Weekly Capital Strategy – February 26, 2016

February 26, 2016

Oil Isn’t the Big Threat to Banks
(Andrew Pyle, Senior Wealth Advisor and Portfolio Manager)

Last year when I cut exposure to Canada’s banks it was on the basis that all of the good news this cycle had already passed and the risks to valuations were growing. The most evident risk to investors was the impact that sharply lower oil prices were having on Canada’s energy sector and what this would do to the performance of bank loans to companies in trouble. When we saw banks report in November it appeared that risks were exaggerated since the impact on earnings and loan loss provisions was minimal. That didn’t prevent a further slide in bank stocks into December, while global market shivers took care of what happened in January. Hence, this week’s Q1 bank earnings parade was closely watched for whether these risks were finally going to show up. They did, but it still wasn’t as broad based as expected.

With all the major banks, except Scotiabank, reporting the results have actually been mildly positive. BMO and National Bank reported net income that was ahead of street estimates.  CIBC followed with not only a healthy bottom line of $2.55/share versus estimates of $2.37, but boosted its dividend by 2.6% as well. For TD there was a small miss ($1.18/share versus calls for $1.19), however, it also raised its dividend by four cents to 55 cents/share. As for Canada’s largest bank, RBC, net income also came in below estimates at $1.64/share, versus $1.66. That might not sound like a big miss, but the bank’s shares experienced the heaviest one-day hit since last August. And it was in this earnings report that investors really saw the weight of lower oil prices.

 

TSX financials Feb 2016

 

RBC announced that Q1 earnings were affected by increased loan losses stemming from four oil and gas accounts and that $410 million was set aside from bad loans. Over $300 million of this came from energy and the overall loss provisions were 52% above levels seen a year ago.

The backdrop for this week’s earnings wasn’t made any better by a report from Moody’s Investors Service. The agency said that a further decline in oil prices would increase stress on energy companies and lead to heavier losses for the banks. In a “moderate stress” scenario, bank profits would decline, but capital levels would not be adversely impacted. In a severe scenario, however, Moody’s believes that banks might have to cut dividends and sell additional shares to bolster capital. Clearly, those banks with higher exposure to the energy sector would be hit hardest. Currently, Scotiabank and National Bank both have exposures of more than 2.5% of their overall loan book, while TD’s exposure is less than 1%. That said, even Scotia’s 3.5% is small in the grand scheme of things.

I am more concerned about the heavier exposure to residential mortgages.  Based on the latest Bank of Canada stats chartered banks had $1.012 trillion in residential mortgages at the end of 2015, or 45.3% of total assets.  Back in the first quarter of 2014 residential mortgages accounted for $918 billion or 44.4% of assets. This isn’t the highest exposure we’ve seen to the mortgage sector since back in 2012 chartered banks had 45.7% of their assets backed by homes. If home prices were to keep rising and interest rates remained near historic lows this exposure would not be a concern. Then again if oil prices were still $100/barrel we wouldn’t be seeing loan loss provisions rising either. The problem is that the downward interest rate trend is about to come to an abrupt end as Canada returns to deficit financing and the US central bank nudges short-term rates higher. Foreign capital inflows into the housing market are also beginning to slow as China’s capital markets remain volatile. At some point a 10-20% correction in home prices is inevitable in my opinion, especially as the weight of higher borrowing costs adds to the reduced purchasing power from a weaker Loonie. It might make the oil price story seem small by comparison.

 

Some Light at the End of Oil’s Tunnel
(Andrew Pyle, Senior Wealth Advisor and Portfolio Manager)

Despite the negative repercussions from oil’s decline on the financial sector, things are beginning to look a little brighter on the commodity front. After reaching $26/barrel in January and again this month a bottom appears to have formed in that region. From a technical perspective this is an important development—referred to as a ‘double bottom’- and it could signify the start of a new uptrend. The counter argument, however, is that crude has not been able to break above $35 in either the January recovery nor this week.

 

Crude oil Feb 2016

 

Perhaps a better way to describe where we are today is to say oil is in a consolidation phase, with a sideways pattern to dominate until there is a significant change in the fundamental picture. This is similar to what we saw after the 2008 plunge, when oil fell from almost $150 down to just above $32 in December. A couple of false starts that low reinforced this floor and, even though the world was in recession, crude oil staged a sustained recovery that eventually brought oil back to $87 before the next sizable correction. By 2011 oil had returned to $110 and so began a 3-year consolidation phase that finally broke apart to the downside in mid-2014. No one expects history to repeat itself in terms of the magnitude of an oil recovery. Many would be happy to simply see a return to $40 rather than waste time with lofty forecasts of $80; but even a small move would significantly alter sentiment.

