Mackenzie Bluewater Team
- Canada is expected to be the fastest growing G7 nation this year. During the quarter, the economic acceleration prompted The Bank of Canada (BoC) to raise overnight rates twice and market expectations are for the tightening cycle to continue. The sudden shift in BoC policy from monetary loosening to a tightening stance drove a significant rally in the Canadian Dollar. From our perspective, the BoC policies risk being a case of “driving while looking in the rear-view mirror”, as it appears that the Canadian economy faces an unusually large and diverse group of headwinds that we expect will materially slow future growth relative to the recent pace.
- During the past several years, globally low inflation has manifested itself in a sustained escalation of asset prices, including the stock market (as we discussed in our last quarterly commentary) and housing. Not surprisingly, the largest contributors to Canadian GDP growth have been housing centered, namely residential construction and durable goods (a category that is often driven by consumers borrowing against their houses to make large purchases of vehicles and appliances).
- In our view, low inflation and the resultant low interest rates should gradually lead to an upward re-pricing of assets, but we find it impossible to determine, without the benefit of hindsight, how large or sustainable the adjustment will be. Ultimately, annual house price increases of 15-20% when incomes are rising at 2-3% inevitably leads to a widening affordability gap. Continued appreciation at that rate will eventually result in median new home buyers spending their entire after-tax income on mortgage payments, with no room in their budgets for essentials like food, gas, and clothing. In light of this, we are watching the recent slump in the Toronto housing market closely to see if it marks a top in the cycle, or just a pause. With 7% of Canadian employment tied directly to residential construction, more than double the current US level, a stall in residential construction may have material implications for economic growth.
- In addition to clear uncertainty around the sustainability of housing related demand, we have several other significant concerns when we look at the Canadian economy.
- The energy sector comprises nearly 8% of Canadian GDP, close to 20% of the S&P TSX, and is an important factor for the Canadian dollar. We have written extensively on electric vehicles and their likely impact on the energy sector. This technological disruption is the confluence of two factors: consistently improving technology and government policies aimed at moving away from fossil fuel consumption. With battery price/performance improving close to 15% per year, we expect electric vehicles to achieve cost parity with internal combustion engine (ICE) vehicles by the early 2020’s, and to be clearly superior several years later. The value proposition for electric vehicles, which provide a better product at a lower cost, creates conditions ripe for a rapid adoption. If anything, the adoption is likely to be hastened by government policies aiming to phase out ICE vehicles. Unsurprisingly, the most sweeping policy changes have tended to come from countries that are significant oil importers, with efforts underway to phase out ICE vehicles by 2040 in the UK and France, 2030 in Germany and India, 2025 in the Netherlands, and while China is still developing a timetable for an ultimate ICE phase out, regulators want to make new energy vehicles (NEV) at least 10% of total sales by 2019 and 20% by 2025.
- The subsequent response from the global OEM’s has been swift and large: Volvo is transitioning to a fully electric/hybrid vehicle lineup by 2019 and phasing out solely combustion engine powered vehicles, Diamler is investing $11 billion, Audi slashing $12 billion in gas and diesel R&D to fund electrification, and Volkswagen is investing $24 billion in the electrification of 300 models. With personal light-duty vehicles accounting for 44% of global oil demand, electric vehicles pose a structural challenge for the energy sector, and by extension the Canadian economy.
- The Canadian government could be accused of “adding fuel to the fire”, given their tough stance on the oil sector which creates a competitive disadvantage for Canadian producers. As a signatory of the Paris Agreement, Canada is required to slash 230 megatons in emissions by 2030. Post the Agreement, we have seen regulatory changes, project cancellations (LNG and pipelines), and global oil companies deciding to exit oil sands projects (Shell, Marathon, Total, and Murphy). None of this is supportive of the cost structure or ease of access to global markets for Canadian producers.
- In the face of elevated risks from housing and energy, Ontario and Alberta have planned minimum wage hikes totaling over 30% in 18 months, under the assumption that they will be a net positive for low income workers. In 2014, Seattle put into motion a roadmap to $15/hour minimum wage over a period of three years for large companies and seven years for smaller companies. A comprehensive study from the University of Washington found that while small increases to the minimum wage did indeed have a positive impact on lower income workers, subsequent larger increases were a clear net negative, as the increase in wages was more than offset by employers cutting back on both hours and jobs. We do not see why the Canadian experience should be different.
- A far more difficult issue to analyze is the ongoing renegotiation process around the North American Free Trade Agreement (NAFTA). From our perspective, the agreement has benefitted both Canada and the United States, with trade well balanced between the two nations and a small trade surplus in favour of the US in 2016 of around $12.5 billion on trade of approximately $630 billion. Nonetheless, President Trump’s protectionist agenda has jeopardized or nullified several trade agreements including KORUS (Korea and US) and Trans Pacific Partnership (TPP) among others and NAFTA is clearly at risk.
- Although it is impossible to determine what President Trump will ultimately do, it appears he wants to reignite a manufacturing renaissance in the US. From our perspective, the practicality of this is highly questionable, given the globalization and automation trends that far precede his presidency. Nonetheless, the US Commerce Secretary has already slapped preliminary countervailing and anti-dumping duties of 300% on Bombardier recently and the auto sector remains a contentious issue in the negotiations. Given that Canadian/US trade accounts for roughly 20% of Canadian GDP but less than 2% of US GDP, it appears to us that Canada is at a large negotiating disadvantage and it seems likely that the ultimate outcome will not be a positive for the Canadian economy or currency.
- So how are we dealing with all these issues? Rather than owning cyclical Canadian oriented businesses, we have been focusing on those Canadian companies that have meaningful international exposure, which will give them growth opportunities that are less constrained by the domestic economy. Greater geographical diversification in their business mix lowers their sales volatility which is attractive to us. This includes companies like CCL Industries, Spinmaster and Winpak. Periods of rapid Canadian dollar appreciation, such as we experienced in the most recent quarter, are a notable headwind for these businesses, as their foreign currency earnings are impacted by the translation back to a higher Canadian dollar. In our view, given the large number of risks for Canadian economic growth over the next few years, there will likely be renewed downward pressure on the currency, which would be a further tailwind for these companies over time.
- Our pure domestic exposure remains limited and defensive in nature including best-in class pharmacies, dollar stores and telecom providers including Jean Coutu, Dollarama and Telus. Our pure Canadian economic exposure is currently quite low when we look through to where the sales of these businesses are derived. In addition, our foreign content is over 40% and there is negligible Canadian exposure in these businesses.
- In general, the global economy continues to expand while inflation remains fairly muted. In our view, this combination should result in continued corporate earnings growth and support for current valuation levels, making it a reasonable environment for equities. The challenge, as always, is to find companies that will thrive and avoid companies that have business specific headwinds. By owning only 30-35 companies, we are able to be highly selective and invest in businesses that are leaders in their respective niches that outgrow their peers with superior profitability, strong free cash flow generation, and balance sheet flexibility to weather difficult economic environments. Our emphasis on total return: the combination of organic sales growth, margin expansion, and the generation of free cash flow, allows us to find companies that will generate a steady returns across a cycle without the risk of chasing businesses with unsustainably high growth rates. Finally, our emphasis on management teams and corporate culture allows us to find companies that can displace competitors and create innovative opportunities for growth in an environment where weaker companies may struggle. We have invested through many different cycles and environments in the past and continue to believe that companies with these characteristics, bought at sensible prices, will outperform over time.