The Market

As the third quarter of 2021 drew to a close, the month of September certainly lived up to its reputation as being unpredictable and volatile.  Global markets touched all-time highs several times before two sizable selloffs near the end of September with the S&P500 down about 5% for the month and posting the first monthly decline since January 2021.  The first selloff was provoked by debt concerns in China’s heavily levered property market and the second was due to the recent spike in US Treasury yields which foretells an improving economy with the corollary of increased inflationary pressures. Signs that the US economy is still expanding at a healthy pace have raised bond yields and lifted stock prices in the energy, materials, and financial sectors, while punishing longer-duration assets particularly in growth and technology-oriented names.

The table below shows the market performance as of market close on September 30, 2021, in Canadian dollar terms:

Performance

The table below compares the YouFirst portfolio composites with their respective FPX Benchmarks:

The outperformance of the YouFirst Growth and Conservative Growth benchmarks were primarily due to an underweight holding of fixed income securities in the portfolios and an overweight of hybrid securities such as convertible debentures and preferred shares.  In the future, we believe that the expectation of rising interest rates will continue to drive outperformance in the minimum rate reset preferred shares that we hold, as the dividend payment on these securities are reset on the Bank of Canada 5-year government bond rate.

Portfolio Activity

During the quarter, we purchased shares in Canadian Pacific Railway Ltd. (CP:TSX), which operates a 22,000 km rail network between Montreal and Vancouver and also links to hubs in the US Midwest and Northeast.  Both CP and CN Rail have been involved in merger discussions with Kansas City Southern (KCS:NYSE), which operates a rail network of about 11,400 km extending from the US Midwest and Southeast into Mexico, the latter being of particular interest (cross-border traffic has been growing by more than 10% annually due to rising intermodal, automotive, and refined products volume).  KCS shareholders subsequently approved CP’s bid, with the full takeover expected in 2022.  The resulting merger will create the only North American rail system that unites Canada, US, and Mexico as well as extends CP’s reach to US Gulf Coast oil refineries.  Although the transaction is expensive (over $30B including CP’s assumption of KCS debt), we believe the resulting synergies of the merger will enable CP to better compete against CN and further reward CP shareholders in the long-term.

After falling short of analyst expectations for second quarter 2021 results and providing weaker-than-expected guidance for third quarter revenues, Amazon.com (AMZN:NASDAQ) shares fell more than 7% in trading post-earnings release in late July.  We saw this as an opportunity to buy shares in Amazon as we believe that the slowdown in post-pandemic online retail sales growth will be offset by future earnings growth in the highly profitable, market leading cloud computing space (Amazon Web Services) which grew its revenues 37% in the second quarter, and Amazon’s “other” business unit: subscriptions, and advertising, which grew revenues 87% over the quarter.

Manulife Financial Corporation (MFC:TSX) is Canada’s largest life insurance company.  It is also a leading provider of other financial products and services, including pension products, annuities, and mutual funds to individual and group customers in Canada, the US, and Asia.  With good second quarter results, we purchased additional shares of Manulife for clients underweight equity as the stock is inexpensive from a valuation standpoint and the 5% dividend yield is attractive. 

We continued to trim Hydro One (H:TSX) in some portfolios which had become slightly overweight and topped up on additional shares of Northland Power (NPI:TSX) on recent price weakness to maintain our allocation in utilities and to increase our portfolio exposure to more pure-play renewables with an ESG focus in mind.

Additionally, we continued to add to First Capital Realty REIT (FCR.UN:TSX). Even with the recent price growth since last quarter, we believe that FCR still trades at a relatively fair valuation and has yet to recover to pre-COVID-19 lockdown price levels. While REITs with long term tenant leases tend to sell off during periods of sharply rising bond yields, we expect any such material downward pressure could present attractive opportunities to include additional REITs, particularly for investors with an income orientation and a longer-term focus.

Finally, we purchased additional minimum rate-reset preferred shares: Brookfield Office 5.1% (BPO.PR.E), Brookfield Renewable 5% (BEP.PR.M), and Pembina Pipeline 5.25% (PPL.PF.C) while continuing to sell non-minimum rate-reset preferred shares: Pembina Pipeline 4.7% (PPL.PR.S), Northland Power 5.1% (NPI.PR.C), and Artis REIT 5.66% (AX.PR.A).  The minimum rate-reset preferred shares will outperform as the dividend rate is reset in the future at higher levels if rates rise, but have an effective “floor” in yield if interest rates decline.

