Views, everyone.

We’re recording this episode on May 17th, and I’m sure most of you would agree that so far 2022 hasn’t been kind to us as investors. The returns for both bonds and stocks reflect recession worries as monetary policy shifts from easing to tightening in an effort to combat inflation, complicating the outlook for inflation as rising commodity prices, which has been driven by a number of demand-and-supply imbalances.

But nevertheless despite recession concerns, Canadian equities have been a relative bright spot year to date, given the exposure to financial services, which should in part benefit from a rising interest rate environment, and also to energy and material companies who benefit from rising commodity prices.

But what might the future hold for Canadian equities from this point forward as it relates to both energy and financial service companies? And with me to discuss the details behind what’s been driving the positive relative returns for Canadian equities and the outlook are my two special guests from the RBC Global Asset Management North American Equity Team.

My first guest is Irene Fernando, Vice President and Senior Portfolio Manager. Irene started with RBC in 2007 and progressed to more senior roles at RBC Global Asset Management over the years from Research Analyst to Associate Portfolio Manager, and then on to Senior Portfolio Manager.

And joining Irene is Sarah Neilson, Vice President and Senior Portfolio Manager. And Sarah joined the firm in 2004 and like Irene she also progressed to more senior roles within RBC Global Asset Management. Sarah also leads the team’s integration of ESG into their investment process, while together Irene and Sarah comanage the PH&N Canadian Equity Value Fund and the RBC Monthly Income Fund, which make up about $10 billion in assets under management.

Both are well regarded as experts in the Canadian equity landscape and are an integral part of the firm’s investment committee.

Irene, and, Sarah, welcome to Counsel Views.

Sarah Neilson:

Thanks for having us.

Stu Morrow:

Sarah, could we—maybe we’ll start with you. And I sort of alluded to some of this in my opening remarks, but Canadian energy companies have been benefitting from the rise in global oil prices. But how are you thinking about exposures to Canadian energy stocks in your portfolios today?

Sarah Neilson:

Yeah. That’s a great question, Stu. And I might back up a little bit and just talk through some of the macro highlights.

As you point out, oil prices have been super strong year to date, as we’ve recovered from the pandemic and the demand for transportation, industrial uses have really climbed close to the 2019, those pre-pandemic levels. Supplies for oil earlier in the year were struggling even to keep up after investment and production growth had been really dialled back. And this is partly due to the low prices we experience, but also from the ESG concerns and investor pressure for less investment growth, and investors really want their capital back from the energy companies. And so they stopped spending.

And the Russian invasion of Ukraine has really tightened that fundamental supply balance even more. Russia’s a major exporter of both crude and natural gas, and the sanctions impacted their ability to supply the global markets. And that’s increasing today. So as a result, crude oil is up over 50% year to date. I think we’re close to $115 per barrel this morning.

And natural gas prices have also been surging. Global stockpiles are low there. Demand has been strong for power generation, specifically in Europe. And increasingly liquefied natural gas, which ships predominantly from North America off the U.S. Gulf Coast has been directed to Europe and that’s really provided support for the North American gas prices, more than it ever has before.

So this solid commodity backdrop has really supported this energy producer stock prices to rally. I think we’re over 55% year to date. And it’s been very beneficial for the bottom line. Even before the pandemic, energy producers had successfully lowered their costs. It was a bit of a tight market and difficult market for energy producers then. They reduced their capital costs.

And so they’ve been able to flow these commodity price gains we’ve seen this year right through to the bottom line. And a metric we often focus on is free cash flow, which is the cash that’s left over after an energy company spends to maintain its current production level. And the surge in the oil and natural gas prices in Canada has resulted in significant amounts of free cash being generated in the Canadian energy sector.

And with little investment and growth happening, partly because investors don’t want to see growth in fossil fuels over the last few years, as well as our lack of pipeline capacity, this cash is being used to drive balance sheet debt lower than we’ve ever seen. The sector at the prices we see today could be debt free in one to two years, depending on the name. And the excess cash beyond then is being returned to shareholders through increasing dividends, special dividends, and buyback.

