Research Report: Income Strategy and Trade War Angst

BY: Richard Croft
CIBC reported earnings that follow an all to familiar pattern. Management warned of slower growth through the remainder of 2019, added more than $1.5 billion in loan loss reserves and generally raised fear that CIBC contagion would spread across the entire Canadian banking sector.



CIBC reported earnings that follow an all to familiar pattern. Management warned of slower growth through the remainder of 2019, added more than $1.5 billion in loan loss reserves and generally raised fear that CIBC contagion would spread across the entire Canadian banking sector.

CIBC’s share price fell 7.25% during mid week and the early fallout could be felt among the other Canadian banks. However, when T.D. and RBC Inc. reported on Thursday, contagion fears were curbed. Both TD and RBC reported healthy earnings and neither issued profit warnings aside from the fact that we would likely see a slowdown in Canadian economic activity.

So once again CIBC is the outlier. Being the premier mortgage lender, it appears the loan loss provisions were related to concerns about weakness in the two major Canadian housing markets; Vancouver and Toronto.

The profit warnings are another story which so often befalls CIBC. Despite having one of the largest deposit bases, management choices have mired financial metrics like return on equity and profit growth. I’ve said many times that CIBC is the best example of the underlying strength of Canadian banks as management has been trying to bankrupt the company for fifty years and hasn’t been able to do it!

Still, the price action on CIBC shares raises two questions:

  1. Why do we hold CIBC in our income portfolios?
  2. Should we be looking to move out of the company given the recent turbulence?

If I may be permitted, allow me to address the first question by paraphrasing President Ronald Reagan famous statement about the economy when he was campaigning for a second term; “it’s about the cashflow… stupid!”

We hold CIBC because it is the highest yielding bank among the big five. With the recent sell-off, the shares are yielding 5.39% well above its competitors. More importantly, CIBC has bumped its quarterly dividend by 16% with eight separate increases since 2016.

For an income portfolio, the analysis that guides buy-sell-hold decisions comes down to an assessment about:

  1. The company’s ability to continue paying the dividend
  2. Weighing the potential for future dividend increases. CIBC passes muster on both questions and so remains one of the core equity holdings in our Income mandates.

Keeping with the income theme, BCE Inc. is another core equity holding. As we see with many high yielding blue chip names, BCE has raised its dividend more than 130% with sixteen increases since 2007. The most recent occurring in the first quarter of 2019.

The dividends began flowing in earnest following a decision by the Ontario Teachers Pension Plan (OTPP) plan and two hedge funds to walk away from their plan to take BCE private during the financial crisis. For OTPP, the appeal of privatizing BCE was the inherent cash flow that could be used fund retiree pensions. We could not agree more, which is why BCE Inc. is another core holding in an income mandate.


BULLS colliding

So much for the “all-but-a-sure-thing” trade deal with China. Like it or not this is a key metric driving financial markets and will likely remain front and center until the G-20 summit. More on that in a moment. What’s important now, is gaining some insight as to how negotiations between the world’s two largest economies will impact financial markets in the short, medium and long term.

It seems clear to everyone but Trump, that his stick and carrot approach doesn’t work when negotiating with political leaders whose agendas that do not always follow economic norms. President Trump’s strategy is more about winning than with getting a deal that benefits everyone. And while it is conceivable that a double down strategy may work – and I emphasize the word “may” – in business, it has a poor track record in politics.

When Chinese leaders pulled back from positions where there was general agreement – notably on issues related to the sharing of intellectual property – the US had every right to re-think its position. The US will not and should not budge from its’ hardline stance on this front. It poses a serious threat to US dominance in technology and if this is not dealt with now… when? Moreover, this issue has bi-partisan support in Congress, backing from technology leaders and support from other industrialized countries. On this front the US is standing on solid ground.

The challenge is when the President negotiates in a public forum berating the opposition in the process. Chinese leaders will appear weak if they sign a trade deal when the US President is using a tariff sledgehammer to further negotiations. At this point, the Chinese leadership would rather save face than sign a deal under duress.

President Trump also has political vulnerabilities. Trump needs a win as he enters the 2020 Presidential election cycle which was likely why the US removed tariffs on steel and aluminum. At least that should be enough to allow Democrats to approve the USMCA. Unless of course, the Democrats simply don’t want to give Trump any win regardless how it impacts the US consumer.

That said, ratification of USMCA will not be enough. My best guess is that China will back away from their hardline stance on intellectual property. It is simply in their best interest. However, any deal will have to include compromises where the leaders can save face. The only way I see that happening is if the two leaders come to some agreement when they meet at the G-20 summit in June. My suspicion is that backdoor negotiations will provide a framework for the two leaders to find a way forward.

Most likely, China will back away from their stance on intellectual property and the US will agree to drop all tariffs when a deal is signed. Trump can say that his tough bargaining stance was needed to solve a long-standing problem, the Chinese leadership can say they were able to get US concessions on tariffs that could only be accomplished with a face to face meeting on neutral ground.

Until the G-20 I suspect the markets will gyrate in a directionless pattern which could add another point or two to volatility. If nothing is accomplished at the G-20 summit, investors will re-evaluate stocks which would likely cause as much as a 10% short term decline. I say that because a 10% sell-off would value the S&P 500 forward price to earnings multiple at 15 which is closer to historical norms. Currently the S&P 500 index is trading at 17 times forward earnings.

That said, historical norms must always be viewed in context. The 15 times forward P/E is a relative measure typically bench-marked against the historical 6% yield on 10-year US treasuries. That 10-year US treasuries are currently yielding 2.5%, one could argue as Warren Buffet did recently, that stocks are cheap.

I make this point because it plays into a no trade deal scenario. Take trade off the table, and investors will most likely re-focus attention on interest rates and valuations which one could argue will underpin a rally later this year.

Green shoots blossoming after the summer doldrums could be the catalyst that causes retail investors to come back into the market. In that scenario, we could witness a melt up in stock values that could see the S&P 500 index breech 3,000.

Bottom line, a successful outcome on the trade front will be a short-term win for the market. No trade deal will be a short-term negative but could set the stage for a fourth quarter rally. Stay tuned!

Richard Croft, Chairman & CIO

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