The oil market also went into a similar downturn after the prices collapse in 2016.  While US shale oil was brought to market quickly in the ensuing recovery, that source of production has a much shorter reserve life and a higher cost structure than longer-term projects.  When prices collapsed again at the beginning of the pandemic, shale production in the US dropped by over 3 million bpd and has not shown much indication of making a quick recovery as many of the larger players have left the industry.  In the short term there is the pent-up demand that will be released as we leap out of lockdown which has already shown up in the strength of oil prices over the past few months. While the long-term picture for fossil fuels is clearly hampered due to a greater focus on carbon emissions and a move to renewable sources of energy, valuations had become overly penalized such that many companies could produce their current reserves and generate enough cash to buy in their entire market capitalization, with money left over.  That spells good value in any industry, even without growth.

Over the past few months, as the largest global mass-vaccination effort in history has accelerated, financial markets have undergone a reversal of fortunes – laggards have become leaders, and vice versa.  Uncharitably coined a “junk rally,” this repositioning has invigorated everything from leisure travel, energy and materials sectors, to micro-cap names, to “meme stocks,” like GameStop.  There are many ways of defining investment quality including financial metrics such as return on assets or financial leverage or dividend yield.  Higher market volatility is also associated with companies that may be of lesser quality.  As the exhibit below highlights, high volatility stocks have outperformed ‘low vol’ over the past few months, after the news of the vaccines was released and ‘re-opening trade’ stocks have picked up momentum after lagging for most of 2020.  The good news for investors is that this type of ‘junky rally’ is generally associated with the earlier phases of any economic expansion, as companies have more time to improve those metrics and ‘grow into their valuations.’ 

February was a big month for Canadian markets as earnings were released late in the month for all the major banks.  Banks had lagged the overall market in 2020 as worries about mounting credit losses from the pandemic, capital restrictions, low interest rates and rising costs would impair returns.  But profits at all the ‘Big Six’ banks handily surpassed expectations, beating profit forecast by more than 20% and rising from year ago levels despite the pandemic.  Reported profits for the six totalled $13.9-billion in the three months ending January, rising above pre-pandemic levels. Massive government stimulus programs, roaring financial markets and clients leaning on banks to help them through the crisis have created an unusually opportune climate for banking despite restrictions in typical ‘bricks and mortar’ banks.  Bank CEOs on the conference calls and in interviews indicated they didn’t expect to be doing so well at such an early stage of the recovery.  But loan portfolios have had fewer problems than banks anticipated, especially after loan deferral programs expired, leaving banks able to reclaim some prior write-downs. That was partly because huge government support programs for workers and businesses, as well as banks’ loan-deferral programs, have helped delay or prevent defaults and insolvencies.  Other key sources of revenue have rebounded more quickly than predicted and there was a frenzy of activity in capital markets that generated soaring quarterly profits.  Low interest rates, a wave of liquidity that central banks have pumped into markets and volatile stock prices have fuelled a boom in trading revenues. Bankers advising companies that raise debt, acquire rivals or go public have also reaped more fees.  Furthermore, the pandemic has made some essential businesses such as banks and telecommunications companies even more necessary to their clients.  Canadian banks have once again shown they can weather the worse that the economy and markets seem to be able to throw at them, much like they did in 2008.   These are not the same banks of the 1980s and 1990s, that would be pushed to financial extremes by collapses in the real estate or energy markets.  They are now more diversified by industry and geography and have ‘steady growth’ wealth management businesses to absorb the ups and downs of the economic cycle.   Yet their valuations are in line with where they have been for decades and, more importantly, they are now sitting on massive excess capital positions that can be used to fund share re-purchases, increased dividends or take on accretive acquisitions once these current capital restrictions are lifted.   We continue to like the sector and have core positions in CIBC, Bank of Montreal and Bank of Nova Scotia.

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