JMRD Market Observer for October 27th 2017- BoC remains preoccupied with the downside risks to inflation

In This Week’s JMRD Market Observer



  • BoC remains preoccupied with the downside risks to inflation

  • JMRD Investment Beliefs

  • Canadian Banks – Thematic research:  “Payment shock” from higher rates: sounds scary, but the reality is not that dramatic

  • Technology: Consider Some Legacy Names – Calendar Q3 2017 Preview

  • JMRD Basket Corner

  • Retirement Corner

  • Reads of the Week

  • Economic Calendar

  • Earnings Reports



BoC remains preoccupied with the downside risks to inflation


As widely expected, the Bank of Canada left the overnight rate at 1.00% today. The central bank upgraded its growth forecasts to 3.1% for 2017 (from 2.8%) and to 2.1% for 2018 (from 2.0%), said that the economy was operating close to potential, and admitted core inflation was on the rise. But it was still concerned about the lack of wage growth which indicate “there is still slack in the labour market”, and risks such as geopolitical developments, fiscal and trade policies (NAFTA). The BoC expects inflation will rise to 2% in the second half of 2018, a little later than previously thought “because of the recent strength in the Canadian dollar”. The BoC said that less monetary policy stimulus will likely be required over time, but made clear it “will be cautious in making future adjustments to the policy rate”. The Bank said it “will be guided by incoming data to assess the sensitivity of the economy to interest rates, the evolution of economic capacity, and the dynamics of both wage growth and inflation”. In its updated Monetary Policy Report, the BoC left its forecast for world growth at 3.4% for both this year and next. The U.S. economy is expected to grow 2.2% both this year and in 2018.

For Canada, the 2017 upgrade was largely due to the stronger-than-expected Q2. The 2018 upgrade was due to slightly better contributions from government and business investment. Real gross domestic income is expected to rise 4% this year and by 2.3% in 2018 (up from 1.5% in last July’s MPR). Potential GDP growth was left unchanged at 1.1-1.7% for next year.


Press conference:

In his opening statement, Bank of Canada Governor Poloz said that with inflation running below target, “we [the Governing Council] continue to be more preoccupied with the downside risks to inflation”. When asked if that meant a December rate hike is off the table, he responded that all meetings are live because the Bank can always alter its view of the economy depending on incoming data. According to the Governor, the Canadian economy may be getting into a sweet spot where endogenous creation of new capacity will allow the economy to grow further without generating much inflation. He admitted, however, this theory has yet to be proven correct given that the pace of new firm creation has been weaker than he expected. Another justification for a cautious approach in removing monetary stimulus, according to the Governing Council, is the uncertainty related to how households will react to higher interest rates and the changes in mortgage rules that have been implemented/announced so far.


Bottom line:                                                                                                                                                             

The Bank of Canada upgraded its Canadian growth forecasts but tried to explain why it did not need to tighten monetary policy further. Even though the economy is now at capacity by its own measure of the output gap, the central bank said that there is still slack in the labour market ─ wage growth is deemed by the BoC to remain muted despite upcoming minimum wage hikes in Ontario and Alberta ─ and it highlighted a string of potential risks including NAFTA, and geopolitical developments. The central bank raised its forecast for 2018 GDP growth to 2.1% and called this “close to potential” even though its range for potential for that year is 1.1-1.7%. Based on the central bank’s concluding statement that it will be “cautious in making future adjustments to the policy rate” and “assess the sensitivity of the economy to interest rates” it’s clear the Bank of Canada would like to delay tightening as long as possible ─ OSFI just gave it a helping hand. That said, we are skeptical about the assumptions put forward by the central bank. The central bank may be underestimating the 2018 outlook (its projections do not include fiscal stimulus from the federal and provincial governments) and cost-push inflation from the biggest minimum wage increase in 50 years. So don’t rule out another about-face from the central bank in the coming months. While we still see the overnight rate ending 2018 at 2.00%, we have pushed to January the timing for the next rate hike in light of the central bank’s dovish message today.


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JMRD Investment Beliefs


Just in case you missed it last week: Over the summer months, the principals of the JMRD Team who form the JMRD Investment Committee set about to articulate our Team’s investment beliefs.  We have been a Team for over 10 years and largely have the same investment views.  However, with added members to the Team and an ever changing investment world, we wanted to dig deeper into our key beliefs.  Our team has processes in place and holds regular strategy conference calls in order to improve our investment decision-making process, as you may be able to surmise from the Models commentary above.  We feel that testing and confirming our investment beliefs provides the solid foundation on which to make the all-important investment decisions on an ongoing basis. 


Belief #2.  A client’s appropriate Asset Allocation is the most important determinant of long term financial success.


Belief #3. We believe investments held for the medium-to-long term are better than a short term trading focus, and that trading activity should be minimized, whenever possible.  Short term fluctuations and volatility are the necessary ingredients for long term gains, which take time to develop.