So while the share prices have really appreciated with the commodities, investors are still enjoying increasing total returns while you take into account the dividends and the lower share count. All this said, valuations in the sector have remained at historical low levels. Investors seem to be unwilling to pay for the current elevated prices. And it makes sense, these are very dynamic markets. There is a lot of uncertainty, especially with prices in oil and natural gas at levels where demand destruction usually occurs. And there’s the potential for increasing supply that could once again pressure prices lower.

All that said, we remain constructive on the sector while companies remain disciplined. However we’re cautious on this call for increasing production at a time of significant cost inflation. We could see some erosion in returns in the sector.

The large Canadian oil sands though stand out to us. They look compelling in this environment with manageable maintenance capital, like I talked about, that capital required to keep your production flat, and they have long life reserves. So not a massive requirement to go out and acquire more reserves.

And specifically, the companies’ refining operations are expected to earn outsize profit in the short term, which will help offset rising costs we’re seeing in the Basin operating costs in the near term. So we still are constructive on the sector. And like that, as well as the service sector, seems to be well positioned to get higher returns and margins as activity does start to pick up in the next wave of spending.

Stu Morrow:

That’s great, Sarah. Thanks for that. And you touched on that capital spending discipline, and maybe get your thoughts around decarbonization efforts and future capital spending requirements there, and your thoughts on whether that could be sort of an overhang, I guess, for the sector.

Sarah Neilson:

Yeah. That’s something we’ve been spending a lot of time on is understanding how the Canadian companies will go about decarbonizing their portfolio and what spending will be required to do that.

And over the last two years, the large Canadian oil sands companies have formed a collaborative group, The Oil Sands Pathways to Net Zero. And that’s really advanced their decarbonization efforts in Western Canada. They’ve highlighted a number of pathways with which to get lower carbon footprint, with carbon capture really being in focus in the near term, and they’re all directing their resources to developing that technology and achieving policy support.

I think numbers in the $50 billion to $70 billion spending required to achieve the carbon capture that has been laid out ahead of them over the next decade—well, one to two decades—has come out. That said, the Canadian government recently announced with their budget that they would support carbon capture spending in the industry through an investment tax credit, which covers close to 50% of those expenditures. So that is a large win for the industry, as well as for the decarbonization efforts of Canada.

So the industry’s looking for more policy certainty, and already started the process of regulatory applications. But the spending for these projects is unlikely to start in the near term. I expect in the next two to three years. And the tax credits will really help make that spending less of an overhang and more of a positive unlocking for valuations, potentially, as we can see a path for lower carbon oil being produced in Western Canada.

Stu Morrow:

Thanks, Sarah. Very interesting.

And let’s stay with another darling part of the Canadian investment landscape, Irene, and talk about Canadian financials. We work at a bank, but given the large weight in the TSX, your thoughts around the outlook for the Canadian banks and on top of most of our clients’ minds would probably be the outlook for the mortgage market, the housing market, of course, like everyone likes to talk about. And then exposure I guess to overall interest rates as well.

Irene Fernando:

Well thank you, Stu, and also thanks for having us both on your webcast.

On the banks, as you said, it’s a very meaningful part of the TSX, so Sarah and I pay very close attention to it. Generally speaking, we are in the environment of rising rates where the central banks, both in Canada and in the U.S., are hiking their Fed funds rate.

And if you step back and you think of course this is positive for the banks, how is it? Well, banks now can go and charge higher price for the same loans that they have outstanding as rates have moved up. So generally, that would contribute to a faster and better revenue growth. So the top line would be in better shape.

But it’s never as simple, because now the market is starting to shift their focus on other things. So in the last 12 months, we had basically zero worries about liquidity, zero worries about the credit experience at the banks, and expense growth was very, very slow. So these things are changing now.

So next week, Canadian banks are starting to report their quarterly earnings and we will be looking for management guidance on what they think that higher rates will do to their outlook for loan growth. We know that they will deliver good loans this quarter, but I think the main focus is now shifting to the outlook in the next 12 months.

And from my perspective where we stand here today, I think on the margin we will see a slower loan growth. So that’s number one, offset to higher rates. So yes, you can charge higher rates, but your loans might grow a little slower. Two, let’s talk about credit experience. Credit is one of the most important inputs in a bank model. And plentiful of liquidity, help from the government during times of COVID really helped consumers and businesses, and we did not really have a real kind of credit recession. But what we’re starting to see today is a bit of uncertainty creeping in. We’re starting to look at lower FICO scores and looking for delinquency levels. And we haven’t seen anything real yet. But yet, again, when you think about a stock market, we always try to look forward. So we’re trying to predict where will the credit experience go 12 months from now? And again because we are at such low levels today, honestly the only way is up. So we will see a bit more losses going forward. So this is the second offset to the higher revenue growth that I talked to from the rate impact.

