Tag Archives: interest rates

How to keep your business solvent

Posted By |
Image courtesy BDO Canada

By Matthew Marchand

Special to Financial Independence Hub

More Canadian businesses are failing this year.

In the second quarter of 2023, the Canadian Association of Insolvency and Restructuring Professionals (CAIRP) noted that there were 1,090 business insolvencies — an increase of 36.9% compared to the same period in last year. It was also the highest volume since 2014.

There are two main reasons why this is occurring.

First, the combination of rising interest rates and high debt levels has resulted in slower consumer demand and increased debt servicing costs for both businesses and consumers. The prime rate has risen 475 basis points since early 2022 and now sits at 7.2%.

Second, the loss of government financial aid plus the need to repay a portion of the aid received — along with tightening credit conditions — are making it more challenging to obtain new financing or to refinance existing debt.

During the height of the COVID-19 pandemic, government financial aid helped limit insolvencies during those challenging times. What we’re seeing now is a normalization after an abnormal period.

It should also be noted that many businesses were beginning to experience financial difficulties prior to the pandemic and the financial aid acted as a buoy to some degree. We’ve seen many instances of businesses being unprofitable prior to the pandemic that became profitable during the pandemic, with much or all the profits being derived from government financial aid.

Now that the financial aid is no longer available and may need to be repaid in the future (depending on the support received), businesses are feeling the challenges of this economic reality.

Ways businesses can survive

Many businesses may think a wind-down of operations is the only option, but that’s not the case. In fact, there are other options:

  • A restructuring or compromise of debt (payments to creditors accepted as a settlement of the debts)
  • Turnaround initiatives, such as lease disclaimers, labour force reductions or the sale of non-core assets

For businesses that are facing financial challenges now, they should expect interest rates will remain elevated for the foreseeable future. While the Bank of Canada left the overnight rate unchanged at 5% in September, it says it “remains concerned about the persistence of underlying inflationary pressures, and is prepared to increase the policy interest rate further if needed.”

Your organization should update its business plans and financial projections accordingly. If your business doesn’t have a detailed cash flow projection, make one.

You should also conduct a stress test on your financial projections to determine potential financial scenarios and what proactive efforts may need to be taken to avoid worst case outcomes. For example, if sales fall 10% or 15%, how will it affect the financial performance of the business? Will the business be able to meet its debt servicing obligations and other critical payments as they become due, and if so, for how long? Continue Reading…

Was Inflation transitory?

Posted By |

By Dale Roberts, cutthecrapinvesting

Special to Financial Independence Hub

Inflation is coming down in Canada and the U.S. And one can argue that the rate hikes have had little effect. After all, Canadians and Americans are spending money, and employment is strong. The economy has been very resilient. Perhaps inflation was transitory after all, caused by the pandemic and the invasion of Ukraine. This is not the traditional inflation fight script. The economic soft landing argument is getting more support. Was inflation transitory?

Total inflation in Canada is back ‘on target’ in the 2% to 3% range.

That said, core inflation is still sticky.

From this MoneySense post …

According to Statistics Canada, the June slowdown was driven primarily by a year-over-year drop of 21.6% in gasoline prices. Meanwhile, the largest contributors to the rise in consumer prices are food costs — which rose 9.1% in June — and mortgage interest costs (up 30.1%).

It’s likely a very good guess that rates are staying higher for longer. The bond market is certainly suggesting that as well.

The 5-year remains elevated.

Fixed-rate mortgage holders will likely be resetting at higher borrowing costs over the next 2 to 3 years – adding several hundred dollars a month to the typical mortgage payment. Of course, that takes money out of the economy and money that would have been spent on goods and services.

Next year may be sunnier than forecast

In the Globe & Mail, Ian McGugen offered a very interesting post. Ian looks to one of the most optimistic economists, and that is a growing group.

Jan Hatzius, chief economist at investment banker Goldman Sachs, has set himself apart from the crowd in recent months by declaring that the United States will not sink into a recession. Continue Reading…

Violating my Principles

Posted By |

By Noah Solomon

Special to Financial Independence Hub

As I have written in the past, predicting stock market returns is largely an exercise in futility. Over the past several decades, the forecasted returns for the S&P 500 Index provided by Wall Street analysts have been slightly less accurate than someone who would have merely predicted each year that stocks would deliver their long-term average return. Importantly, not one major Wall St. strategist predicted either the tech wreck of the early 2000s or the global financial crisis of 2008-9.

To be clear, I am still adamant that consistently accurate forecasts are beyond the reach of mere mortals (or even quant geeks like me). Any investor who could achieve this feat would reap returns that put Buffett’s to shame. However, there may be some hope on the horizon. Good is not the enemy of great. The objective of any investment process should not be perfection, but rather to make its adherents better off than they would be in its absence.

