RESEARCH UPDATE – Inflation, Bitcoin and Bond Substitutes
POLITICS AS USUAL
It did not take long for newly installed Republican party Representative Elise Stefanik (she is Liz Cheney’s replacement) to go after Joe Biden. It was grandstanding at its best. Standing at the Congressional bully pulpit in front of a scrum of news reporters Stefanik said the latest US jobs report (released on Friday May 14th) was the worst in over 20 years. “Unemployment is up, small businesses are struggling to hire workers,” and it is all the result of the Democrats “far-left radical socialist policies.”
While it was not the worst jobs report in over twenty years, she made some valid points. According to the report the US added 266,000 new jobs in April. Well below the one million that was anticipated and according to Oxford Economics, created the largest gap – between expectations and reality – since 1999 when Refinitiv, a financial data provider, began tracking the data. Think of that snippet as the politician’s version of fact checking “the worst report in twenty years.”
Getting beyond the far-left-radical-socialist-policy hyperbole, her other point has merit. The employment report surprised everyone. While the chasm between expectation and reality is obvious, the rationale for the differential is more difficult to quantify.
On the one hand, the employment numbers belie the fact that there is an abundance of jobs left unfilled. Some eight million unfilled job postings at last count. There are many reasons for this, although the most notable explanation is that the unfilled positions are lower paying jobs. Stefanik posited that Biden’s extension of unemployment benefits bears some responsibility for the alleged crisis. To her point, the wage gap between government subsidy programs and wage postings provides no incentive to join the workforce. Add to that, lingering concerns that one might catch COVID in the workplace. What we can glean from this, is that the re-opening phase may incur more hurdles than initially forecast.
Central banks have taken the position that inflation will be transitory. As discussed in previous reports, the transitory thesis hinges on the normalization of two factors: base year biases and supply chain bottlenecks.
The base year bias is relatively straightforward. As the early months of the pandemic (i.e.: March through June 2020) get dropped from the annual CPI calculation, base year comparisons should dissipate. We think year-over-year CPI should decline by 2% from current levels by the end of the summer.
Supply chain logjams are more difficult to quantify and in a best-case scenario, will take longer to normalize. Especially when companies are under pressure to maintain margins during a period of elevated demand, limited supply, and shipping delays from the Asia Pacific Basin. We think demand will return to normal over the next twelve months but that may not be enough to alter the trajectory of inflation.
Commodity prices have nearly tripled since the beginning of the year according to the Bank of Canada Commodity Price Index. The cost of shipping containers has tripled since the onset of the pandemic and exit prices for Chinese manufactured goods is up 6.8% annually as of the end of April 2021.
It comes as no surprise that the main request on earnings calls is forward guidance on inflation expectations. More often than not, management teams are raising prices to protect margins. It is simply too difficult to absorb wholesale price increases when there is limited visibility on re-opening timelines.
However. like the plot of a soap opera, there is more to the inflation story investors are obsessed with these days than the well-known supply-chain constraints that are slamming both large and small companies alike. One of the sub plots feeding supply chain challenges has been substitution effects driven by unexpected changes in consumer spending patterns that were unique to the Covid-19 recession.
As with most recessions, unemployment surged, spending abated, businesses scuttled supply lines and reduced inventory. And there lies the problem! Factories were closing due to health concerns and expectations that the recession would dampen demand. However, this recession was different. Massive support programs initiated by governments kept consumers liquid.
Stay-at-home orders lead to a surge in on-line consumption which caused big name retailers like Amazon and Walmart to re-think their inventory priorities. Money earmarked for vacations and dining out was gravitating to electronics, home decor and recreational products. Goods typically manufactured in Asia. The trick is to manage a shift in short-term demand without having any long-term visibility. An unprecedented scenario that caused the initial bottlenecks along traditional shipping channels which has yet to be purged.
Solutions are being developed which include targeting alternative ways to ship goods. Peloton Interactive Inc., the maker of interactive fitness equipment, took advantage of more expensive air freight to meet demand. Many ships are being directed to and off-loaded at smaller ports. The freight is then transferred to surface modes of transport such as rail lines and trucking companies.
As more activities come online – e.g. travel, dining out, etc. – the pandemic-fueled substitution effects will disappear and consumption patterns will normalize. The question is how long will this take, and what impact will the transition have on investor sentiment?
Another factor that we have not discussed in previous updates is variability in the inflation data. The concern is that inflation instability can be as damaging to the psyche as prolonged periods of above trendline price increases. Especially in light of the transitory framework global central banks have assigned to the upward bias in prices.