And the third one is inflationary pressures that every business is experiencing today, and banks are no exception. We have seen a couple of banks already, they came out two weeks ago or so saying we will raise wages by at least 3%, they’re giving more benefits. So what I’m saying is that it will be a bit harder for them to have this positive revenue from rising rate flow through to the bottom line because you will have the offset from lower loan growth, you will have the offset from credit losses rising potentially, and you have to manage your expenses, and expense growth should be a bit higher.

So just to summarize it all, we were in a very good last 12 months for the banks in terms of earnings. We saw revisions of earnings higher. And I think the next 12 months will be a bit harder. We are running scenarios introducing recessionary scenarios to understand what the impact would be if we have a real stress in the system, something we haven’t done in a while. So that’s kind of in the summary.

And so on the housing side, I mean it’s on everybody’s mind. Right? It’s on every newspaper. But I think if I just bring it back to the banks, what does this mean for the banks? Is that yes, are we concerned about housing market cooling? For sure. But in our opinion is that there’s still a lot of cash in the system.

Canadians are sitting on historically high deposit amounts. And although those deposits are not growing—so we’re not getting more cash—but there is enough cushion for a stress scenario. And it doesn’t mean that there’s cushion for everyone, but on average for the bank as a whole, I think they will be able to weather a slowdown in a housing market without significant losses.

So this is our base case under which we work. Of course in the recessionary scenarios, we think about far stress level for the credit losses, and the outcomes, obviously, more severe. We could get up to 20% lower in terms of earnings for the banks if we see losses rise significantly.

But one thing I wanted listeners to pay attention to is obviously all the talk about de-affordability. But I think the refinancing risk is something that is very important and we watch it very, very closely.

So let me just bring an example. You got a mortgage in 2017, and on average the mortgage rate was 2.9%. If you go and refinance today, the five-year fixed mortgage rate will be north of 4.25%. So if you’re lucky, you get 4.25%, maybe even 4.5%. Now that is a meaningful difference for any household cash flow. It obviously depends on your mortgage balance, but this is something that we really need to talk about and need to understand.

And in the next two years, those expiries are around 130 bips, or 1.3% to 1.5% higher than expiring mortgages. But as we go further into 2025 and 2026, the gap between the mortgage rate and the mortgage rate in place will be much wider. So I think we have a bit of room before we hit that, but that’s kind of the outlook for the housing.

Stu Morrow:

That’s great, Irene. I’m sure that’s on everyone’s kind of mind too, and the refinancing risk kind of makes me give myself a little pat on the back for locking in a fixed rate last year.

Irene Fernando:

Good for you.

Stu Morrow:

Probably my best trade ever, but we’ll just keep that between us.

Irene Fernando:

If I could summarize maybe just saying all these concerns I brought to the audience, I think a lot of it is already reflected in the valuations. Canadian banks don’t trade expensive. Canadian banks actually did a little better than the market. So we are trading at 10 times 2023 earnings and this is historically below average—around 10% lower average.

So as an investor, you will say well oh, this sounds really bad. But I think it has been already reflected to an extent in bank valuations today. And I think our base case is just maybe best 2% to 4% return plus dividends for the foreseeable future.

Stu Morrow:

Still pretty respectable. And like you said, the market is always looking forward, so that’s a good point that this would’ve already been sort of reflected at some point in the prices today. Right?

Irene Fernando:

Yes.

Stu Morrow:

Yeah. It’s a good segue, Irene, into a question I have for both of you. Maybe I’ll start with Sarah.

But we certainly realized in our research—in your research too—but there’s this valuation difference between the Canadian equity market and the U.S. equity market of, of course there’s big differences in the sectors and exposures; we talked about the two big ones today. In financial services and energy in Canada, are very different weights in some U.S. equity market indexes.

But can you maybe talk about this historical valuation discount today and your thoughts on potential outcomes in a Canadian equity space over the next year or so?

