Q3 2021 Investment Commentary

In this commentary: 

Supply chain pain | Fixed Income | Canada | U.S. |  International  

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Supply chain pain

Scott Blair, CFA
Chief Investment Officer

A year ago, we wrote an article titled, COVID-19 winners and losers in the market which mentioned a colleague who experienced an unusually long delay in receiving a pair of Adirondack chairs they’d ordered. It took eleven months, to be exact. That story highlighted how record demand for the chairs, hitting up against reduced supply due to COVID-19 protocols, affected a factory in Ontario. 

Early in the pandemic, these issues seemed very unusual. How could a huge recession lead to record demand for a “nice to have” item like patio furniture? The answer, of course, was that this was like no recession we’d ever seen. On average, incomes and savings rose due to generous government programs, while the outlets to spend those dollars fell as travel and other services were – and still are –  limited.

Port pains – more than just a nuisance

We’re now eighteen months into the pandemic and supply chain issues are no longer just a nuisance – they’re starting to impact our recovery. Recently, a company we own in our U.S. portfolio shared that one of their chartered containerships was denied entry into China because a crew member tested positive for COVID-19. The ship had to go back to Indonesia and change the entire crew before it could return to China. The result was a delay of more than two months from the original timeline.

Stories like these highlight the complexity of running a port during a pandemic. Not only have ports been ill equipped for the increase in demand, but they’ve also had to deal with worker shortages and increased complexity due to the implementation of social distancing. Occasional COVID-19 outbreaks have also caused delays. The result has been significant disruption leading to ships having to spend a lot more time at ports, and the cost of shipping (freight rates) skyrocketing. 

As of mid-September, there were 61 ships anchored off the two major U.S. west coast ports. In normal times, even five is considered too many. Not surprisingly, freight rates are through the roof. It used to cost $1,600 to transport a container between Shanghai and Los Angeles. Today, the price is closer to $11,000 (Figure 1).

Figure 1: Supply chain bottleneck

Early in the pandemic, companies had inventories they could draw from to cushion the supply chain disruptions. In effect, inventories act as a shock absorber. Those inventories are now at near record lows in many categories and industries, while manufacturing facilities continue to be impacted by COVID-19. Our double whammy of surging demand for goods and reduced production capacity continues.

Short-term impacts on companies and consumers

In the short-term, the major impact is a significant increase in transportation costs. This ultimately leads to higher prices for consumers, and potentially lower profits for companies if they can’t pass on the price increases. 

While the short-term picture might look concerning and the impact from supply chain disruptions is real, we view this as a transitory issue that will get resolved. With vaccination rates increasing and stimulus running off in the U.S., ports are likely to be able to hire more workers which is a first step in eliminating some of the bottlenecks in the global supply chain. 

Things are looking up in the long-term

Looking past the supply chain shock, we’re seeing strong consumer demand backed by unprecedented savings, intention to increase CAPEX spending by corporations, and the need to rebuild the inventory levels. All this should provide a boost to economic activity over the next 12 to 18 months. 

Of course, the biggest wild card in looking at the future continues to be COVID-19. The delta variant was a significant drag on what should have been an exceptionally strong summer of economic growth. It appears today that the delta wave is ebbing. Also, news of a new pill from Merck that might cut the risk of death or hospitalization from COVID-19 in half could be a game changer for the recovery.

As investors, we’re taking the longer view. Global recovery is still strong and we anticipate robust economic growth well into next year, which should be positive for the markets. Investing in companies with reasonable leverage and resilient businesses provides good protection against all the bumps along the way.

Fixed Income

Malcolm Jones, MBA, CFA
Senior Portfolio Manager, Fixed Income

Watching

During the second quarter, bond yields moved around with little direction as the market tried to digest the competing forces of the economy opening up while COVID-19 mutated and staged a resurgence. As we moved through the third quarter, and particularly through September, bond yields moved up while the yield curve steepened (Figure 2).  

Figure 2: Canada yield curves




The market believes the economy is recovering. Various central banks lend credence to this idea, shown by their reduction in stimulus. The Bank of Canada (BoC) will likely stop its net bond buying completely by the end of October. The Fed has strongly hinted it will start reducing in October or November, likely being complete by summer 2022. We may also see bank rate increases in 2022 from any or all of the Fed, the BoC and the Bank of England (BoE). The market is suggesting that yields are moving upwards.

