Encounter

Three big questions hang over the Canadian market.
By Sonita Horvitch | 29/01/18

Editor's note: Where are interest rates headed? Will NAFTA survive? What's next for oil? In today's first installment of our three-part roundtable series on Canadian equity income, the portfolio managers address big-picture questions that will shape their securities-selection strategies in 2018.

About the Author
Sonita Horvitch is a Morningstar columnist who specializes in reporting on money managers and their strategies. A veteran financial journalist, she was formerly with the National Post and its predecessor, the Financial Post. At the Post she was best known as the author of the popular Buy & Sell column, which she wrote from its inception in 1994 to December 2008. She holds a master's degree in business economics from the University of the Witwatersrand in Johannesburg, South Africa.

The panellists:

Peter Frost, senior-vice-president and portfolio manager at AGF Investments Inc. His responsibilities include two income-oriented balanced funds: AGF Monthly High Income and AGF Traditional Income.

Michele Robitaille, managing director and equity-income specialist at Guardian Capital L.P., a sub-advisor to the BMO family of funds. The Guardian equity team's mandates include BMO Monthly High Income II.

Stephen Arpin, vice-president, Canadian equities at Beutel, Goodman & Co. Ltd. Arpin's responsibilities include Beutel Goodman Canadian Dividend and Beutel Goodman Small Cap.

The roundtable was convened and moderated by Sonita Horvitch, whose series continues Wednesday and concludes on Friday.

 


 

Q: Low interest rates have provided a tailwind for dividend-paying stocks. Are we still in a "lower for longer" interest-rate environment?

Frost: Interest rates and bond yields are likely to rise. We have had two years in the United States where the 10-year U.S. Treasury yield has closed at a higher yield than the previous year. It will probably move higher. This yield was recently at 2.6% and it may get to 3%, or a little higher this year. The U.S. move will cause other jurisdictions to raise their interest rates. The 10-year Government of Canada bond yield was recently 2.2%

Peter Frost
Peter Frost

Inflation will probably be a little higher this year. We have strong global economic growth. U.S. economic growth is probably going to improve in 2018 over 2017. Tax reform in the United States is a big tailwind. The recent U.S. government shutdown was limited in duration and will not have a material impact on U.S. economic output. Tax cuts will have a more significant positive impact, provided any government shutdown in the future does not continue for an extended period.

The Canadian economy outperformed most economists' forecasts for the second half of 2017. It should probably continue to do fairly well this year, particularly if commodity prices, especially the oil price, move higher.

Robitaille: We expect the Canadian economy to slow down a little, since 2017 was so robust. The increase in the Bank of Canada overnight target rate to 1.25% on Jan. 17 was not unexpected. We think that the Bank of Canada will pause. There is a lot of uncertainty, particularly related to the North American Free Trade Agreement (NAFTA), and the Canadian dollar. We are still in a lower for longer interest-rate environment. There are a lot of structural impediments to a higher level of economic growth.

Arpin: The low-interest-rate environment has been a huge supporter of the move to dividend-paying stocks. We expect short-term interest rates to rise, but I am more concerned about what happens at the longer end of the yield curve, as this is more important for the move of money into equities in search of income.

Q: How will the lack of an agreement between United States, Canada and Mexico on NAFTA affect the Canadian economy?

Arpin: There are a lot of unknowns. The discussion is about the order of magnitude of the fallout. The financial markets are saying that the Canadian automotive industry and Canadian agriculture face more risk than other areas of the economy. There are other questions. How integrated is the supply chain between Canada, the United States and Mexico? It is difficult to gauge the extent to which a change in NAFTA is already discounted in the Canadian equity market.

Frost: The change in investor sentiment would probably be the biggest factor initially, if the United States withdrew from NAFTA.

Robitaille: The biggest challenge is that these NAFTA discussions introduce uncertainty and the market does not like uncertainty. The U.S. administration is unpredictable.

Q: Another question mark hanging over the Canadian economy and the equity market is the outlook for the oil price.

Arpin: Prices for light-oil producers have improved a lot. But Canada is a substantial heavy-oil producer. Of concern is the large price differential between Western Canadian Select or WCS, the Canadian heavy-oil benchmark and West Texas Intermediate or WTI, also known as Texas Light Sweet, the benchmark for crude oil in North America.

