Weekly Capital Strategy – June 19, 2015

June 19, 2015

Rate Hikes – Not If, Not When, But How Much?
(Andrew Pyle, Sr. Wealth Advisor and Portfolio Manager)

After this week’s Federal Reserve FOMC meeting there should be little doubt in the minds of investors that interest rates in the US are going to move higher and it is likely to start by the end of the next quarter and continue into 2016. In the accompanying statement we saw previous remarks about the economic malaise in the first quarter replaced by comments about moderate growth and improvement. Employment growth barely slowed in the wake of that malaise and wages are picking up. Even this week’s reported decline in May housing starts failed to counter the more optimistic  tone (the 1.036 million unit pace is still higher than what the previous report showed for April).


Fed funds Dec 16 future


Despite the more favourable backdrop and what seems to be a stronger lean at the Fed towards rate hikes, it is surprising that the market went the other way and inferred that the Fed is going to prolong its first tightening move towards the end of the year at the earliest. How do we know this? Simply by looking at the September Fed funds futures contract, which is now trading at an all-time high of 99.82 (implying that the fed funds rate will be less than 0.2% in September—or unchanged from today). The December contract has also improved back towards 99.70 which barely prices in a quarter-point hike by the end of 2015. Looking out to the end of 2016 the contract has recovered back to almost 99 (which suggests a fed funds rate of 1%. The reality is that the Fed cannot kick the can down the road much longer. While it may not want to tinker with rates ahead of and during an election year, the risk is that it gets caught so far behind the curve that the market sees its policy handling as inept and forces its hand. A continued string of 200K plus gains in employment along with higher wage inflation will quickly have the market pricing in more than just one rate hike this year, but more than four hikes next year. That would spread through the US yield curve, sending 2yr bond yields above 1% for the first time since 2010 and could easily push the 30yr yield through 3.5%, if not back to the 2013 peak near 4%.

The strategy through this is to maintain a short– to medium-term bias in your bond portfolio since equivalent increases in both short and long-term yields will have a greater downward effect on the prices of long-term bonds. The 30yr yield has already risen from lows near 2.2% at the start of the year to above 3.10% this month. Given that there has been sufficient volatility in global capital markets to prompt investors to shift out of risk assets into safer US treasuries, this yield move is significant. If we see a Greek resolution and European and US economic growth firms, there will be less incentive to seek out safe havens. The strategy for Canadian investors is to again stay short in terms of average bond maturity. The argument is that the Bank of Canada probably won’t follow the Fed in tightening and that is likely going to be the case for this year. If the Bank resists tightening into 2016, selling pressure on the Loonie will intensify, causing global investors to move out of Canadian bonds and eventually the Bank will have to follow suit. Bottom line, rates are heading higher. How far they go is unclear, but it won’t take much to cause damage to long dated bond portfolios, not to mention the housing market.


Energy Patch Rolls Again, But it isn’t About Price
(Andrew Pyle, Sr. Wealth Advisor and Portfolio Manager)

There has been a lot of discussion lately about the poor performance of Canada’s stock market vis a vis the rest of the world. When global capital markets are in a tizzy over things like Greece and uncertainty surrounding US interest rate policy the discussion sometimes gets overshadowed, but it is still there.  Last year when oil prices were tumbling the underperformance in the TSX was easily explained yet this year we have seen stabilization and, outside of some less than stellar Canadian economic numbers, one could say that stocks should have at least been mirroring what other indices have done. Not the case. In Canadian dollar terms the TSX is woefully behind the pack with a gain of only a percent since the start of the year. Contrast that to the 7% improvement in the Dow and 14% jump in the NASDAQ. Over in Europe, where Greece and Ukraine should be weighing on sentiment, stocks are up about 9%, while Japan’s Nikkei has risen 18%.  Even China’s market, where we constantly hear worries about the country’s growing debt, the market is up more than 40% over the past 5-1/2 months. Since the US is our best comparison, let’s have a look at how the TSX has differed with the S&P500 this year.


TSX vs S&P and Stoxx 50 from Dec 2014


Again, using the Loonie as the base currency, we find that all subgroups of the S&P have improved this year with the exception of utilities (down about 3.5%) – the only sector that the TSX has in common as it has fallen close to 5%. Financials in Canada have languished this year and are currently off about 0.7% since the start of the year, versus a  7% increase in the S&P financials index. South of the border financials account for about 16% of the S&P, whereas they take up more than a third of the TSX. But the divergence is even more pronounced for energy. Here at home this group is 20% of the index compared with just under 8% for the S&P. Yet, the TSX energy group has lost 6% since the beginning of 2015, while energy stocks in the S&P are up about a percent in Canadian dollar terms.

After the rout experienced in 2014, energy stocks were enjoying a slow yet welcome recovery during the first four months of this year, with the sector returning to levels seen in November. Since mid-April, however, it has been a disappointing ride as the group has fallen back close to the lows seen in the middle of March. At current levels we are less than 10% from the depths of December. What has been more perplexing is that the price of crude oil has managed to sustain its improvement up to the $60/barrel area, while stocks reversed course in May and now through June.


Oil and TSX Energy from Dec 2014


Some of this can be attributed to a lack of conviction that prices will be able to hold at current levels for the rest of the year, given talk of increasing supply. So far we have not seen any evidence to support that concern as inventories continue to tighten (albeit from bloated levels) and curtailed spending on projects means production will be impacted beyond the next few months. No, in this comparison it appears that the reason is all Canada-driven, or Alberta to be more exact. In the wake the surprising NDP victory in that province investor attention has shifted to the ramifications for corporate taxes and possible energy royalty increases. Analysts have downgraded their views on oil companies with a majority of their production in Alberta and those views also resonate with global investors. As we have seen before, investors will often shoot first and ask questions later. Unfortunately, some of the questions have already been answered. The province announced this week that it will implement higher corporate taxes in July, as well as eliminating the flat 10% tax on personal income in the fall. Hiking taxes in an economy that is already floundering is not usually good medicine, but if oil prices continue to improve there is still hope for Canada’s energy patch.


Living in Canada
(Emily Downie, Senior Associate)

Living in Canada, we have the option of designating a property as a principal residence when we decide to sell it.  Under the principal residence exemption any capital gain that is triggered by this disposition is not subject to tax.  The scope for deciding what property falls under this label can be fairly wide.  For example, you are not required to spend all of your time living in the property but only to “ordinarily inhabit” it- meaning there is flexibility in terms of your time spent in the residence.  It does not necessarily only apply to the traditional dwelling of a house but includes, among other things, a house, cottage, condo, and land up to ½ hectare of land around the house.  The property does not necessarily need to be located in Canada and can be elsewhere, provided that the owner is a resident of Canada.  The exemption is limited to one per family per year but it can be claimed by any family member. The deciding factor of how to maximize this benefit can be based on the number of years you have owned the property, the number of properties that you own and the potential capital gain on each.   There is a formula that calculates the exemption that determines which portion and how much is exempt from a capital gain.  For example, if you choose to designate your vacation property as your principal residence for every year you have owned it, then the entire capital gain will be exempt.  However, if you only designate it for a few years, then only a portion of the gain will be exempt.

These decisions are best to be contemplated well in advance of any sale or transfer of a property.  In a financial plan, future tax projections and estate analysis are also helpful tools to be used when discussing any important issues such as these with the assistance of a tax professional.


TSX and Dow from Jun 19 2014


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