Sarah Neilson:

I’ll start. Just to reiterating some of where we see the earnings picture for the TSX. So like you talked about, Stu, the TSX is now 50% weighted to energy and financials. Energy now makes up close to 20% of the TSX versus in the S&P 500 I think it’s still sub 4%. So it really does have an outsize impact on the earnings outlook.

And that move that I talked about earlier of 50% increase in underlying prices and a lot of that flowing to the bottom line has really flowed through to a massive earnings recovery. So we’ve already had very strong earnings revisions higher in Canada in the last six months. And even in the last month I saw earnings revised another 8% higher.

So we’re looking for over 15% growth in 2022 in Canada, which is above what other markets are expecting. And I still think there’s the potential for some commodity price upside to be factored into earnings as we go ahead if we maintain some of the levels we see today.

Now of course that also is a risk and may spell to why the valuations sit where they are, but we do see these prices being quite attractive from that point of view.

And I’ll pass it to Irene now to talk about the valuation dynamic.

Irene Fernando:

That’s great.

So let’s look at the relative performance. TSX is down 5% on the year versus S&P 500 is down 16%. That is a meaningful difference. TSX stands out in the global markets as one of the strongest market this year. And to Sarah’s point, a lot of it was driven by positive earnings revisions in sectors like energy and materials.

So going forward, what do we think about valuations? Usually a playbook for valuation is following. It’s not the earnings that impacts valuations, it’s liquidity in the system and it’s the level of rates. So if we are in a central bank tightening cycle, no one is expecting valuation for the stock market to expand in the near future.

I think market has anticipated this tightening cycle and this drawback of liquidity in the markets that valuations have pulled back meaningfully versus last year. So for example, TSX currently trades at 13 times forward earnings versus U.S. market S&P 500 that’s 17 times. This is far below the levels we saw last year at the same time. It’s over 20% correction in valuations.

So the gap between the two is 4 times today. In the last few months, we’ve been actually at a deeper discount that’s 5 times, and we’re seeing this discount narrow slightly so because S&P/TSX is holding in so much better than U.S. market. So how to summarize it all? Given the TSX is trading at 13 times, which is way below the average of around 15 times or so, we believe that with earnings revision being slightly lower, the outlook for the next 12 months for the TSX is a bit of a sideway action. With rising risk of recession, it is unlikely that the multiple will expand in the next 12 months. Yet again, it’s not a bad place to be—comparatively speaking—to other global markets.

Stu Morrow:

Thanks, Irene and Sarah. That was great. I certainly learned quite a bit about the relative attractiveness of the Canadian market to the U.S.

Thank you for both joining this podcast. It was a pleasure seeing you, at least virtually. I do hope to see you around the office sometime soon this summer.

Sarah Neilson:

Stu, thank you so much.

Irene Fernando:

Thanks so much.

Stu Morrow:

And to our listeners, thanks for tuning in to this podcast. If you have any questions about what you’ve heard here today or about your portfolio in general, please reach out to your investment counselling team for more.

Take care and bye for now.

Disclosure/Disclaimer

This “Counsel Views” podcast, episode 26, was recorded on May 17, 2022.

Stuart Morrow is the Chief Investment Strategist of RBC Phillips, Hager & North Investment Counsel Inc. (RBC PH&N IC). All opinions of Stuart Morrow and his podcast guests are solely their own opinions and do not reflect the opinion of RBC PH&N IC nor of any of its affiliates including RBC Global Asset Management Inc. (RBC GAM). ;

This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. This podcast is not an offer to sell or a solicitation of an offer to buy any securities. Past performance is no guarantee of future results. Interest rates, market conditions, tax rulings and other investment factors are subject to rapid change which may materially impact analysis that is included in this document. This information is not investment, tax or legal advice and should only be used in conjunction with a discussion with your RBC PH&N IC Investment Counsellor and in consultation with qualified tax and legal advisors before taking any action based upon any information contained in this podcast. Neither RBC PH&N IC, nor any of its affiliates including RBC GAM, nor any other person accepts any liability whatsoever for any direct or consequential loss arising from any use of the information contained in this podcast. Clients of RBC PH&N IC may maintain positions in the securities discussed in this podcast. All opinions constitute our judgment as of the dates indicated, are subject to change without notice and are provided in good faith without legal responsibility.

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