Outlook

The world has changed considerably since Justin Trudeau and the Liberal government were handed their last minority in October 2019 yet political preferences seemingly have not. Only a handful of seats changed hands across the country, results that are likely disappointing for all parties involved.  The following is an excerpt (and truncated where possible) from RBC Global Asset Management¹ highlighting the possible investment and economic landscape in Canada moving forward:

While the Liberal platform contained an exceptional number of promises, several now come into focus from an economic and investment perspective:

• The Liberals campaigned on a platform of increasing government spending, to the tune of an additional $78 billion over the next five years. Given that the pandemic isn’t yet resolved, some further policy measures are arguably justified. It’s also important to note that minority governments tend to be more fiscally expansive as they attempt to meet the spending objectives of multiple parties. When combined with low interest rates, this strategy is unlikely to encounter near-term concerns about debt sustainability.
• On the topic of housing: Key Liberal pledges include placing limits on foreign ownership and instituting an anti-flipping tax on houses owned for less than one year. There is also a focus on affordability, with plans to build more homes, encourage cheaper mortgage insurance and create a tax-sheltered program for down payments [the First Time Home Buyer Savings Account: we will keep our clients updated when this becomes available]
• In addition to continuing many of their existing pandemic support programs, the Liberals plan to provide wage and rent support for the tourism sector, subsidizing cultural events facing reduced capacity.

Elsewhere, the new government has also proposed support for working Canadians and families, including:

• Continue rolling out its new $10 childcare program
• Expand the number of individuals who are eligible for the Canada Workers Benefit.
• Increase the generosity of the guaranteed income supplement for low-income seniors.
• Lower the threshold for repayment relief on federal student loans.

Finally, the Liberals promise to continue implementing a suite of green initiatives, including a gradually rising carbon tax.  They have also committed to reduce emissions in the years and decades ahead.

What it Means for Markets

Elections rarely lead to a large deviation from the prior economic trajectory, particularly when the incumbent wins. While the formation of a minority government often creates greater potential uncertainty, Canada is no stranger to minority Parliaments and this outcome is virtually identical to the representation that existed prior to dissolution. Thus financial markets have responded to the results of this election in a muted fashion, focused more on other events. History further suggests there is no definitive path for rates during or after elections, and the Canadian dollar tends to take its primary cue from commodity prices and other market variables rather than political changes.

RBC GAM indicators suggest considerable work remains to be done to get Canada back to its full economic potential. However, with the growing adoption of vaccine mandates and passports, further economic restrictions are now less likely to occur.  In addition to the continuing pandemic supports, an important factor for robust growth ahead is the Liberal commitment to accelerated immigration over the next few years.
An important topic not discussed in RBC GAM’s report is taxes, which the Liberal platform included roughly $4B of net tax increases by 2022/2023, rising to $8B in 2025/2026.  The biggest-ticket items are proposed taxes on large financial institutions, at around $2.5 billion per year. At the same time, expanding the CRA’s revenue-collecting ability adds a net $4.6 billion by the latter year of the plan.

Smaller-ticket items in the Liberal plan are a minimum tax on higher-income earners and a flipping tax (on homes).  In that light, the NDP are openly pushing for taxes on higher-income earners, corporations and an increase in the capital gains inclusion rate. It appears that these are areas that the Liberals potentially may be willing to go in order to garner support. In fact, it’s notable that tax changes are an area where the Liberals and NDP see plenty of overlap, and one could argue that the risk of tax increases is higher in this minority mandate than it was in the last.

The equity market is still the place to be for investors these days.  Until bond yields rise materially and the nominal returns on fixed income securities become meaningful, equities will remain the most attractive investment. At this time, we are still treading carefully and purchasing stocks that are trading at a reasonable valuation with strong forward-looking growth prospects and wide moats in their respective industries.  We remain on the lookout for good buying opportunities when short term price weaknesses present themselves.  Until then, patience and a strong stomach for volatility is a virtue.

Please reach out to us if you have any questions about the information contained in this report or if we can be of help in any way.

1. Manzer, Krystyne, CFA. “It feels like déjà vu.”  Canada Votes, RBC Global Asset Management, September 21, 2021.

Doug Garner, P.Eng., CFA
President, Portfolio Manager

Jane Garner, BA, EPC
VP Operations and Client Experience

Simon Chun, P.Eng., CFA
Director, Associate Portfolio Manager