Even transitory inflation can be subjected to wobbles much as we saw from the mid-60s to early 80s. Ian Mcgugan, noted in a recent Globe and Mail article, that “surging prices caused widespread pain not just because of the heights they hit, but because they jumped up and down more often than a hockey fan watching playoff overtime.”
Taking us down memory lane, Mcgugan went on to write: “volatility [in the inflation datapoints] made it impossible for companies and households to know what was coming next. In Canada, core inflation (that is, inflation with volatile food and energy prices stripped out) shot up to nearly 6% at the end of the 1960s, fell below 2% at the start of the 1970s, soared above 12% after the first oil crisis in 1973, subsided below 7% per cent by 1977, then exploded back to nearly 12% by the end of the decade.”
The wobble takeaway is important because inflation instability limits a company’s ability to set prices and consumer’s capacity to adjust wage demands. Both hamper the potential re-opening recovery.
THE BITCOIN COLLAPSE
The recent collapse in Bitcoin is fodder for cryptocurrency bears. It supports the position that crypto is too volatile to be considered a replacement for fiat currencies as a medium of exchange. But that alone, does not negate crypto’s potential as an alternative to gold.
According to Nobel laureate Paul Krugman, who has long been a skeptic of their value as a medium of exchange, crypto currencies are a better alternative than gold. If investors believe in that thesis, then downside volatility should produce upside performance in the crypto currency space in much the same way as the gold market has acted for the past fifty years. As Krugman wrote in the New York Times, “One fact that gives even crypto skeptics like me pause is the durability of gold as a highly valued asset.”
In an interview on Bloomberg televisions’ Wall Street Week, former U.S. Treasury Secretary Lawrence Summers shared that sentiment. He said cryptocurrencies within the context of global markets, could act as something akin to “digital gold,” even if their importance in economies will remain limited. The argument is based on the position that cryptocurrencies were an asset class “separate and apart from the day-to-day workings of governments.”
Where gold has played that role for decades, Summers believes that crypto has a chance of becoming an agreed-upon form of safety people can utilize. “My guess is that crypto is here to stay, and probably here to stay as a kind of digital gold.”
If cryptocurrencies despite their volatility, are able to maintain a core following, a scenario where Bitcoin achieves even a third of the gold market crisis insurance mantra, Summers believes we could see a “substantial appreciation from current levels.”
The concept that, over time, Bitcoin could displace gold is a common theme among crypto enthusiasts. Under an equalization scenario, the upside is significant. Notes Yassine Elmandjra, crypto analyst at Cathie Wood’s Ark Investment Management LLC, if gold is assumed to have a market cap of around US $10 trillion, “it’s not out of the question that Bitcoin will reach gold parity in the next five years.” That process translates into a price target of US $500,000 per Bitcoin. An intoxicating scenario that some argue borders on reckless. Our view is somewhere in between.
On the one hand, we believe cryptocurrencies are here for the long term. One the other, excessive optimism always leads to outsized volatility. On a risk / reward basis, we prefer to hold a small crypto position as part of the alternative asset class within the Conviction Equity Pool. The limited exposure will add value if the upside targets are realized and dampen volatility as Bitcoin finds its floor. We can also manage some of the risks with Bitcoin options.
THE CASE FOR PREFERRED SHARES AND FIXED INCOME ALTERNATIVES
Even before the COVID pandemic, we were questioning the value of bonds as a reasonable fixed income solution. When the first wave of COVID gained momentum in March 2020, global central banks upped their bond buying programs (i.e.: Quantitative Easing) and lowered the overnight lending rate to near zero. The overnight rate is what central banks charge commercial banks in need of liquidity infusions.
Early in the pandemic bond prices collapsed amid liquidity concerns. But when central banks stepped up to provide liquidity by increasing their bond purchase program and lowering rates, bond prices surged through the summer of 2020. That is the teeter totter effect where bond prices move opposite to interest rates.
To our way of thinking the bond market topped out in the summer of 2020 (see accompanying chart [next page] that shows the performance of the iShares Core Canadian Bond Universe ETF) which likely represents the summit of fixed income’s outsized performance. With short-term rates at or near zero, and pockets of mid to long-term rates in negative territory, there is not much to support further upside. To that point, we believe in the current environment, bonds may be the highest risk asset class.