Canadian Banks – Thematic research:  “Payment shock” from higher rates: sounds scary, but the reality is not that dramatic


  • Rate hikes creating “payment shock” concerns. The Bank of Canada has surprised the market with two rate hikes in 2017, and the market is assigning a high probability of another hike before year-end. While rate hikes boost optimism about margin expansion, they create (arguably greater) concerns about the impact of higher rates on consumer debt affordability and, ultimately, credit quality. We believe this reaction is understandable considering: (1) based on bank guidance, the upside to bank earnings from recent rate hikes is incremental; and (2) low rates have kept affordability in check, despite a multiple year increase in consumer indebtedness. The focus of this report is to estimate how much of a re-pricing shock Canadian homeowners could face and, in turn, what risk this situation could present to credit quality of bank loan books as consumers face a greater financial burden.


  • Higher financing costs facing households do not appear “shocking”. Data from the National Housing Association securitization filings (NHA-MBS) provides insight on what a sub-set of borrowers representing roughly a third of the total Canadian mortgage market are currently paying and, more importantly, what they could be paying as they refinance in coming years. Using a few simplifying assumptions (outlined in the report) we estimate that if current mortgage pricing holds that Canadian households that currently have a mortgage could see their monthly costs rise by nearly $40 over the next several years, with those most impacted feeling this pinch in the 2020-2022 period. Assuming another two rate hikes, and a commensurate impact on fixed mortgage pricing, we estimate that monthly financing costs could rise by $80 for the average consumer.


  • We do not see a material risk to credit quality as financing costs rise. Rising rates have emerged as the factor that some expect could cause the Canadian housing bubble to burst, or at least cause a spike in consumer lending delinquencies. While we do not view a likely increase in consumer debt (e.g. mortgage) financing costs as a positive outcome, we do not believe a material deterioration in credit quality will ensue. We note: (1) the biggest jump in financing costs will be faced by borrowers re-financing 4-5 years from now, which is less concerning; (2) our estimated increase in financing costs is small relative to household incomes and expenditures; and (3) other indicators, such as consumer credit utilization rates, do not signal a separate level of strain that would raise additional concerns.


  • Credit concerns should not inhibit a strong finish to 2017 (and 2018 is looking similar). Big-6 bank stocks have a consistent track record of strong second half performance, outperforming the broader market in eight of the past 10 years. 2017 is maintaining this trend, with the banks beating the S&P/TSX by ~200bps since June 30th. With a benign credit environment, strong GDP growth, and banks making strides with their efficiency improvement programs, we expect a strong finish to the year. Looking ahead to 2018, we see similar conditions supporting bank stock performance. We note that consensus forecasts for 5% growth next year could once again prove conservative, leading to another year of positive EPS revisions driving stock performance. Our top picks are BNS, TD and CM, with the latter stock the most “opportunistic” way to play improved sentiment towards Canadian credit quality. 


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Consider Some Legacy Names – Calendar Q3 2017 Preview


It’s no secret – technology stocks have had a big run this year. In the United States, the technology component of the S&P 500 is up 30%. In Canada, the sector’s relative move when compared with the broad TSX has been equally strong with the TSX Information Technology Index up 16% versus 3.7% for the TSX. Candidly, there hasn’t been any specific commonality in the names that have run, other than the stronger relative sentiment behind their growth prospects as organic growth names, acquirers or turnarounds. Some of those names included Shopify (Outperform; Target: US$120) despite the recent pullback care of a short report, BlackBerry (Not Rated) on speculation that it could become a prominent player in the world of autonomous vehicles, and Sierra Wireless (Outperform; Target: US$32) given its positioning within what finally seems to be an accelerating market for the Internet-of-Things (IoT). What’s lagged are the legacy names – like CGI and OpenText – both of which have underperformed the group; in our view, that’s been due to their limited organic growth when the market appetite has favoured organic growth names of late. The fact is that we’ve had positive views on the names that have outperformed – like Shopify and Sierra Wireless, but we believe the legacy names remain compelling particularly given their relative valuations. In addition, with growing signs of caution when it comes to valuations across the global tech names – particularly in the United States, we believe names like CGI, OpenText and Mitel provide relatively attractive valuations today. That’s not to say we’re stepping away from names like Kinaxis or Shopify; we just believe the relative valuations across the legacy names are equally compelling.