Credit spreads have been relatively stable in the third quarter. They’re higher than the lows seen at the beginning of the year but remain low relative to history.

Inflation figures have been coming in somewhat higher than expected. At present, inflation can be explained by temporary supply chain disruptions and increasing labour costs. 

The U.S. is a rarity in that it has a legislated debt ceiling. Once again, the U.S. government debt load is pressing against its limit with some concern that politics will get in the way of increasing the debt ceiling.

Thinking

After a summer lull, we expect more upwards pressure on Canada and U.S. yield curves. If inflation is seen to be more permanent, this could cause greater upwards pressure on longer term rates. Should the economy start to overheat, causing central banks to be more aggressive with bank rates, there will be more pressure on short rates. 

We believe the economy will continue to recover and feel that some of the current inflationary pressure is transitory. As such, we think the yield curve will rise overall and will steepen slightly. In other words, rates will rise in an orderly fashion such that neither the economy nor the equity markets will be substantially disrupted by these moves.

Both the Fed and BoC have indicated they wish to be finished with their respective bond buying programs before raising the bank rate. There’s a need for caution. While the economy is seen as strong enough for the bank rate to return to normal, going slowly will help avoid any disruption to the recovery.

Both governments and corporations have been issuing a lot of debt. However, credit spreads remain subdued. This suggests that the market still feels we’re in an economic recovery. As the economy recovers, revenues should increase, boosting interest coverage even with increased debt loads. We feel comfortable with an overweight position in credit bonds. While the spread may be low relative to history, it’s unlikely to surge higher. In the meantime, we can collect a higher coupon.

Supply chain issues are causing some temporary inflationary pressure. At this point, we’re not seeing excessive wage inflation. There are some anecdotes of wage increases, however, widespread wage inflation remains elusive. As the summer months end, so will government support programs and we expect to see an increase in the number of job applicants. 

While we continue to monitor the situation, at this point we feel inflation is more likely to settle into the 2-3% range laid out by the central bank, rather than repeat the disruptive inflationary pressure seen in the 1970s.

We think the U.S. debt ceiling discussion makes for exciting headlines, but that it’s ultimately more of a political issue than an economic one. This will lead to discussion continuing until the final hour, only to have the debt ceiling raised and all government bills paid in a timely manner. We will see some disruption in very short-dated U.S. T-Bills, but otherwise the market seems to be dismissive of this issue.

Doing

With expectations for continuing upwards pressure on yields, we are underweight duration (exposure to interest rates). In particular, we’re very under-duration in Canada bonds. We’re willing to hold longer-dated bonds in corporate and provincial bonds, so that we’re able to collect a higher coupon. Further, we feel that credit spreads are unlikely to surge higher.

Canada

Gil Lamothe, CFA
Senior Portfolio Manager, Canadian Equities

Watching

After a torrid first half of the year, the Canadian equity markets took a breather in the third quarter with the S&P/TSX Composite index gaining 0.17%.

One of the more notable performers in the portfolio was Methanex, which gained over 40% in the quarter. At the outset of the pandemic in 2020, Methanex was suffering a perfect storm of very low oil prices, low methanol prices and a levered balance sheet. The company was forced to drastically cut its dividend – the first cut in over 15 years.  

Today, methanol prices are strong and somewhat stable, oil prices are high, and the company is generating sufficient cash to not only address their balance sheet, but they’ve increased their dividend and intend to buy back stock. 

Figure 3: Methanex price per ton



Figure 4: Methanex stock price 


The COVID-19 delta variant has had a material effect on the speed and nature of the global recovery. Chemicals such as potash and methanol are enjoying high global prices, whereas base metals and gold are struggling. There’s strong demand for consumer goods globally, but the ability to produce and ship those goods has been impeded by a lack of labour and the necessary pandemic distancing measures – neither of which are conducive to efficiency, whether producing chips or loading ships.

What was once the well-oiled and functioning globalization trade machine, now has some gears with broken teeth. The good news is that demand is strong and this will fuel the rebuilding of the trade machine as the pandemic eases over the coming months.

On the M&A front, there have been a few developments in the quarter. The CN Rail and Canadian Pacific (CP) tussle over the purchase of the Kansas City Southern railway, which would allow access into Mexico, turned abruptly into CP’s favour. The U.S. regulator ruled against CN establishing a trust in which to hold the acquired railway. This is a necessary element to any deal approval, and as CP’s trust proposal had already been approved, they were essentially the only viable bid. We’ll be closely monitoring how much value CP can extract from this acquisition.