That does not diminish the role of income producing assets within a portfolio. Because appropriate income assets are typically less volatile. As such, these securities can provide ballast and the steady cash flow can be re-invested to dollar cost average asset purchases over time.
There lies the challenge. We understand the value of income assets but recognize that the fixed income characteristics of bonds will weigh on performance.
Think about it! The nominal yield on ten-year AAA bonds is approximately 1.5% per annum. Central banks want to see sustainable inflation in the 2% range. In that environment, the real inflation adjusted yield on ten-year bonds is -0.5%. Over the life of the bond, the investor will experience a 5% loss in purchasing power, assuming the inflation we are currently witnessing is transitory.
Taxes are another issue. Interest income is fully taxable at your marginal tax rate which means the after-tax real return is somewhere around -1.25%. The negative impact of taxes and inflation on bonds outweigh any benefit from price stability and cash flow. Moreover, any rise in rates over the next ten years, will push the price lower adding to your pain threshold.
So, the inclusion of income assets that dampen portfolio variability comes down to finding alternatives that look and feel like fixed income but will experience less pain in a rising rate environment. That’s where preferred shares come into the discussion.
To buy into a preferred share strategy as a fixed income alternative, we need to examine a bit of history. Prior to the great recession (2007 through 2009), high quality Canadian preferred shares typically traded with yields about 80% of those offered by high quality bonds issued by the same company. That preferred share discount reflected the tax advantages of dividend income versus interest income.
Prior to the financial crisis, preferred shares were considered by many to be as safe as bonds. As such, there was no risk premium for buying a preferred share. Despite the fact that companies can choose not to pay the dividend. That ended with the financial crisis.
During the great recession (no one like to use the “depression” nomenclature), many of the large US money center banks ceased paying their preferred share dividends. The market for preferred shares collapsed with global reverberations.
Interestingly, Canadian banks continued to pay dividends on their preferred shares throughout the crisis. As did many other large cap Canadian institutions like BCE Inc. Despite that, Canadian preferred shares fell in concert with their US counterparts. More importantly, the relationship between the yield on preferred shares and bonds was permanently altered.
In the current environment, there is a risk premium in the value of a preferred share that reflects the fact the dividend payout is at the discretion of the company’s board of directors. At present, preferred shares are trading with yields that are about 150% of what one would get investing in the ten-year bonds of the same company. The question is whether the premium is excessive given real-world risks associated with the preferred share category.
On that point, we believe the risk premium is excessive. Especially given the tax advantages afforded by the dividend tax credit. Moreover, many high-quality preferred shares issued by Canadian banks offer dividends that are tied to the 5-year Government of Canada bond yields and that reset every 5 years. In short, the dividend will increase over time with interest rate hikes in contrast with bonds that will decline in that scenario.
Another consideration is safety. Fact is Canadian banks have never missed a preferred share dividend in over 80 years. That is very compelling when making a variability dampening argument.
Other fixed income alternatives can be found in blue chip common shares that pay above average dividends. These are companies whose share price will not rise significantly or fall precipitously. Another advantage is the potential for dividend increases over time. Companies like BCE Inc., Canadian Utilities, Emera and the big six Canadian banks all fall into that category.
Canadian banks are notable as their governing body, the Office of the Superintendent of Financial Institutions (OSFI) has restricted their ability to raise dividends or buy back shares during the COVID pandemic.
The big six Canadian banks have significantly more capital than required and when the restriction is removed, will likely return capital to shareholders in the form of dividend increases. The base case will see a 10% to 30% increase in dividends. Royal Bank of Canada is expected to be at the high end of that range, while National Bank of Canada is expected to increase dividends by 17%. Look for that to take place beginning in the fourth quarter of 2021.
As a case in point, Dave McKay, Royal Banks CEO said during a post-earnings conference call with analysts, “When regulatory restrictions are lifted, we will look to accelerate capital return to our shareholders through a mix of share buybacks and higher dividends, given our payout ratio is at the bottom end of our 40% to 50% range.”
Our view is that Royal Bank may hike dividends to the middle of their payout range in the fall (i.e., 45% of earnings). Assuming a profit of $11.50 per share for 2021 that translates into a dividend of $1.30 per quarter or $5.20 annually. Based on Royal’s current dividend of $1.08 quarterly or $4.32 annually, that translates into a 16.9% increase. After that we suspect dividends will increase twice a year until the payout reaches the top end of the range, making bank stocks an excellent fixed income substitute.