To this end, I have decided to sin a little and model some of the most commonly cited macroeconomic variables that influence stocks market returns, with the objective of (1) ascertaining whether and how these factors have historically influenced markets and (2) what these variables are signaling for the future.

Don’t Fight the Fed

It is often stated that one shouldn’t fight the Fed. Historically, there has been an inverse relationship between changes in Fed policy and stock prices. All else being equal, increases in the Fed Funds rate have been a headwind for stocks while rate cuts have provided a tailwind.

Prior 1-Year Change in Fed Funds Rate vs. 1-Year Real Returns: S&P 500 Index (1960-Present)

As the preceding table illustrates, the difference in one-year real returns following instances when the Fed has been pursuing tighter monetary conditions has on average been 6.6%, as compared to 10.6% following periods when it has been in stimulus mode.

As of the end of June, the Fed increased its policy rate by 3.5% over the past 12 months. From a historical perspective, this change in stance lies within the top 5% of one-year policy moves since 1960 and is the single largest 12-month increase since the early 1980s. Given the historical tendency for stocks to struggle following such developments, this dramatic increase in rates is cause for concern.

Valuation, Voting, and Weighing

Over the past several decades, valuations have exhibited an inverse relationship to future equity market returns. Below-average P/E ratios have generally preceded above-average returns for stocks, while lofty P/E ratios have on average foreshadowed either below-average returns or outright losses.

Trailing P/E Ratio vs. 1-Year Real Returns: S&P 500 Index (1960-Present)

Since 1960, when P/E ratios stood in the bottom quintile of their historical range, the S&P 500 produced an average real return over the next 12 months of 9.4% compared with only 6.9% when valuations stood in the highest quintile. Sky high multiples have proven particularly poisonous, as indicated by the crushing bear market which followed the record valuations at the beginning of 2000.

To be clear, valuations have little bearing on the performance of stocks over the short term. However, their ability to predict returns over longer holding periods has been more pronounced. As Buffett stated, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Although valuations are currently nowhere near the nosebleed levels of the tech bubble of the late 1990s, they are nonetheless elevated. With a trailing P/E ratio hovering north of 21, the S&P 500’s valuation currently stands in the 84th percentile of all observations going back to 1960 and is at the very least not a ringing endorsement for strong equity market returns.

From TINA To TARA To TIAGA

At any given point in time, stock market valuations must be considered in the context of the yields offered by high quality money market instruments and bonds. The difference between the earnings yield on stocks and interest rates has historically been positively correlated to future market returns.

Earnings Yields Minus Fed Funds Rate vs. 1-Year Real Returns: S&P 500 Index (1960-Present)

When the difference between earnings yields and the Fed Funds rate has stood in the top quintile of its historical range, the real return of the S&P 500 Index over the ensuing 12 months has averaged 8.7% versus only 2.2% following times when it has stood in the bottom quintile.

Until the Fed began to aggressively raise rates in early 2022, TINA (there is no alternative) was an oft-cited reason for overweighting stocks within portfolios. Yields on bank deposits and high-quality bonds yielded little to nothing, thereby spurring investors to reach out the risk curve and increase their equity allocations.

As the Fed continued to raise rates, increasingly higher yields made money markets and bonds look at least somewhat attractive for the first time in years, thereby causing market psychology to shift from TINA to TARA (there are reasonable alternatives). Continue Reading…

Inverted Yield Curves & Recession: How smart are Markets?

Posted By |
Image Outcome/Creative Commons

By Noah Solomon

Special to Financial Independence Hub

Today’s Special: An Inverted Yield Curve with a Side Order of (Possible) Recession

In our discussions with clients over the past several months, the two frequent topics of conversation have been:

  1. The inversion of the U.S. Treasury curve, and
  2. The possibility of a recession occurring within the next few quarters.

In the following missive, I use a data-based, historical approach to explore the possible investment implications of these concerns.

How Smart is the Yield Curve?

The U.S. Treasury market has an impressive track record in terms of forecasting recessions. Going back to the late 1980s, every time the yield on 10-year U.S. Treasury bonds has remained below that of its two-year counterpart for at least six months, a recession has followed. Such was the case with the recession of the early 1990s, of the early 2000s, and of the global financial crisis.

When it comes to investing (as with many things), timing is critical. Given that yield curves do occasionally invert and that recessions do happen from time to time, it follows that every recession has been preceded by an inverted curve, and vice-versa. What makes the historical prescience of inverted yield curves so impressive is that the recessions which followed them did so within a relatively short period.

