Thoughts on the Market: June Edition
Written by Head of Research, Jamie Murray, CFA
D’Oh Canada
As we celebrated our country’s 157th birthday, we couldn’t help but reflect on the “vibecession” happening in Canada. A vibecession, paraphrased, is a when it feels like we are in a recession, yet the data says otherwise. Why is that? In Canada, real GDP per capita has declined in six of the past seven quarters, with population growth outpacing total economic growth.
Economic malaise is not limited to Canada, with similar issues like housing shortages and inflation affecting other Western economies, but we believe Canada is in a unique position with its strong demographics and abundance of natural resources. This note will touch on some issues at a higher level and offer our thoughts on options to improve the lives of all Canadians.
Issue #1: It all starts with Housing
Unsurprisingly, Canada has the worst housing affordability in the G7. High prices and high interest rates have created a two-class system in Canada: homeowners without a mortgage and everybody else. In early 2023, the Government of Canada released survey results highlighting that only about one-third of renters and mortgage holders can meet their financial obligations without any problems. This compares with 57% of mortgage-free homeowners. We believe these numbers have deteriorated further over the past 18 months as evidenced by additional mortgage renewal increases and higher delinquency rates. Figure 1 highlights that home ownership costs as a percentage of household income are near all-time highs currently.
Figure 1. Housing Ownership Costs as a Percentage of Household Income
Source: RBC Economics
Issue #2: Our bizarre CPI methodology
Canada is one of the few countries to use a modified user cost approach to estimate shelter inflation. This approach looks at costs incurred when owning a home and includes the volatile mortgage interest cost component. Only Ireland, Sweden and Iceland use comparable methodologies that include the latter. In contrast, the United States, the United Kingdom and Germany use the rental equivalence approach, which imputes a rent-focused inflation methodology. Neither are perfect. A rental equivalence method relies on estimates as opposed to transaction-based methodologies that capture actual changes. However, mortgage interest costs relied upon for the modified user cost approach fluctuate with market interest rates, which are heavily influenced by the Bank of Canada (BoC), particularly on the short end of the curve (for variable rate mortgages).
Current interest rates, when compared to the extremely low rates in 2020-22 (again, set by the BoC), will result in the shelter component of inflation increasing at a 6% rate this year, under various interest rate scenarios, according to a report from TD Economics. This means inflation is not likely to reach the Bank of Canada’s target of 2% in 2024 unless the remaining CPI basket indicates broad-based deflation. Deflation, in a heavily indebted society, can wreak havoc for many years as witnessed in Japan post-1980s. The report additionally highlights that inflation would be at the 2% target level using the U.S. definition of inflation (Figure 2). The Bank of Canada is surely aware of these limitations; however, we believe continued apathy towards its distorted methodology would amount to a massive policy error.
Figure 2: CPI Inflation Rates Under Different Methodologies
Source: TD Economics
Issue #3: Our Unemployment Rate
The Canadian jobs numbers released Friday painted a grim picture of the current employment market. Overall, the unemployment rate rose to 6.4%, up from 5.2% last year (Figure 3). Ontario is particularly problematic, with the unemployment rate reaching 7.0%, given that it is also dealing with Issues #1 and #2 more than any other province. While the rate is just slightly above its long-term average, beneath the surface are more troubling trends such as increasing part-time work relative to full-time and higher unemployment in the 15–25-year-old cohorts. We could see additional pressure if consumer spending or other economic indicators deteriorate further.
Figure 3. Canada Unemployment Rate
Source: TD MWG, Refinitiv Workspace
Canadians will head to the polls in 2025 and it is clear from the June 25th by-election in Toronto that the status quo will no longer stand. With more than a year to prepare, we expect topics such as immigration reform, housing, and tax policy to be front and center. We hope our political leaders are up to the task at hand. The Bank of Canada is independent from the Federal Government, and thus, more firmly entrenched. With yields on two-year bonds trading 70 basis points below three-month rates, the market is expecting significant rate cuts from the Bank of Canada over the next two years. In our view, the sooner the better.
GLOBAL EQUITY GROWTH FUND
The MWG Global Equity Growth Fund rose 1.5% in June, below the 2.2% rise in its benchmark. Year-to-date, the Fund has returned 17.5% versus the benchmark return of 12.1%. The Fund’s top three performers in the month were Broadcom (+22%), Aritzia (+14) and Uber (+13%) while Airbus (-19%), Converge Technology (-9%) and Major Drilling (-8%) were the biggest detractors.
Portfolio Managers Summary
Market leadership remains with a narrow group of companies. AI leaders like Nvidia, Broadcom, Alphabet, Microsoft, Meta and Amazon all reached new all-time highs in early July. We continue to see improvement in inflation data, which should translate to lower interest rates and broader performance improvement across sectors. Aerospace companies were weak in the month as Airbus (supply chain) and Boeing (multiple issues) are unable to meet strong demand for new airplanes. We continue to believe supply issues will resolve in the mid-term and unlock higher production capabilities.
During the month, we exited our investment in Boston Scientific. We initiated our position in 2019 in the low-$30 per share range and added to it during COVID lockdowns, when surgical centre utilization was low. We exited our final tranche at US$76 as the P/E multiple had expanded from low-20x to 33x on the recent success of its new atrial fibrillation technology. We may look to re-purchase the company at a better entry point in future.
INCOME GROWTH FUND
The MWG Income Growth Fund fell –1.7% in June versus the 0.5% increase in its benchmark. The Fund is higher by 3.6% year-to-date versus the benchmark increase of 13.8%. IGM Financial (+5%), Gibson Energy (+4%) and Blackstone (+3%) were the top performers, while Evertz (-15%), Northwest Healthcare REIT (-7%) and Kingfisher (-6%) were the top detractors. The fund yield was 6.3% at month end.
Portfolio Managers Summary
We continue to see tremendous value in the core holdings of the MWG Income Growth Fund. Fifteen of the 29 holdings have increased their dividends in the past year, while three others pay variable or special dividends based on profitability or liquidity. We expect a similar proportion to raise dividends this year. Real Estate, Energy and Financials combined make up 61% of the Income Fund portfolio and should respond well to rate cuts as inflation continues to fade lower in most global economies.
This Month’s Portfolio Update is written by our Head of Research, Jamie Murray, CFA.
The purpose is to provide insight into our portfolio construction and how our research shapes our investment decisions. As always, we welcome any feedback or questions you may have on these monthly commentaries.