Also available in PDF: McMurtry Investment Report Portfolio – January 2022
Investment Commentary January 2022
US Yield Curve
The ten minus two- year US Treasury yield curve rose by 11 basis points to 0.89%. This was caused principally by the ten- year yield rising to 1.73% as of January 7th, compared to the November 30th level of 1.43%. This widening of the curve should be viewed as positive for the economy and indicates the probability of an imminent recession remains low.
US Corporate Debt Spreads
As of January 7, 2022, Baa rated US corporate bond spreads relative to 10-year US Treasuries actually declined modestly by three basis points from November 30th to the current level of 1.78%. Once again this is a positive sign for economic growth.
Covid – 19 Health Stats
The Omicron variant is proving to be much more transmissible than either the basic Covid-19 strain or the Delta variant. Globally there are more than 2.5 million new cases daily. This is one of the highest levels since the pandemic began. The global daily death rate is around 7500 which remains stubbornly high, but not at record levels compared to the daily new cases. In the US daily new cases are 800,000 plus with daily new deaths coming in around 2300 plus. Hospitalizations in the US are also climbing rapidly.
Currently more than 59% of the world has received at least one dosage, but only 8.9% of people in low- income countries have received their first dosage. More than 77% of Canadians have received at least two dosages compared to 62% in the US.
Taking into account all the above trends, more lockdowns are occurring throughout the world. Looking at all the stats, it still looks like this new variant is less severe than the others and for many people results in flu like symptoms. However, the very high level of transmissibility keeps everyone on their guard.
Equity Market Valuations
The forward PE multiple of the S&P 500 index rose to 21.4 as of January 7th. This compares to the long -term median of 19.6 times.
Central Bank Monetary Policy
Faced with rising inflationary pressures, the US Federal Reserve Bank has become even more hawkish from last month. This will probably result in more interest rate increases than originally expected and the rate increases starting earlier than anticipated.
As a result of a more hawkish Federal Reserve and a highly transmissible new variant, Omicron, I am increasing my cash weight for both portfolios by 3% to 20%. I am reducing the overall equity weight for both portfolios by 2.5%, while increasing the preferred exposure by 1% to 4%. In the Income portfolio I am reducing the 1-5 year Canada bond ladder ETF by 1.5%, while reducing it by 1.75% for the Growth portfolio.
Equity prices in 2022 are expected to be much more volatile in this period of rising rates and increasing pandemic concerns. Currently the monthly stats do not point to any economic recession anytime soon, but a stock market correction in the midst of a bull market is not out of the question. Last year we only saw a small correction of less than 5%, but 2022 may see several corrections of this magnitude. As I have highlighted many times in past newsletters, predicting a short- term correction in an ongoing bull market is very difficult if not impossible. However, it is much easier to predict an imminent recession where equity markets could fall up to 50% before recovering. Having a cash reserve will act as a risk reducer for your portfolios and provide you with an opportunity to purchase more equities on short term market dips. But I want to reiterate that I do not expect a major market correction based on an upcoming recession anytime soon. Do not get tempted to increase your cash weight beyond 20% at this time or you may end up missing a lot of potential upside.
Equity Sector Weights
I remain overweight my North American benchmark Financials, Energy, Materials, Industrials, Consumer Discretionary and Real Estate. I remain underweight Consumer Staples, Healthcare, Technology, Utilities and Communications. I continue to favour cyclical industries over both growth and defensive ones with their pricing power helping them to pass on their raw material cost increases to their clients. Given the high probability of rising rates this year, growth sectors like Technology and US Communication stocks will have difficulty performing as well as they have performed with PE multiple contractions widely expected for these groups. Once again, I would maintain exposure to all groups but reduce and increase sector weights as highlighted.
Individual Equity Changes
In a portfolio blog dated December 15th, I reduced my precious metal exposure by deleting Pan American Silver, Barrick Gold, Kirkland Lake and the US GDX ETF.
In a portfolio blog dated December 30th, I added InterRent Reit to both portfolios in the REIT sector. The current dividend yield is 2.05% that is well covered by cash flow. The Reit’s net operating income is spread between Ontario and Quebec at 52% and 18.5% respectively. The 3rd quarter saw a 7.7% increase year over year in total suites and a 5% increase in average rents. Adjusted funds from operations rose by 13.2% year over year. EBITDA is expected to grow by 21% this year.
In a portfolio blog dated January 3rd, 2022, I added the US mid cap equity First Trust ETF, FNX US to both portfolios. Its distribution yield is currently 0.95% and its weighted average PE is much lower than the S&P 500 index at only 13.31 times.
I am deleting both Capital Power and Boralex from both portfolios in the Utility sector. While Capital Power is cheaper than many of its peers on a Price / TTM Funds from Operations basis, both its 2021 performance and its projected growth in EBITDA for 2022 is very low. Boralex is one of the most expensive stocks in the Utility sector, yet its projected growth this year in EBITDA is on the low side.
I am adding Northland power to both portfolios. While the fundamentals slowed sharply in 2021, its projected growth in both revenues and EBITDA this year is very favourable.
Lastly, I am adding Brookfield Renewable Partners BEP.UN to both portfolios in the Utilities sector. Its current dividend yield is 3.59%. Last year the renewable energy companies did not perform very well. However, at current prices Brookfield Renewable Partners is trading at a Price to Trailing 12 months Funds from Operations of only 6.93 times, much cheaper than most of the domestic utilities. In addition, its projected growth in Funds from Operations is in the range of 8-10% for 2022. While its balance sheet is more levered than other utilities, this is solely how the parent, Brookfield Asset Management, accounts for its subsidiaries’ debt. The parent calls their debt non recourse, implying that the parent is not responsible in the case of bankruptcy. At first this appears very unfavourable for the subsidiaries. However, after closely studying the Brookfield empire of companies, I have come to a more favourable conclusion for the subsidiaries. Last year one of the parent companies’ real estate subsidiaries was in some financial difficulty and the parent company bailed them out even though their debt arrangement indicates non recourse.
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