We’re providing a summary of our expectations for the upcoming calendar Q3 2017 reporting season which takes over our calendars over the next few weeks. With this preview, we are also updating some of our estimates and revising some of our ratings. All those changes are highlighted in Exhibit 1 in the attached report.  Of note, Constellation Software, Kinaxis, Shopify and Open Text are held in JMRD’s Canadian baskets


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JMRD Basket Corner


DIG Basket

Capital Power (CPX) – CPX reported Q3/17 adj. EBITDA of $161 mln (excluding unrealized losses), matching our estimate with stronger U.S. Contracted contributions offset by slightly lower than expected results from the AB Commercial and Contracted segments. The company also indicated that based on its outlook for Q4/17, 2017 adjusted FFO is tracking near the midpoint of the company’s previously announced guidance range of $340 to $385 mln. Capital Power remains a ‘buy’ for growth and a healthy 6% yield with a number of catalysts on the horizon.


Waste Connections (WCN) – Trash is treasure! Waste Connections shares jump after earnings


All-Cap Growth Basket


Jamieson Wellness (JWEL) – NBF initiated coverage of Jamieson Wellness this week with an Outperform rating and a $22.25 price target. Our positive view is based on the company’s domestic and international growth strategy that is supported by a number of positive factors including: 1) its leading market share and brand recognition in Canada, 2) broad range of products for a variety of age groups and lifestyles, and 3) market-driven product innovation; all supported by 4) favourable demographic trends and the growing use of vitamins, minerals and nutrition supplements (VMS) products by all Canadians, although particularly so by those in the 71+ years old group. We believe international growth will be supported by the manufacturing quality as well as the “Made in Canada” brand that are appreciated and sought after in the targeted emerging economies of Eastern Europe, the Middle East and Asia. Jamieson’s 95-year legacy is matched by a leading 20%-25% share of the Canadian consumer health market (closest competitor at 7%).


U.S. Growth Basket


Norfolk Southern (NSC) – Third-quarter net income was $506 million, up 10 percent year-over-year, driven by an 11 percent increase in income from railway operations – yielding a record quarterly operating ratio of 65.9 percent. Diluted earnings per share were $1.75, up 13 percent year-over-year. “Norfolk Southern continues to deliver strong financial results through execution of our strategic plan. We are unwavering in our commitment to improve productivity as demonstrated by seven consecutive quarters of year-over-year improvement in our operating ratio,” said James A. Squires, Norfolk Southern chairman, president and CEO. “Our balanced approach focuses on increasing efficiency and delivering a strong customer service product, giving us the ability to achieve our goals and deliver sustainable shareholdervalue.”


Owens Corning (OC) – Reported consolidated net sales of $1.7 billion in third-quarter 2017, compared with net sales of $1.5 billion in third-quarter 2016, an increase of 12%. Third-quarter 2017 net earnings attributable to Owens Corning were $96 million, or $0.85 per diluted share, compared with $112 million, or $0.97 per diluted share, during the comparable quarter in 2016. Third-quarter 2017 adjusted earnings were $141 million, or $1.25 per diluted share, compared with $125 million, or $1.08 per diluted share, during the same period one year ago.


Visa (V) –Beat Wall Street’s quarterly profit expectations on Wednesday helped by more people using its world-wide network to pay for everything from groceries to Uber rides, sending its shares to a record. Visa has seen an uptick of card payments in the U.S. as consumer spending, which accounts for more than two-thirds of U.S. economic activity, remains at a healthy clip. The company’s U.S. market share for card payments has climbed steadily as consumers switch from cash and checks.


Waste Management (WM) – Waste Management, Inc. (NYSE: WM) today announced financial results for itsquarter ended September 30, 2017. Revenues for the third quarter of 2017 were $3.72 billion compared with $3.55 billion for the same 2016 period. Net income( )for the quarter was $386 million, or $0.87 per diluted share, compared with net income of $302 million, or $0.68 per diluted share, for the third quarter of 2016.((a)) On an as-adjusted basis, net income was $398 million, or $0.90 per diluted share, in the third quarter of 2017, compared with $374 million, or $0.84 per diluted share, in the third quarter of 2016.



Retirement Corner




Reads of the week




Economic Reports


Monday October 30th – Personal Income (US)

Tuesday October 31st – Real GDP (CAD)

Wednesday November 1st – MBA Mortgage applications (US) Manufacturing PMI (US)

Thursday November 2nd –  Initial Jobless claims (US)

Friday November 3rd – Employment change (US), Unemployment rate (US), Trade Balance (US)



Earnings Reports


Monday October 30th – PrairieSky Royalty Ltd., Vermilion Energy Inc.

Tuesday October 31st – Shopify,

Wednesday November 1st – Kinaxis Inc. Savaria Corporation, Whitecap Resources Inc., ZCL Composites Inc., Facebook Inc., Tesla Inc.

Thursday November 2nd – BCE Inc., Enbridge Inc., Great-West Lifeco Inc., Open Text Corporation, Saputo Inc. Apple Inc. Inc.

Friday November 3rd – RioCan Real Estate Investment Trust



Enjoy the weekend!

By | 2017-11-03T20:23:10+00:00 October 27th, 2017|JMRD Updates|0 Comments

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