Recent discussions between Saudi Arabia and Russia over the capping of production have definitely contributed to this consolidation, though there is still the overhang of growing Iraqi output and the emergence of Iranian supplies on the market. As G20 finance ministers meet in China this weekend there will no doubt be a lot of discussion around oil prices and the effect on global economic activity. Given how broad this forum is the discussion will not just be about the negative implications since some countries (such as India) are benefiting from the slide in energy prices.

At the same time the demand story for oil is still positive. Concerns of an impending global recession finally seem to be dissipating thanks to healthy data from the US economy and a period of relative calm with respect to China. As I have discussed before there are no signs that growth in oil demand will falter and I still believe we will see demand of 100 million barrels per day by 2018.

The supply story is static right now, pending action on a production freeze. However, the credit stress that oil producers are feeling is going to translate into output reductions, even if banks are said to be offering some relief to those unable to make loan payments. This may be true in Canada, but in the US and Europe where energy loan exposures are far greater (over $125 billion in the US and close to $200 billion by European banks), the transmission effect from tighter credit to reduced output will be faster. This does not include the production cuts that have already been built into the system from dramatic reductions in capital spending.  I would expect material results from this to show up later this year and definitely in 2017. Enough for oil prices to remain sideways and once storage inventories get eaten into this would mark the beginning of a real recovery. Again, I wouldn’t set too lofty a forecast.

From a portfolio perspective this continues to be a time for underweight positioning in energy stocks (note, underweight does not mean no weight). If the bottom doesn’t hold then a reduced weighting will contain losses, but if we get a sudden rally then at least there is some participation. I wouldn’t recommend a neutral weighting until the actual global supply glut shows meaningful signs of decreasing. The question is whether we will ever get to an overweight position in energy? That is a tough one since a recovery may prove short-lived ahead of the next global economic downturn and greater penetration of electric vehicles and alternative energy sources.

 

TSX vs Dow from Feb 26 2015

 

Winning a Settlement Doesn’t Mean Winning Your Freedom
(Emily Downie, Senior Associate)

Imagine being involved in a catastrophic automobile accident where there is not only significant bodily harm but legal ramifications.  In some cases there is ultimately a settlement to the claimant.  This type of settlement, depending on the damages caused, can be in the millions of dollars in payout.  Typically the payout is in a lump sum form.  However, history and human behaviour patterns have shown that lump sum settlements may be squandered and the funds are mismanaged; thus not providing for the victim or claimant for the period of time that the funds were intended for.  An alternative to the lump sum settlement is the structured settlement.  This was introduced first in the United States and termed a structured judgment.  The most obvious motivation to pursue this option is the tax treatment of the payout.  The settlement is a financial package that is designed to meet the claimant’s needs and is structured through periodic payments- either for a fixed term or for life.  The structure of these payouts is that all payments received to the claimant are received tax free.  The premise behind the tax status is that the design of the treatment parallels the traditional treatment of a lump sum payment.  Normally in a lump sum payout for damages in personal injury or death, the payout is received tax free.  Thus in a structured settlement, the payments are mimicking the lump sum payment in terms of tax treatment.  In a lump sum settlement, although the initial lump sum and compensation are received tax free, the interest and income derived from the lump sum is not tax free.  As the idea is to have the payout last as long as possible, the government has an incentive as well to keep the claimant fiscally sound and not relying on government support; thereby supporting the tax free status of the annuity payouts.

Structured settlements are produced by life insurance companies and federally regulated.  The settlement itself must be negotiated during the settlement process and must be part of the documented settlement agreement. Once the annuity and payments are created, the annuity is non-commutable, non-assignable and non-transferable. This means that no one (including creditors) can change or stop the annuity under any circumstances.  If the claimant received a lump sum settlement, the money is open to creditors.  For example, if during the proceedings a claimant accumulated personal debt, the creditors can seize the proceeds in the lump sum payout.  If the claimant opts for a structured settlement, the worry of having the settlement seized is eased.

 

 

Upcoming Events

  • Canada: Current account, producer prices, December GDP, Q4 GDP, merchandise trade, Ivey PMI
  • US: Pending home sales, ISM manufacturing, vehicle sales, ISM non-manufacturing, ADP payrolls, non-farm payrolls

 

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