Income-paying equities: Is the sell-Canada theme nearly over?

Michele Robitaille, managing director and equity-income specialist at Guardian Capital LP, a sub-advisor to the BMO family of funds. The Guardian equity team’s mandates include BMO Monthly High Income II.

Jason Gibbs, vice president and portfolio manager at 1832 Asset Management LP. Gibbs is a senior member of the firm’s equity-income team, which has a wide range of mandates including Scotia Canadian Dividend.

Peter Frost, senior vice president and portfolio manager at AGF Investments Inc. His responsibilities include two income-oriented balanced funds: AGF Monthly High Income and AGF Traditional Income.

The roundtable was convened and moderated by Morningstar columnist Sonita Horvitch, whose three-part series continues on Wednesday and concludes on Friday.

Q: On Dec. 16 last year, the U.S. Federal Reserve Board announced an increase in its federal funds target-rate range to 0.25% to 0.50%. What will the Fed do in 2016?

Robitaille: The Fed move in December was a big financial-market event. The Fed communicated, at the time, that it would adopt a gradual approach to the future path of this rate and that it would continue to watch the economic data. It also noted that the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. The lower-for-longer interest-rate environment is therefore intact. Through 2015, some of the dividend-paying sectors of the equity market sold off, particularly as we moved into December, in anticipation of the rate hike. They subsequently rebounded a little, once the hike occurred. It was important for the Fed to move from a credibility standpoint and to signal its views on the strength of the U.S. economy and its views on global growth.

Gibbs: I agree with the lower-for-longer outlook for interest rates. I subscribe to the secular thesis of low global economic growth. We’ve added something like US$57 trillion in both public and private-sector debt globally since the financial meltdown in 2007. That’s a lot of additional debt on top of the fair amount of debt already in place at that stage.

Also, the global labour force is not growing by as much as it used to, and it’s aging. This all adds up to lower economic growth and lower inflation. It’s hard for interest rates to go up materially in this environment. Looking at 10-year government-bond rates, the Government of Canada rate is 1.3%, the U.S. Treasury rate is 2.16%, the German government-bond rate is 0.53% and Switzerland’s government-bond rate is negative 0.14%. The Fed gets a lot of attention and it should. It has raised its policy rate. But since that date, the market interest rates that are really important have kept going down. There are bigger forces at play than the Fed.

Frost: The Fed is going to find itself in a conundrum with the U.S. dollar’s strength becoming a big headwind for the U.S. economy. If you look at year-over-year U.S. industrial production growth from 1990 to where we are today, it has gone negative of late. Negative growth has heralded a recession in the past. The U.S. economy is different today than in the 1990s, but the level of industrial-production growth has always been a good economic indicator. The U.S. manufacturing sector is in a recession. I would hate to see 12 months from now that the Fed actually tightened into a recession.

Q: What does this economic backdrop mean for Canadian dividend-paying stocks? The dividend yield on the S&P/TSX Composite Index is about 3.5%.

Frost: Dividend stocks look to be tremendous value. Compare their dividend yield to the yield on the 10-year Government of Canada bond of 1.3%.

Gibbs: You do have to look at every sector. Dividend stocks encompass a lot of stocks in a lot of different sectors. There is a difference between a dividend stock in the Canadian energy sector and a dividend stock in the Canadian telecom sector, where revenues and dividends are more sustainable. Investors have to realize that resource companies that pay dividends can have highly volatile revenues. But big picture, the theme of getting paid dividends from stocks in a low investment-return world is as strong as ever. The dividend yield plus capital growth is attractive versus the risk-free Government of Canada bond yield.

Q: In 2015, the S&P/TSX Composite High Dividend Index, which focuses on dividend income, produced a total negative return of 14.6%, underperforming the S&P/TSX Composite Index, which had a total negative return of 8.3%.

Robitaille: Energy and materials did quite poorly in 2015.

Q: In particular, energy represented some 30% of the High Dividend Index at the end of 2015 versus its 18.5% weighting in the Composite. Its hefty energy weighting must have hurt this dividend index.

Robitaille: In energy, the low commodity-price environment has brought the dividends of both the higher-yield energy producers and those services companies that had implemented dividends into question. You saw a lot of pressure on those areas of the equity market, even more so than on the broader energy sector.

Frost: The Canadian pipeline stocks came under selling pressure following the drop in U.S. energy-infrastructure stocks. There was the early December announcement by major U.S.-based pipeline company Kinder Morgan, Inc.(KMI) of a 75% cut in its dividend. In the wake of this, Canada’s Enbridge Inc.(ENB) got hit pretty hard.

Q: The ongoing weakness in the Canadian energy sector has been a drag on the S&P/TSX Composite. The low commodity price is also taking its toll on the Canadian economy.

Gibbs: There is a divergence in the Canadian economy. Alberta is finding it tough. But Canada has 36 million people and for a reasonable portion of this country, low fuel prices and low interest rates and, in some cases, a low currency, is a good thing. Ontario, Quebec and B.C. are a big part of the Canadian population and these provinces are doing OK. But if you add it all up, you will probably get weak Canadian economic growth.

Frost: Part of the problem for our manufacturing sector is that the emerging-market currencies are down significantly relative to the U.S. dollar. So the Canadian competitive advantage as a result of the low Canadian dollar is not as powerful.

Q: Has most of the good economic news south of the border been factored into the U.S. equity market? Have all the economic challenges in Canada been discounted by the Canadian stock market? Is the sell-Canada theme getting long in the tooth?

Robitaille: If you look at the valuations in particular Canadian sectors, such as energy, there has been a lot of negative pressure. This is largely driven by commodity prices. These have continued to grind lower since the beginning of the year and put pressure on the Canadian equity market as a whole. It’s hard to say that we’re at an inflexion point in the short-Canada thesis. We consider that oil prices in the US$30-per-barrel range are not sustainable. But there is an inventory overhang. You could go through a period over the next month or two, at least, of continued pressure on oil prices. We’re probably not at the very bottom.

Frost: You could see further dividend cuts in the Canadian energy sector. There are only a handful of Canadian energy producers that have not cut their dividends.

Robitaille: It’s hard to get excited about the idea of stepping into this sector. In other sectors, bank-stock valuations seem very attractive relative to historic levels.

Gibbs: You do have to look at all the Canadian sectors. You wouldn’t say that some consumer stocks, for example, are undervalued. You have to take a long-term view when it comes to the Canadian banks, and from that perspective I think bank stocks are attractive. The stock prices are assuming a pretty material increase in bank loan-loss reserves.

Frost: We haven’t seen this materialize yet. I agree that bank stocks are attractive.

Robitaille: The negative sentiment surrounding Canadian bank stocks, which is already reflected in bank-stock valuations, will remain until we have an improvement in energy prices. The thesis on the banks is that as long as we have low oil prices, the Canadian economy is at risk and if it goes into recession, then not only will there be loan losses related to energy, but the Canadian housing market could also be at risk. If you think this is unlikely to materialize, as we do, then there is good long-term value in Canadian bank stocks.

Frost: The short-sell-Canada thesis could be long in the tooth, unless we start to see real estate turn down in Canada. We haven’t seen that yet. Interest rates have been low and have buoyed real-estate prices.

Gibbs: The unemployment rate in Canada has remained stable, so this has helped the housing market.

Robitaille: Job creation has been solid through the course of 2015.

Gibbs: We could be at the beginning of the end of the short-Canada theme. It should be pointed out that the S&P/TSX Composite Index has underperformed the S&P 500 Index in local currency terms for five years now. That is pretty long.

Editor’s note: This is part one of a three-part equity-income roundtable.