Winners and losers when the ball stops bouncing
The decision by Bank of Canada to hold interest rates unchanged at 5% at its most recent meeting was echoed by the U.S. Federal Reserve’s Open Market Committee at its Sept. 20 meeting. The all-items U.S. Consumer Price Index rose 3.7% year-over-year (core CPI rose 4.3%) in August, less than the 5.25% Fed funds rate.
The European Central Bank (ECB), on the other hand, chose to raise short-term interest rates to a record 4% earlier in September, as core EU inflation (excluding food and energy) has remained stubbornly high at over 6%, even as Germany, the largest economy in the euro area, entered recession. It seems the ECB may be repeating its errors of a decade ago when it raised interest rates while Greece, Spain, and Portugal were being hammered by the euro debt crisis. The Bank of England is also expected to consider raising rates to 5.5% even though growth in the U.K. is slowing rapidly as inflation remains higher than expected.
The (perpetually) inverted yield curve
The government bond yield curve has been inverted for over a year, with benchmark Government of Canada 10-year bonds yielding 730 basis points less than short term rates (3.99% vs. 4.72%) in mid-October. The same scenario is playing out in the U.S. (4.71% vs. 5.09%), the U.K., and in the euro area. As central banks always remind investors, monetary policy works with a long and variable lag. A sustained inverted yield often precedes a recession, and this one has been signalling a slowdown in North America for more than a year.
Any slowdown might turn out to be a “soft landing,” i.e., a mild recession, due in part to the stimulus payments from pandemic support programs bolstering consumer spending for longer than had been expected. But recent strikes such as the walkout by Hollywood actors and screenwriters and now by auto workers will contribute to slower GDP growth and might be enough to tip the economy into a real recession.
Oil is another wild card, as prices have risen to over US$90 a barrel from US$70 in the last quarter. Saudi Arabia and other producers have maintained restrictions on supply as demand has recovered, keeping prices elevated.
Thus, although most economists are not expecting more than one further increase in short-term interest rates, they are also not anticipating a rapid drop in rates in 2024, with many expecting rate cuts only in 2025. The forecast from the majority of observers is that rates will remain higher for longer, and that borrowers and investors should get used to 4%-5% interest rates.
With approximately one-fifth of Canadian mortgages maturing each year, this will result in large increases in mortgage payments for many borrowers. In the U.S., the prevalence of 30-year mortgages has somewhat insulated mortgagees from rising rates. Together with higher oil and gas prices, which effectively act as a tax on consumers, reducing their disposable income, it’s difficult to see consumer spending remaining as robust as was coming out of the pandemic. Anticipating the downtrend, Canadian banks all raised their provision for credit losses in their results for the quarter ending July 31, even though loan losses have not yet started in earnest.
Investors should be defensively positioned, with exposure to resilient sectors that have outperformed in previous recessions. These include healthcare and consumer staples such as personal care, food and beverage, and grocery retailing. Amongst Income Investor recommendations, companies in the healthcare sector (such as Johnson & Johnson, Novartis, and GSK) and in the consumer sector (such as Diageo, Unilever, P&G, Empire, and Loblaw) are reasonably valued and offer defensible dividends.
At the same time, interest rate-sensitive sectors have underperformed over the last 18 months during the rate-hike cycle, and the likelihood is that short-term rates are near their peak. So, sectors such as the banks look attractive, as the decline in their share prices has baked in the negative effect of higher loan losses. RBC and TD, for example, yield more than 4.5%, while CIBC and Scotiabank yield over 6%. Insurers such as Manulife and Sun Life yield between 3.5% and 5.5%.
Looking at sector performance, the U.S.-based Invesco KBW Bank ETF is down 24% over the last year while the iShares S&P/TSX Capped Financials Index ETF is flat. Compare that with increase of 5% for the S&P/TSX 60 Index and 15% for the S&P 500 Composite. The Nasdaq Composite Index gained 28%, driven by the massive outperformance of the so-called Magnificent Seven large-capitalization technology stocks (Apple, Microsoft, Amazon.com, Nvidia, Alphabet, Meta Platforms, and Tesla).
The size of the banks’ underperformance takes a very negative scenario for credit into account, but it’s notable that the oligopoly of the large Canadian chartered banks has held up much better than more fragmented U.S. banking industry. In the volatile U.S. banking sector, the recent bankruptcies of regional banks Silicon Valley and Signature reminded investors of the risks of concentrated loan books.
Despite carrying long-term debt at fixed rates, debt-heavy utilities and pipelines have also sold off sharply as their high dividend yields have become less attractive against 5% interest rates. The iShares S&P/TSX Capped Utilities Index ETF is down 17.5% as a result.
With its recent purchase of three U.S. natural gas utilities, Enbridge is set to become the biggest gas distributor in the U.S. It’s apparent that management feels the outlook for regula ted utilities remains attractive, while the pricing regimes for utilities allows for inflation-linked increases or take-or-pay features. Income Investor recommendations such as Enbridge and TC Energy, Pembina Pipeline, Capital Power, and AltaGas all offer yields over 5%.
Lastly, certain categories of REITs have sold off because of the rise in interest rates, even though their underlying fundamentals remain strong. These include grocery and necessity-anchored retail REITs such as Choice Properties, CT REIT, Crombie, and Slate Grocery, industrials (Granite and Automotive Properties), and apartment REITs, as high immigration into Canada supports full occupancy and rising rentals.
Gavin Graham is a veteran financial analyst, money manager, formerly Chief Investment Officer of BMO Financial, and a specialist in international investing, with over 35 years’ experience in global investment management.
Notes and Disclaimer
Content © 2023 by Gavin Graham. This article first appeared in The Income Investor. Used with permission.
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