Late in the quarter, Agnico Eagle announced the proposed merger-of-equals of itself with Kirkland Lake Gold (KL). This gold miner has operations in Canada and Australia, both politically stable jurisdictions, which we see as a strong positive. The new Agnico Eagle would be run with senior management from both companies, as well as 13 board members, six of whom would come from KL’s existing board. There’s the possibility of another suitor emerging, so we may be in for another merger saga on Canadian soil.

Watching 

The third quarter of 2021 started on a positive note. Stellar performance in both July and August was helped by another strong reporting season, where a record number of companies beat earnings expectations by a significant margin. However, with the quick spread of the delta variant towards the end of summer, sentiment changed and equities declined by more than 4% in September. U.S. equities ended the quarter up slightly. 

Recent economic data disappointed and the U.S. CITY economic surprise index, which measures the degree to which economic data is either beating or missing expectations, is currently in negative territory. Supply chain disruptions and their far-reaching impact was a hot topic throughout the past three months, with the two biggest impacts being a significant increase in transportation cost and delays in product deliveries. More companies are warning about the negative impact this could have on near-term earnings.  

Finally, towards quarter end the Fed hinted that it might start reducing its bond buying program in October or November, and we could potentially see rate increases as early as in 2022, which also put pressure on market returns. 

From a sector perspective, the returns were mixed with half of the sectors in negative territory and the rest finishing up in Q3. Cyclical sectors suffered, being heavily dependant on the global economic recovery and China. Consumer Discretionary also lagged with Amazon being a big drag on the sector. Leading sectors this quarter were Financials, Health Care and Technology. Financials were helped by an increase in interest rates towards the end of the quarter. Growth outperformed value with large tech companies performing well.  

Thinking 

We acknowledge that inflation pressure and growth constraints from the supply chain disruptions are real, but don’t want to lose sight of the big picture. While these will impact both the economy and corporate earnings in the short term, we continue to see strength in both consumers and corporations. The government transfer payments and decreased spending on services during the pandemic has resulted in households amassing more than $2 trillion of excess savings. That’s roughly 15% of annual consumption. 

With strong pent-up demand – especially in certain areas – we expect at least some of these savings to be spent in the next 12 to 18 months. Wages are also rising which should further boost consumer confidence and spending. As for corporations, balance sheets are in great shape with cash balances near record highs, and interest coverage (interest payments/earnings) the lowest it’s ever been (Figure 5).

Figure 5: Inventory levels near record lows

Another factor that makes us optimistic on the economic recovery is the current level of CAPEX and inventories. Both are close to all-time lows. The COVID-19 pandemic caused many disruptions in the inventory cycle that are taking longer than usual to resolve. However, we expect that once bottlenecks in the supply chain get resolved we’ll see businesses rebuilding depleted inventories. This, coupled with companies’ intention to ramp up CAPEX spending in the coming years, should support the economic recovery in 2022 and 2023 (Figure 6). 

Figure 6: Upward trend in CAPEX spending



We think we might continue to see earnings surprising to the upside. During the first two quarters of 2021, we had huge earnings surprises with the market underestimating the recovery of the earnings substantially. With economic data being disappointing lately, we saw upward revisions in earnings stalling. With expectations already reflecting current headwinds, we could see a continuation of earnings surprises into the second half of the year, which should be positive for markets. 

Doing 

During the quarter, our U.S. holdings fared better than the index with stock selection driving the performance.  We exited a few of our positions wherein our thesis either played out or had less probability of materializing.  These included names such as Pfizer, Cummins, Newmont, Verizon and M&T Bank. We redeployed the capital in several high-quality businesses that were trading at attractive valuations and offered compelling risk/reward. 

Some of the names that we initiated during the quarter are MasterCard, UnitedHealth, Deere, and Amazon. Our thesis on these names is based on continuation of revenue and earnings growth which is not yet being priced in by the market. Amazon deserves special mention as it’s a stock that we’ve stayed away from in the past, mostly due to valuation. With the pandemic, there’s been a pull-forward demand for its products – e-commerce and cloud business. This pull-forward, which we deem sustainable, led to earnings growth while the stock has done little in the last year resulting in an attractive entry point for this high-quality business. We also added Dollar Tree and Wells Fargo – turnaround situations where we see a significant upside if management teams execute well on the existing strategy. 