IMPLIED TRADING RANGE
Analysts often cite the trading range for companies about to report their quarterly earnings. For example, before Amazon reported their latest numbers, analysts believed the stock could rise or fall by 5% in after-hours trading. That trading range was predicated on the current value of Amazon options leading up to the earnings release.
It works this way. The value of an exchange traded option is calculated using a complex mathematical formula that includes six inputs. The inputs are 1) current price of the underlying stock, 2) strike price of the option, 3) time to expiration, 4) dividends, 5) interest rates and 6) volatility.
Looking at the six components, we know with certainty (or near certainty) what most of the inputs ought to be. We know, for example, exactly what the current price of the stock is. The strike price of the option is part of the option contract. We know precisely when the option contract is set to expire (options expire on the Saturday following the third Friday of the expiration month) and we have a high degree of confidence what interest rates are, and what dividends if any, will be paid by the underlying stock.
What really underpins the value of an option is the volatility input which is what traders use to define risk. To an option’s trader, an estimate of future volatility ought to be as important as earnings estimates are to a security analyst. In terms of the math, volatility is simply a measure of how much the stock price is expected to vary from its current price. The input into the option pricing formula is the annual standard deviation of the stock’s price.
The problem is most option traders overlook volatility as a consideration when making investment decisions. Traders will simply buy calls if they are bullish on the outlook for the underlying stock or buy puts if they are bearish. But if traders pay too much for the calls or the puts, they discover that being right about the direction of the underlying stock is not enough. Most end up losing money on the position if they make an incorrect assumption about volatility.
That most individual option traders lose money over time, speaks to the importance of understanding volatility. The challenge is that most investors don’t understand when volatility is over or understated. For example, if I tell you that at-the-money options on Microsoft are implying a volatility of 21%, is that good or bad? Without a point of reference, it is impossible to know.
In the options market, you pay a premium to play the game. The option premium handicaps the underlying market, much like the spread handicaps the wager in a football game.
If we were making a bet on the outcome of a football game, and team “A” with a ten and one, record was playing team “B” with a one and ten, won loss record, we would expect team “A” to win the game based on their past records.
But if we were to make a bet on the outcome of the game, and the handicap was 60 points, that would dramatically alter our view of the outcome. While team “A” might win the game, in professional football, it is highly unlikely that team “A” will win by more than 60 points.
When we make investment decisions, we follow a similar process. We make decisions to buy or sell XYZ stock based on its’ history. You may choose to look at specific price patterns on a stock chart, or perhaps use fundamental analysis, or earnings estimates. But the decision to buy or sell is based on how the stock has historically acted given a specific set of circumstances.
We trust you see the problem. While we intuitively know that winning by 60 points in a football game is not reasonable, we do not have the same intuitive feeling about implied volatility. Is a 21% volatility assumption on say, Microsoft too high or too low?
One way around this is to translate implied volatility into an implied trading range. Without, of course, having to use a spreadsheet to determine the end result.
To deal with this, consider the following approach. We know for example, that Microsoft (symbol MSFT, listed Nasdaq) recently traded at $250 (all prices in US dollars). The Microsoft July 250 calls were trading at $7.50, and the Microsoft July 250 puts were trading at $7.00.
Now, if you were to buy the Microsoft July 250 call and Microsoft July 250 put, your total cost for this position would be $14.50. Buying both of these options is referred to as a straddle which has no directional bias.
To that point, with a long or short straddle, the investor is not concerned whether the stock rises or falls. The call profits in a rising market, the put will profit in a declining environment. The only concern is whether Microsoft will move far enough before the July expiration so that you earn more than the total cost for the straddle. That becomes your implied trading range.
If you were to add the $14.50 cost of the Microsoft straddle to the strike price of the options, your upside breakeven is $264.50 with a downside limit of $235.50. That is the trading range that is being implied by the Microsoft July options (the last trading day for these options is July 16th).
The question is whether you think Microsoft is likely to breach either end of that trading range between now and the July expiration. If you think Microsoft is likely to be above or below the outer boundaries of that trading range, then you are effectively saying that the options on Microsoft are inexpensive relative to the volatility expectations. Similarly, if you think that Microsoft is unlikely to breach either end of that trading range before expiry that implies that Microsoft options are overvalued.
With that information, you can make an informed investment decision using options. If you are bullish on the short-term prospects for Microsoft you can buy calls or implement a bullish option writing strategy (i.e., a covered call write or a cash secured put). The choice of which strategy is appropriate depends on your view about whether Microsoft options are over or undervalued.
Richard N Croft
Chief Investment Officer