EQUITIES COMMENT - " TSX - Gaining Speed"
After a slow first half, the TSX Composite picked up speed in the third quarter of 2017 with a return of 3%. Sectors that did well include Energy and Financials, two heavyweights that make up over 50% of the TSX.
From Last Place to First The energy sector benefitted from stronger than expected oil demand out of the U.S. and Europe where economic growth has accelerated. On the supply side, increased OPEC compliance, renewed turmoil in Libya and unplanned outages of oil facilities held back growth. Inventories are continuing to shrink which is providing support to oil prices. The North American crude oil benchmark (West Texas Intermediate-WTI) managed to move back above $50 per barrel during the quarter.
The accompanying graph shows the major producers of crude oil. You can see that the U.S. is one of the world’s largest suppliers thanks to new technology that spawned the shale revolution. Oil that was previously inaccessible can now be reached with horizontal drilling. Most of the increase in global oil supply in recent years has been due to rising U.S. shale production. Russia and Saudi Arabia, the other major producers, have reigned in production in order to bring down inventories and balance the market with the hope that the price will increase. In the OPEC countries, a higher oil price is needed in order to boost government revenues and maintain fiscal spending. Among most non-OPEC countries, finding and developing new reserves is uneconomic at the current low price. A higher oil price will have a positive impact on energy stocks and the TSX Composite.
Banks No Longer in Neutral Despite a booming economy, Canadian bank stocks had paltry returns for the first half of this year due in large part to concerns about bubbly real estate markets in Vancouver and Toronto. In our view, these issues are manageable and will not have a severe or long lasting negative impact on bank earnings. Here’s why:
Canadian banks are diversified geographically having built up significant operations outside of Canada.
BMO, Scotia, TD, Royal, Commerce and National Bank (Big 6) together earned $10.7 billion after tax in the third quarter. Earnings have been diversified beyond “banking” through the growth of wealth management, capital markets and insurance businesses.
Interest rates are rising in Canada, the U.S. and Mexico. This causes the spread between the rates on loans and deposits to increase, boosting profit margins.
Banks are expected to slow the growth of expenses going forward. While spending on technology will continue, the branch network will get smaller.
Mortgages are a big business ($1.2 trillion) and account for 54% of bank total loans. 48% of mortgages are insured by government approved providers. For the Big 6’s uninsured mortgages, the loan to value ratio is approximately 54%. That means real estate values would have to fall more than 40% across Canada for the loans to be worth less than the properties.
Default rates on mortgages have historically been modest. (See graph.)
Capital ratios are strong and exceed global requirements.
The TSX has passed our year-end target of 15,650 at the time of writing. We expect the market to continue to power ahead over the next 6-12 months if oil moves beyond $50 and confidence improves further in the banks’ earnings power. Valuations remain attractive and the stronger Canadian dollar could generate foreign interest.