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TriDelta Insight Q1 – Managing through change

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Overview

The world is a difficult place to navigate in the best of times, and Q1 2022 was certainly not the best of times.

In this quarterly review, we will look at:

  • Interest Rates and Inflation
  • TriDelta’s current view on stocks, alternative investments, bonds and preferred shares
  • Some personal finance highlights from the recent Federal Budget – including Flow Through Shares

Q1 proved a difficult three months for many stock, bond, and preferred share markets globally but did also give rise to some positives and opportunities. While March was largely a positive month and provided a recovery from the first two months of the year, the U.S. had its first negative quarter in two years while Canada remained positive. Canada’s outperformance can be attributed to our greater concentration in Energy and Materials sectors which outperformed the broader markets. Notably, the US indices have less concentration in these sectors while our lower concentration in higher growth tech sectors provided further protection from the market turbulence.

Source: Bloomberg.

Q1 Market Returns

Interest rates and Inflation

The economy is at a delicate moment in which high inflation could become entrenched. That has created a new urgency to raise interest rates, itself a source of risk for markets and the economy. Central Banks around the world have signaled more aggressive steps to fight inflation and here in North America we are no different as both the Bank of Canada and U.S. Fed raised rates in March with further expectations to do so throughout the year. There has also been a focus on reducing the size of balance sheets in recent months with the U.S. Fed stating they intend to cut their bond holdings by about $95 billion a month – nearly double the pace implemented five years ago when they last shrank their balance sheet. Financial markets now expect much steeper hikes than previously in the year. Higher rates from these Central Banks will heighten borrowing costs for mortgages, auto loans, credit cards and corporate loans. In doing so, they hope to cool economic growth and rising wages enough to rein in high inflation, which has caused hardships for millions of households and poses a severe political threat to those in power.

We are still positioned for higher inflation and higher interest rates but are open to buying into sectors that may be oversold. We continue to place a premium on active management in the face of immense uncertainty and volatility. The two TriDelta equity funds have performed well in comparison to global equity markets, with what we view as much less risk. The TriDelta Pension Fund was up 0.86% on the quarter, while the TriDelta Growth Fund returned -0.44% for Q1. This outperformed our benchmarks (which include Canada, the U.S., International and Emerging Markets) by 2 to 3 percentage points on the quarter. Outside of Canada, major equity markets globally fell as much as 5% to 15% in some cases.

TriDelta equity view – what we are doing and why

Three risks dominated headlines this quarter: the Omicron wave, the spike in inflation/Fed rate hike fears, and the war in Ukraine. Due to these concerns equity markets had a difficult quarter with high growth companies and those exposed to the Ukraine conflict suffering the most. The focus has continued to be on quality as investors have prioritized profitability, stability and realized growth. Coupled with a strong balance sheet there are companies which are still well positioned despite the risks moving forward.

The move in commodities has also been notable over the past three months. Energy, in particular, had a great move to the upside, justifying the gains in the equities and helping the TSX manage this tough quarter. Prices have been driven higher because of the lack of capital provided to this sector over the past few years and the sanctioning of one of the largest commodity-producing countries.

Into the remainder of 2022 TriDelta Funds continue to be nimble and active to take advantage of attractive opportunities.

  • We continue to view this as a rangebound market and are focused on adding equities when oversold and trimming when overbought.
  • In the funds, we are becoming more concerned about the cyclical sectors and have been trimming some cyclical exposure and adding to underperforming sectors like technology, consumer discretionary and financials.
  • The world seems to be coming to the realization that the transition to clean energy will not happen over night and we will need a period of transition. Energy has been the leader, but we should also see strength across the materials sector going forward.
  • There has been a common theme among many multi-national companies who have stressed the need to reorganize their supply chain to help insulate themselves from the issues currently being experienced. This will have a significant impact on these businesses and has been dubbed “de-globalization” by many influential investors and business leaders.

 

 

TriDelta Alternative View – what we are doing and why

The Alternative asset class provided greater insulation relative to being invested in a typical stock and bond portfolio.

On Real Estate,

  • Real Estate continues to perform well and include critical inflation protection and steady yields.
  • Many of the partners we work with were able to pass along the added costs of inflation to tenants in 2021 with some increasing rents 10-20% in some areas.
    • Property types with short lease durations can reset lease rates more frequently and are in a more advantageous position to grow cash flow. Concurrently, lease structures offer inflation protection with built-in rate increases tied to inflation.
  • North America continues to be a top performer while Europe and Asia have struggled.
  • Moving forward North American Residential and Industrial Facilities are poised for further growth while high quality Office Space may be well positioned to attract tenants. We also share the view that the fragmented Self-Storage market offers an attractive opportunity.