In our U.S. portfolio, we focus on long-term investing in high-quality companies with strong returns, healthy balance sheets and stable cash flows. While different factors may work during different periods, we believe that buying fundamentally strong businesses at lucrative prices and owning them over long periods will lead to superior returns for the portfolio.

Watching 

The past few months have been very eventful in China. One of the more notable events has been the unraveling of Evergrande, one of its largest property developers. Evergrande recently announced that it will not be able to pay interest on its USD bonds due in September, due to lack of cash. 

Evergrande is the most indebted company in the world and its inability to repay its debt surfaced in 2020. The company carries net debt of $64 billion. It also carries another $148 billion in its account payables, which can also affect other Chinese companies. 

Its current problems were exacerbated after China announced its “three red lines” for the property sector, which formulated new financing rules for companies that want to refinance or increase their debt. Given that Evergrande was in breach of all the red lines, it couldn’t continue borrowing, so to generate cash it attempted selling assets and selling houses at steep discounts. 

Given Evergrande’s high debt and its struggles to raise cash, the market has been calling its potential demise China’s “Lehman moment” that could spill over into a broad financial downturn.

Another sector that was in the news recently is Macau’s gaming sector. The government recently issued a consult document prior to legislating a new gaming law. The last law, enacted in 2001, must be updated given the significant changes in Macau over the past 20 years. 

The document stipulates nine points, of which the following are of particular interest:

1. Dividends will require government approval
2. The government will monitor daily activities
3. Higher taxes

Thinking 
Experience has shown us that “Lehman moments” rarely, if ever, are on the front page of the newspaper ahead of time. Evergrande now occupies the attention of all policy makers in China. The central bank provided liquidity to the banking system several times and though the government stated that it will not bail Evergrande out, it has asked state-backed property developers to conduct due diligence on some of its assets for a potential purchase. 

If regulators are worried and it’s in the news, the market is already discounting it. As such, we’re less concerned about a financial crisis and more concerned with trying to understand potential fallout.

We don’t own Evergrande but are particularly interested in determining how its issues may impact our holdings in two Chinese banks (ICBD and CCB). The banks provided loans to Evergrande but won’t disclose their size. As such, we gathered data to figure out how much exposure the banks have to their largest customers. 

Among its largest 10 customers, ICBC has none that operate in the real estate sector. CCB’s 2nd largest customer does operate in that sector. Digging deeper, we know that the size of the loan is RMB38.4 billion. However, we also know that CCB has reserves of RMB615 billion for loan losses – more than enough to cover this loan even if it goes to zero – which real estate loans rarely do.

Given that the market is concerned about contagion, we checked the banks’ exposure to real estate loans. Both banks’ non-performing real estate loans (2.96% for ICBC and 2.03% for CCB) are in line with the bank’s corporate loans average (2.46% for ICBC and 2.49% for CCB). The banks have sufficient reserves to cover substantial losses, and because most of these loans are collateralized (sold to others), losses should be relatively small.

Bottom line, we believe the banks we own in our portfolio have small and manageable exposure.

Moving to Macau, we believe that the market’s concerns are overblown. The focus of the government is employee welfare and, most importantly, investments so that the industry will continue contributing to employment and the financial stability of Macau.

1. The government will not forbid dividends, it just wants them to be reasonable to withstand crises and to invest in the community.
2. The government already monitors daily activity, especially in the count rooms. Further monitoring will likely be through a board membership, which is nothing unusual in China.
3. Higher taxes are not part of the consult paper, so it’s not part of the discussion. For this reason, we’re not concerned about it.

Considering these points, Galaxy is the best positioned company in our view in our portfolio. It’s Chinese, so there are no issues with its concession. Its owners’ relationship with the government is very good and it has one of the best products on offer in Macau. 

Galaxy’s current earnings are only about a fifth of what it had prior to COVID-19. As the pandemic recedes, we believe that most restrictions will be lifted and earnings will recover. Additionally, there’s a large project coming online in 2022, plus two other potential development opportunities.

Doing 

The Chinese banks valuations have declined due to Evergrande’s troubles. Figure 7 compares the Price to Book Value of ICBC and CCB to a Canadian bank (TD). TD is trading at 2x the Price to Book Value of the Chinese banks, which is a huge divergence that we’ve taken advantage of by increasing our weight in both names.

We also took advantage of the volatility in Galaxy by increasing our weight in the name as well.

Figure 7: Significant divergence in bank valuations