United States – Months from Yield Curve Inversion to Onset of Recession: 1989-Present

The table above covers the past three U.S. recessions, excluding the Covid-induced contraction of 2020, which I have omitted since it had nothing to do with macroeconomic factors, monetary policy, etc. As the table demonstrates, the time lag between yield curve inversions and economic contractions has ranged between 12 and 18 months, with an average of 15 months.

However, the yield curve’s impeccable record of predicting recessions has not been matched by its market timing abilities. As summarized in the following table, the S&P 500 Index has produced mixed results following past inversions in the Treasury curve.

S&P 500 Performance Following Yield Curve Inversions: 1989-Present

When the Treasury curve inverted at the beginning of 1989, stocks proceeded to perform well, returning 24.1% over the following two years. Conversely, when the curve became inverted in March 2000, the S&P 500 fared poorly, losing 21.5% over the same timeframe. The index suffered a similarly undesirable fate following the Treasury curve inversion in September 2006, when stocks suffered a two-year decline of 9.1%.

How Smart is the Stock Market?

In the past, the economy and equity markets have not been correlated. Stock prices are forward looking. Historically, equities have started to decline prior to peaks in economic growth and have tended to rebound in advance of economic recoveries.

The trillion-dollar question is not whether the market is smart, but whether it is smart enough. Do prices bake in a sufficient amount of bad news ahead of time so that they avoid further losses following the onset of recessions? Or do they lack sufficient pessimism to avoid this fate? Frustratingly, the answer depends on the recession!

S&P 500 Performance Following Start of Recessions: 1990-Present

Stocks managed to skate through the recession of the early 1990s unscathed. Following the peak of the economy in mid-1990, the S&P 500 Index went on to produce a total return of 27.2% over the next two years. Unfortunately, investors were not so lucky during the recession of the early 2000s, with stocks losing 24.6% in the two years after the recession began. Similarly, the recession of 2008 was no walk in the park for markets, with the S&P 500 falling 20.3% after the economy began contracting at the end of 2007. Continue Reading…

Franklin Bissett overweights defensive stocks over traditional Canadian sectors like Energy & Financials

Posted By |

 

Despite a looming recession acknowledged by most of the financial industry, Franklin Templeton Canada is relatively upbeat about the prospects for both Canadian stocks and fixed income over the short- to medium-term. In a Toronto event on Wednesday aimed at financial advisors and the press, Garey J. Aitken, MBA, CFA — Calgary-based Chief Investment Officer for Franklin Bissett Investment Management — described how he has been positioning his Franklin Bissett Canadian Equity Fund somewhat defensively. (There was also a webinar version of the event.)

As you can see from the above breakdown of the fund, Aitken is way overweight defensive sectors like Consumer Staples relative to the index: the S&P/TSX composite. In Canada, consumer staples amounts to the major grocery stores like Loblaw and Metro: there’s little along the lines of such American staples giants as Proctor & Gamble or Colgate Palmolive. Aitken said his fund has owned Saputo Inc. since its IPO in the late 90s, and has long owned Alimentation Couche-Tard Inc.

The fund has been overweight consumer staples for more than a year: as the chart shows, he was overweight this defensive sector by a whopping 730 basis points a year ago and this year is even more overweight by 770 bps. He is also overweight the other big defensive sector, Utilities, by 210 bps, compared to overweight by 110 bps a year ago. The third major defensive sector globally is Health Care, but the Canadian stock market has only minimal exposure to that sector.

Aitken has moved from a small underweight position in industrials a year ago to a modest overweight in 2023 of 170 bps. And he is slightly overweight Information Technology by 140 bps, compared to a small underweight of 20 bps a year ago.

Underweight Energy, Financials & Materials

On the flip side, the fund has been and continues to be underweight in the three big sectors for which the Canadian stock market is famous: Energy, Financials & Materials. Financials (chiefly the big Canadian banks) were underweight 330 bps a year ago and Aitken has moved that to an even bigger 730 bps underweight this year. In Materials he has stayed largely pat, with a 530 underweighting today compared to a 550 bps underweighting a year ago.

The chart below shows the fund’s holding in Canadian financials. You can see that among the big Canadian banks, the fund is over the index weighting only for the Bank of Nova Scotia, and is slightly overweight Brookfield Corp. and Brookfield Asset Management:

 

However, Aitken has moved Energy (Canadian oil & gas stocks, pipelines etc.) from a small 20 bps overweight position last year to a 370 bps underweighting in 2023. The chart below shows the major Energy holdings relative to the index, with overweights in certain less well-known names: 

 

Aitken remains slightly underweight Consumer Discretionary stocks, moving from a 100 bps underweight last year to 150 bps underweight currently. Real estate is almost flat: from a slight 10 bps underweighting a year ago to a small 70 bps underweight today.  Continue Reading…