On Private Credit,

  • Private Credit returns remained favourable and, in many cases, offer protection from rising interest rates. Loans from these managers tend to be shorter term which offers them the ability to provide new financing terms to reflect the increase in interest rates.
  • These managers continue to see increased deal flow and expect further opportunities as traditional bank lenders restrict capital to small and mid-size businesses. Moving forward, we see this as an ample opportunity.
  • Borrowers continue to look to the private markets due to its relatively greater speed and certainty of execution, after many were burned by public markets and banks pulling back capital during more uncertain times. Equally, borrowers value the adaptability and partnership of private lenders.

Yields on Private Credit and Real Estate remain much more favourable than investing in traditional bonds.

Source: BofA Securities, Bloomberg, Clarkson, Cliffwater, Drewry Maritime Consultants, Federal Reserve, FTSE, MSCI, NCREIF, FactSet, Wells Fargo, J.P. Morgan Asset Management. *Commercial real estate (CRE) yields are as of September 30, 2021. CRE – mezzanine yield is derived from a J.P. Morgan survey and U.S. Treasuries of a similar duration. CRE – senior yield is sourced from the Gilberto-Levy Performance Aggregate Index (unlevered); U.S. high yield: Bloomberg US Aggregate Credit – Corporate – High Yield; U.S. infrastructure debt: iBoxx USD Infrastructure Index capturing USD infrastructure debt bond issuance over USD 500 million; U.S. 10-year: Bloomberg U.S. 10-year Treasury yield; U.S. investment grade: Bloomberg U.S. Corporate Investment Grade.

TriDelta bond view – what we are doing and why

While we remain at historically low interest rates and ultimately view increased interest rates as necessary, the Central Banks walk a thin line with very little room for error. Here at TriDelta we share several views moving forward:

  • Central Bank logic is twofold – (1) to rein in inflation (which is evidently no longer transitory) and (2) to raise rates surrounding a strong economy.
    • Many perceive them to be too late on this front; we agree in terms of the underlying economic conditions, but not on inflation as, unlike other periods of outsized inflation, the drivers are largely structural, such as the inefficient deployment of physical capital and labour forces due to the COVID mitigation measure, the shifting landscape (including work from home), economic warfare, and ESG shifts are raising costs.
  • Lowering the demand for money through raising the price of money does not address these long-term supply issues. This is occurring while the underlying economy, particularly in the U.S., is already slowing.
    • Consumer demand has softened into 2022; corporate spending was already reduced; mortgage rates are up 1.75% year to date in the U.S.
    • Coupled with fiscal support being withdrawn this year poses a significant risk to the economy.
  • While it is possible to have a recession without monetary tightening, the opposite does not hold true; monetary tightening always happens with a recession.

In recent updates we have continued to share our preference towards using a tactical approach to bonds and owning short term bonds for their greater protection in a rising interest rate environment. As you can see in the chart below this has proven the correct approach.

Source: Purpose Investments

We continue to view bonds as an important component of a diversified portfolio and advocate for a focus on being selective and tactical in our approach.

On Bonds,

  • Central Bank intentions are clear, but they will not likely be able to raise rates as much as intended before underwhelming economic performance and falling markets derail their efforts.
  • We believe we are at or near the highs in government bond yields.
  • As opposed to 2021, the 1-5 year bonds represent the best value in our opinion as the yield curve has become exceedingly flat.
  • The outlook for riskier bonds is uncertain. Spreads have widened in the high grade and high yield spaces and are likely to continue to do so as corporate bond supply is continuing to be issued while the extent of an economic slowdown has not been fully recognized.

TriDelta preferred share view – what we are doing and why

Preferred shares have had a volatile start to the year, with many cross currents in play. Down roughly in line with bonds, Rate-Resets have outperformed Straight preferred shares by about 3%. This is a continuation of 2021 when Rate-Resets outperformed by a large margin. Many institutional preferred share investors have shifted out of the space and back into traditional yield markets or into equity opportunities.

In our 2021 Q4 update we referenced one of the challenges in the preferred share market being that the market is shrinking as banks and some oil and gas names redeem issues in favour of cheaper financing via specialized bonds. Perhaps shockingly, the first three months of 2022 saw several new issues into this challenging market at yield “concessions”, rendering existing preferred shares relatively expensive.

Moving forward there are important trends we continue to watch closely.

On Preferred Shares,

  • Higher rates should be a positive for Rate Resets and Floaters.
    • Wider credit spreads are not, and resets will likely take their cue from corporate bonds.
  • The shrinkage of the market is still a tailwind, and the recent selloff represents an opportunity.
  • We continue to hold our allocation steady and pick away on further weakness while being comfortable with near term volatility.
  • The rate pressure is the greatest challenge for Fixed Rate Preferred Shares but most of the backup should be behind the market.