Stephen Arpin
Stephen Arpin

Frost: The differential is wide. Canada has structural problems.

Robitaille: It is a challenge for Canadian producers to get their product to markets.

Frost: The political and environmental challenges of getting new pipelines built or extending existing ones remain a problem.

Robitaille: The U.S. regulatory environment under President Trump's administration is less onerous in this regard.

Arpin: In Canada, the federal government has approved two major pipeline projects. Canada is losing a lot of money and investment by having the price for its oil at less than optimal levels. The challenge is the pricing of the product rather than the efficiency of the companies. Natural-gas prices are under severe pressure and that is going to hurt too.

Q: Can we briefly discuss the outlook for the Canadian dollar versus the U.S. dollar?

Frost: Monetary policy is an important determinant. For the Bank of Canada, it will depend on how the Canadian economy progresses in 2018 and whether NAFTA remains a concern.

Robitaille: Our macro view is that the Canadian dollar is range-bound between US$0.75 and US$0.85.

Q: In summary, how will rising interest rates affect the asset-allocation decision by investors and the valuation of dividend-paying stocks?

Frost: It depends on how far and how quickly rates rise.

Arpin: If you have substantial increases in interest rates, it will adversely impact dividend-paying stocks on both sides of the border and the valuation of those stocks. Classic interest-sensitive stocks like utilities and real estate have benefitted from lower rates. Based on what we said earlier, we do not expect interest rates to rise sufficiently to cause competition to equities. But rising interest rates are going to affect bond proxies (such as utilities stocks).

Frost: The process has already started. Utilities stocks like Fortis Inc. (FTS), Canadian Utilities Ltd. (CU) and Emera Inc. (EMA) are off their 52-week highs. The headwind of rising bond yields will continue to weigh on these stocks.

Canadian Utilities Ltd.Emera Inc.Fortis Inc.
Jan. 25 close$36.10$46.39$43.59
52-week high/low$42.44-$35.53$49.48-$44.68$48.73-$40.73
Market cap$9.7 billion$9.9 billion$18.3 billion
Total % return 1Y*0.75.28.8
Total % return 3Y*-1.88.05.7
Total % return 5Y*2.48.78.1
*As of Jan. 25, 2018
Source: Morningstar

Robitaille: There is unlikely to be a full-scale shift out of equities into bonds, based on our forecast of where bond yields are likely to go. As a result of global synchronized economic growth, there was a shift in the last four months of 2017 within the Canadian equity market toward cyclical stocks. This shift has continued into the beginning of 2018. Investors had been hiding in the interest-sensitive sectors. There is a general view that interest rates will go up in tandem with the strengthening economy, so bond proxies tend to be the most vulnerable.

Q: The S&P/TSX Composite High Dividend Index underperformed the S&P/TSX Composite Index in 2017. The former had a total return of 7.61% versus the benchmark's total return of 9.10%. Why is that?

Michele Robitaille
Michele Robitaille

Frost: One reason for this underperformance is the larger weight of energy in the dividend index. Energy's weight in the S&P/TSX Composite High Dividend Index was 30.4% at the end of 2017, its largest sector weight. At that date, energy represented 19.7% of the S&P/TSX Composite Index and was its second largest sector, after financials. In 2017, the energy sector recorded a negative total return in both indexes, whereas there were a lot of other sectors that produced positive double-digit total returns.

Robitaille: Another reason for the underperformance of the high-dividend index in 2017 was this cyclical shift in the Canadian equity market towards the end of last year.

Frost: Weakness in the Canadian energy sector in 2017 was also an important contributor to the Canadian equity market's underperformance relative to other leading indexes around the world, such as the S&P 500 Index in the United States and the MSCI World Index, which covers the performance of developed-country stocks.

Q: The Canadian benchmark delivered a total return in Canadian dollar terms of 9.10% in 2017. By contrast, the U.S. benchmark had a total return of 21.83% in U.S.-dollar terms and the global developed-market benchmark had a total U.S.-dollar return of 23.07%.

Arpin: The Canadian benchmark has a much heavier weighting in energy than both these U.S. and global developed-market benchmarks.

Photos: Paul Lawrence Photography

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