Jury still out on recession risk but Canadian economy holding up better than expected
Our last Strategy Note, dated April 30, explained our short term caution and why we had become more defensive in the near term in our portfolios. Without re-iterating the entire Note, the major reasons included;
Stock market outlook – introduction
< Central Banks becoming more dovish. Initially this accounted for the sharp gains in equity markets which recovered most of the second half 2018 losses. However, investors now have to face the fact that GDP globally is still slowing.
< The continued decline in the U.S. monetary base suggests that the U.S. economy will continue to slow from its former growth pace.
< Real money six-month growth still slowing globally which means that global GDP is unlikely to start picking up until 2020 at the earliest.
< Initial encouragement by investors from the Chinese March Purchasing Manger Index (PMI) numbers are belied by the recent Chinese real M1 numbers which suggest that GDP expansion will stabilize at a weak level in the second/third quarters and recover only modestly towards year-end.
< As mentioned in a Strategy Note a couple of months ago, global debt has hit a new peak at $244 trillion. Any economic slowdown will exacerbate servicing portions of that debt.
< Seasonally, equity markets often weaken in Q2 and Q3 after strong starts to the year as portfolio managers seek to lock in profits.
< The ECRI Weekly Indicators (WLI) peaked in early 2018 at +8.8% which presaged good GDP growth last year into Q3. However, the WLI fell steadily to their lowest reading of -6.5%, which presaged at a minimum slowing GDP growth through to Q3 this year. The WLI thereafter have recovered to a slightly positive reading before slipping back to almost neutral in the week ending May 10.
U.S. and Chinese April industrial output figures were released on May 15 and fell well short of what was expected, meaning that global industrial activity continues to weaken sharply. In particular, U.S. output fell very surprisingly by 0.5% month-on-month and the numbers for earlier months were revised lower. The six-month decline in U.S. output is now similar to the decline in the Eurozone.
Over the last few months, we have been interviewing managements of companies in our equity universe. This will be an ongoing process through to July as we complete the 60-odd contacts in that universe. Readers of these Notes will know that the economic indicators that we follow closely have stopped declining in recent weeks and we are into a process where we are waiting to see whether they resume declining over the next few months or start to re-accelerate. In other words, the jury is still out on which way it will go. After the sharp recovery in our portfolios in the first four months of the year, we thought it is prudent to nail down some profits and raise some cash until we had more confidence in the direction – up or down – that North American and global GDP would take from here. However, if the GDP outlook starts to improve, we are in a position to put cash to work quickly in favoured equities. On a macro basis, the U.S. numbers, as they relate to capital investment and retail sales (down in April), have not been particularly encouraging. In Canada, despite the Bank of Canada significantly cutting its GDP forecast last month, recent numbers – particularly on the labour front with respect to jobs created – have been somewhat more encouraging. We will highlight a couple of sectors – banking and retail – where we have had recent interviews with management and are encouraged that all is not gloom and doom in so far as the Canadian economy is concerned.
Recent company interviews
As mentioned in our April 30 Strategy Note, we interviewed all of the major six banks in the month of April. Bank revenues on the Personal and Commercial (P and C) side are very much affected by GDP growth. Particularly as mortgage growth is slowing to the low single digit area, domestic P and C earnings growth is likely to be half of what it was last year for the banks. In addition, the Bank of Canada, as mentioned, has also lowered its expectations for Canadian GDP growth significantly recently. Bank analysts have been concerned about the fact that we are late in the business cycle and the risk of a negative credit cycle is high. That may well be true in the corporate credit market but all the banks are reasonably confident that they are not seeing anything other than requiring minor increases in credit provisions. That excludes the impact of a one-off negative credit experience like the Pacific Gas and Electric bankruptcy which impacted several of them. In addition, a significant portion of five-year mortgages are coming due this year and those mortgages are priced off GOC five-year bond yields. These have declined significantly of late and so Canadians renewing their mortgages are not suffering from the mortgage payment difficulties that Australians are experiencing currently.
We also recently interviewed Canadian Tire which has made a significant effort over the last few years to build its “big data”, which allows it to track a whole host of its customer behaviours. During this interview, we asked what their data indicated about consumer spending and consumer confidence. In this regard, Canadian Tire pays particular attention to three different areas that they monitor to see if consumers are becoming more cautious which is often the precursor of recession.
These three particular areas that Canadian Tire (ticker CTC.A) monitors for changing consumer attitude are as follows:
1) Big ticket discretionary businesses
This represents about one third of CTC.A retail portfolio. That portion of CTC.A portfolio softens when the economy starts to soften. The Company affirmed that to date they have seen no declines in this segment either from a unit or dollar point of view.
2) Portfolio of repairs and maintenance businesses
These businesses include plumbing, electrical, automotive DIY and replacement parts categories. The Company has seen no noticeable difference in the performance of its repairs and maintenance businesses in the recent past.
3) Trading down
When the customer is feeling squeezed in terms of income and expenses, he or she will tend to trade down. CTC.A particularly follows the pet food category in this respect as trading down in quality of pet food is a key indicator of increasing customer financial duress. CTC.A has seen no recent signs of this in the pet food category or trading down generally.
In sum, CTC.A is one of the key retailers in Canada with aspirations to become the #1 retail brand in Canada by 2022 (Costco is the leader in this respect currently) and consumer spending represents two thirds of the economy. On this evidence, it would seem unlikely that there is a Canadian recession in the offing in the next few quarters.
Clearly, however, there are some significant downside risks on the geopolitical front currently: in particular, a continuing trade war with China, Brexit at the end of October and the Middle East – particularly in U.S. dealings with Iran. However, on the economic front, three months ago we thought that the risks of a recession within the year were about 50/50. That is still possible but, if we had to put odds on it now, we would reduce them to 20/80. Markets have recovered strongly – both globally and in North America – from the Boxing Day lows but they are not cheap. As we have frequently pointed out the U.S. market is particularly expensive using the Shiller P/E ratio, which is currently at 30.2 times. That is the third most expensive in the last 140 years – exceeded only in 1929 and 2000.
The TSX on the other hand is selling roughly at its 10-year average multiple on a price-to-earnings (P/E), price-to-cash flow (P/CF) and price-to-book value (P/BV) basis and modestly above those three metrics on a 2018 and a three-year average basis using consensus 2019 estimates. As mentioned, we stand ready to put cash to work if we develop more confidence in the global and North American economic outlook. If we had to guess as to at what point, if that did occur, that might happen, we would suggest it might be sometime in September/October when equity markets often reach their interim lows.
We have already mentioned above that Canadian Tire sees no signs of a recession short term in terms of the indicative signs it normally watches. The stock has been down sharply from its $183 high last year and $155 high this year as recently as early May. The Q1 earnings were disappointing but very much explained by weather conditions this winter. In addition, Canadian Tire has become very much a second half weighted company in terms of earnings results – particularly since the purchase of Helly Hansen. This should be evident over the next six to nine months and result in upwardly revised earnings estimates. We use a sum-of-the parts methodology in calculating our stock target for Canadian Tire. This suggests that the market is currently valuing the CTC.A Retail operation at under four times EBITDA. It could easily be valued at six times or more. 35% of CTC.A retail sales are of their own brands and the Company has aspirations to increase that to 50% over the next few years. Pure branded companies sell at double digit multiples of EBITDA. We added to our small position in CTC in our Defensive Income portfolio and initiated positions in our High Income and Dividend Growth portfolios. The dividend yield is currently 3.0% and we expect it to be 4% on today’s cost within three years.
Director, Wealth Management
Senior Portfolio Manager