Some personal finance highlights from the recent Federal Budget

  • Very few negatives.
  • No change to capital gains taxes.
  • Flow Through Shares were largely left alone. These continue to be a great tax savings opportunity for those with taxable income of $275,000+ or those with a Corporation where you are drawing out $400,000+. Be sure to talk to your Wealth Advisor if you are in that category.
  • There may be some changes to Alternative Minimum Tax in the Fall. It will be focused on those with taxable incomes over $400,000, who are currently paying less than 15% of Federal taxes.
  • New Tax Free First Home Savings Account in 2023. This is meant to provide savings room for up to $8,000 a year and up to $40,000 in total, that can be used for a first-time home purchase. While this isn’t a negative at all (other than the tracking and implementation of another tax- sheltered account), it will likely have very little impact for younger people in saving and putting in down payments on a first home.
  • There are all sorts of other details in the Budget, but these are the ones that would likely affect some of our clients.

In conclusion

The World is particularly complicated at the moment. In times like these, our general tilt is towards companies making solid profits, with reasonably low debt ratios, especially those with hard assets like real estate and commodities. Rate reset preferred shares and shorter term bonds, along with some higher yielding alternative investments, should work well in an increasing rate environment.

As always, we are here to help. If you have any questions, please don’t hesitate to contact your Wealth Advisor.

TriDelta 3rd Q 2012 Market Outlook

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What Happened in the Quarter

The third quarter can be summarized by two major government announcements:

  1. The European Central Bank announced the Outright Monetary Transactions programme aimed at providing significant monetary support to ensure that the “Euro Will Not Fail”. The new bond-buying plan is aimed at easing the eurozone’s debt crisis. The ECB aims to cut the borrowing costs of debt-burdened eurozone members by buying their bonds.
  2. Later in September, the US Federal Reserve Bank headed by Ben Bernanke announced Quantitative Easing 3. This included a commitment to buy $40 billion in mortgage backed securities each month from Fannie Mae and Freddie Mac (the US version of the Canadian Mortgage and Housing Corporation – CMHC). This is in addition to the $2 trillion in Treasury bonds that it bought in QE1 an QE2.

Both of these actions and the expectations of these actions drove markets higher during the quarter. Among the biggest beneficiaries were precious metals, energy, and other commodities – sectors of the market that lagged for much of the year.

The Toronto market was up 6% on the quarter after having fallen over 6% in the previous quarter.

The bond universe market was up 1.2% on the quarter.

How did you do?

At TriDelta Investment Counsel we have two main types of clients. The first group seeks conservative growth and income and are invested in our ‘Pension’ model. The second group is looking for growth, which is delivered via our ‘Core’ model.

Pension Clients:

This group is typically in retirement or close to it and looking for less volatility, higher income and steadier 5% to 10% gain, especially while interest rates and GIC rates are so low.

Most pension clients grew by 1.5% this quarter (after fees).

Our Pension model (based on 60% stocks and 40% bonds) returned 5.5% year to date (after fees). So far on the year we are very pleased to see that our Pension portfolios are delivering the type of returns that they were designed to deliver.

While the performance this quarter was not as strong as the super charged stock markets, it is important to remember why. Our approach is based on finding a mix of bonds, preferred shares and dividend paying stocks that will provide a steady level of income. The capital gains growth from the portfolio will usually come from companies that are rarely flashy in the short term (like the precious metals index) but act more like the tortoise than the hare. Companies like Trans Canada Pipelines, Philip Morris, and Colgate Palmolive.

These are the type of companies that will not jump meaningfully upon hearing about the latest round of quantitative easing.

Dividend Changes in Q3 – Pension

One area of Pension focus for us is to hold companies with stable and growing dividends. In terms of dividend changes this quarter we saw 7 dividend increases and no decreases:

  • Microsoft boost its quarterly dividend by 15%
  • Phillip Morris boost its quarterly dividend by 10.4%
  • Norfolk Southern boost its quarterly dividend by 6.4%
  • BCE boost its quarterly dividend by 4.6%
  • CIBC boost its quarterly dividend by 4.4%
  • Emera boost its quarterly dividend by 3.7%
  • Verizon boost its quarterly dividend by 3.0%

 

Core Performance Clients:

This group of clients is looking for greater growth, less concerned about income, and want to beat the market over time. Ideally for peace of mind, these portfolios will still have less volatility than the market overall. We call this group Core Performance portfolios.

Most Core Performance clients grew by 2% this quarter (after fees).

Our Core Performance model (based on 60% stocks and 40% bonds) returned 9.7% year to date (after fees), with a healthy part of the gains coming in the first quarter.

The numbers are quite positive although we saw a little portfolio drag of higher cash balances in the Q3 performance in our Core Performance portfolios. We look forward to adding some more momentum to the portfolio over the next few months as opportunities present themselves.

