Weekly Capital Strategy – May 20, 2016

May 20, 2016

Has the TSX Run Out of Gas?

Global equity markets have been dealt a setback this month as anticipation of a Federal Reserve rate increase grows and while world economic growth estimates shrink.  While improvement in commodity prices  has been sustained, in particular crude oil, the TSX has also started to show signs of fatigue and failure to break out to the upside could be a precursor to a summer slip. 

Ranked against the major developed markets, Canada’s stock exchange still comes out on top during the first half of this year. This has drawn in many a strategist into believing the good times will continue and that global investors should plough more money into our quirky over-concentrated market. On the surface, the fundamentals seem compelling. Canadian economic growth did pick up in the first quarter as the US economy stagnated and Europe and Japan remained stuck in neutral. Higher prices for most of Canada’s key commodities have led to a positive terms of trade shift, which has provided much of the strength behind the Loonie.  The move in the currency itself, from a low near 68 US cents in January to a high above 80 cents earlier this month, has created a miss-the-boat anxiety among analysts and fund manager. That anxiety is misplaced in my opinion.


TSX May 20 2016


The TSX does look in better shape technically than either the S&P500 or Dow, but it has not been able to crack the 14,000 mark since last October. Even then the gains above this level were minute and short-lived. In the past month, three attempts have been made each one failed to push through this psychological mark.  This is reminiscent of the first half of 2013 when the TSX struggled to move above 13,000. By October it finally did break above, but only after almost a year of underperformance against the S&P. Even then the boost was aided by continued strength in US and global stocks as investors sold out of bonds (which were caught in the Fed’s taper tantrum) and another drive in oil prices above $100/barrel fueled earnings in energy patch. Things are different today.

First, there is no help to be found from a strengthening in global equity sentiment. US stocks have faltered this month and there enough risks, from the UK referendum to a Donald Trump presidency, to prevent a major rally in world markets. If investors only got a calm sideways summer they would probably be relieved.


Front vs Dec oil future May 2016


Second, there are impediments to a further advance in commodity prices. Crude oil is sneaking towards $50 but shale producers are coming back on stream and Middle East output is increasing. Over the near-term this could cause the global supply glut to stop decreasing and lead to at least a partial reversal in prices.  Futures markets are already looking less optimistic further out. For example, the spread between the December and front-end crude futures was close to $10 back in January.  Today, that spread has fallen to about $2.  If there is so much optimism about diminishing supply, as the headlines suggest, it is not reflecting in the actual pricing of crude.

Finally, the currency is no longer providing a major leg up for manufacturers and exporters as it did at the start of the year. True, the Loonie has slipped from its 80 cent peak down below 76.50 cents this week but the marginal stimulus to growth is going to fade as we watch the economic indicators for the second quarter. Manufacturing shipments fell an additional 0.9% in March and wholesale trade was down 1%. Without the already over-inflated housing market, Canadian growth in March will be weak. And that provides for a low base going into the second quarter. Of course, there is the possibility that the TSX actually breaks above 14,000 in the coming days and weeks. If so, investors may finish the second quarter happy. The odds are not, however, hugely in their favour.


REITs Need More of the Right Stuff

As decent as the 6% gain in the TSX looks so far this year, the real money has been found beneath the surface.  REITs, for example, have delivered more than twice this advance and has vindicated the decision we made earlier to overweight the group in the equity portfolio. Indeed, all members of the TSX REIT sub-group have delivered positive performance this year, led by Milestone Apartments (+22%) and 17% plus gains in RioCan, Allied Properties, Cominar and Northview Apartments. Low and steady interest rates, a strong housing market and the appeal of higher dividend yields have all contributed to the move higher in REITs these past five months.


TSX REIT May 2016


The yields on REITs have certainly been compelling, with a dividend yield of 5.8% for the sector as a whole.  Compare that to a 3.1% yield for the overall TSX and 1.3% yield on a 10-year Government of Canada bond and you see the attractiveness.  Pricing is also attractive in the REIT space with a price-to-earnings (P/E) ratio of 14 versus 21 for the TSX.

Similar to the TSX though, the REIT sub-group is having a hard time extending gains and has found a ceiling at 1350.  This is basically where a recovery halted last July and selling pressure since Monday’s high of 1347 took the index to as low as 1310 on Thursday.


CAD May 20 2016


Where investors have to be careful is chasing a bus that has already stopped for repairs. For one, Canada’s housing market expansion is on its last legs. Debt levels are simply too high and it is unrealistic to assume mortgage rates will stay low. There was a warning sign from this week’s release of the latest Federal Reserve FOMC meeting, where officials seemed more inclined to vote for a rate hike this summer. This is, after all, one of the more interest sensitive sectors you can play in and 2013 was a stark reminder to investors of the risk that a rise in bond yields can pose. I don’t think yields are ready for a sharp spike any time soon, but the prospect of even a modest rise suggests that portfolios go to a neutral weighting in REITs and possibly start to underweight, lest the right stuff turns wrong this summer.


Gold May 20 2016


Deciding When to Exit a Trust
(Emily Downie, Senior Associate)

Estate planning and testamentary trusts were synonymous for many years until changes were introduced in December 2014.  The landscape of creating and drafting wills and estates changed dramatically as a result of these changes.  A testamentary trust historically was created based on favorable tax rates.  This type of trust was established by a person as a result of his or her death for the benefit of another person.

The tax rates previously enjoyed by the trust were progressive tax rates and have been removed as a result of the 2014 federal budget.  What was once a favored estate planning tool has evolved into a still beneficial planning option but one must weigh the benefits against the costs. The key areas of changes to the trusts are the loss of graduated tax rates, a deemed year end of December 31 (previously the trust was allowed to have an off-calendar year end), and tax installments are now required by testamentary trusts.  If the trustee is given the discretionary authority to wind up or dissolve the trust they may determine that the administrative effort and ongoing cost is not worth the effort.

To transfer or dispose of these assets would be considered a deemed disposition and thus a taxable event.  Even so, one may determine the need justifies it and the trust can be brought to an end.  The option of contributing to a Tax free savings account or topping up an RSP (Registered savings plan) with these assets could be a planning discussion point to have with your financial advisor. The upside is that trusts do remain useful in several ways and if the trust exists for a disabled beneficiary, then the entity will continue to bypass all of these changes and remain eligible for graduated income tax rates.

The stipulation is that the trust must be considered a Qualified Disability Trust- meaning that one or more of the beneficiaries must qualify for the disability tax credit in Canada. The regulations regarding the changes in the trusts have presented challenges for trustees and legal advisors and it may be appropriate to review the wills and trust that are impacted by these changes.  The need for the existence of trusts remains, however, ongoing assessment of the benefits and costs should always be reviewed with legal expertise.


Upcoming events

Canada:  Bank of Canada meeting,

US:  New home sales, trade balance, durable goods, pending home sales, Q1 GDP, University of Michigan consumer sentiment (final)


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