Some of the trades we made this quarter and why?

In Pension Portfolios:

  • We sold a Manulife bond that had a coupon of 4.08% and came due in 2015.
  • We bought a Manulife bond that has a coupon of 5.06% and comes due in 2041.

Rationale – The short term Manulife bond had a yield to maturity of 2.57%, and we replaced it with a bond from the same company that has a yield to maturity of 6.02%. The 2041 bond also has a current yield (the coupon payment of 5.06 divided by the purchase price of $86.50) of 5.85%.

We will not likely hold this bond to maturity, but feel that the significant increase in yield (while holding the same company), will benefit investors in the short to medium term, while we remain confident that long term interest rates will remain low (or lower) over that time.

  • We sold Barrick Gold

Rationale – This was a difficult decision. The stock was purchased for most clients around $40, dropped to $31, and came back to $37 when we sold it for Pension clients. The volatility is what made us sell the stock. It remains in our Core portfolios as it passes the financial hurdles of the Core model and the speculative nature and volatility of the stock is more appropriate for that mandate.

In Core Portfolios:

  • We did the same Manulife bond trade as noted above in the Pension portfolios.
  • We bought Tesoro Corporation. It is up 16% since our purchase.

Rationale – Tesoro is an independent petroleum refiner and marketer in the United States with two operating segments: refining crude oil and selling refined products in bulk and wholesale markets and selling motor fuels in the retail market. They had a great earnings report this quarter and continue to prove themselves as one of the best operators in the refining space. Growth wise they have two expansions that should contribute positively to earnings shortly and help accelerate growth. The stock ranks very well and is breaking out of a 11/2 year range that should provide substantial support.

  • We sold Discover Financial Services.

Rationale – The stock had a really good run and was up 45% YTD when we sold it. There was some concern about high valuations and their entry into new market segments such as student loans. So far the stock has continued to do well in August and September.

Our Investment Outlook and how it will impact your portfolio

We believe that some of the market gains in Q3 have been driven by ‘hot air’. By this we mean that it is relatively easy for governments to print and throw money at a major economic problem. What is difficult is seeing fundamental economic improvements on the ground and in the economy.

On the positive side there continues to be signs that the US housing market is stabilizing, with price gains in many markets. Housing market changes tend to move slowly, and a turn from one direction to another can be a significant signal. We are hopeful that this slow shift in US housing will provide one of the foundations for an improving economy.

The other big positive is that historically when the government provides economic stimulus and provides lower than average borrowing costs for consumers and companies, the markets tend to benefit. We have certainly seen some of this benefit in the U.S. market, and think that in the medium term that will continue.

On the negative side, there are a few items:

  1. The China Purchasing Managers Index is at 47.8. This is very low and suggests weak growth in China.
  2. Eurozone Purchasing Managers Index is at 46.0, historically a very low level, and one that indicates a continuing high unemployment and low (if any) growth in the region.
  3. Spain, Greece and Italy have been out of the news for a while, and markets have seen solid increases. At some point, they will make negative economic headlines again and the market will see a pullback.
  4. The U.S. “Fiscal cliff” is the popular shorthand term used to describe the conundrum that the U.S. government will face at the end of 2012, when the terms of the Budget Control Act of 2011 are scheduled to go into effect.

Among the laws set to change at midnight on December 31, 2012, are the end of last year’s temporary payroll tax cuts (resulting in a 2% tax increase for workers), the end of certain tax breaks for businesses, shifts in the alternative minimum tax that would take a larger bite, the end of the tax cuts from 2001-2003, and the beginning of taxes related to President Obama’s health care law. At the same time, the spending cuts agreed upon as part of the debt ceiling deal of 2011 will begin to go into effect.

TriDelta’s defensive stance (with higher than average cash balances) will remain until we see a meaningful 5%+ pullback in markets, so that we can find some better entry points. An example might be outside of Canada. We currently have a meaningful position in the U.S. markets. We will likely be expanding our non-Canadian positions for two reasons. The first is that the Canadian dollar is currently very strong, and we believe it is at the high end of the range making it a good time to invest outside of Canada. Also, we continue to look for greater diversification from the core energy and materials that Canada has in abundance.

When we look at the movements of the markets in the last quarter, through the list of positive and negative items that we are facing, we believe that one of the list of four negative items will be the focus of markets’ attention at some point this quarter, and will lead to a pullback that we can take advantage of.

In the meantime, our portfolios (while a little conservative) are well positioned to continue to see some growth in most market situations.

TriDelta Investment Counsel Investment Committee – October 2012
Cam Winser, CFA, VP Equities
Edward Jong, VP Fixed Income
Ted Rechtshaffen, MBA, CFP, President and CEO
Anton Tucker, CFP, FMA, FCSI, VP, TriDelta Financial Partners

 

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