Canada’s Big Six banks had a blockbuster start to the year, with all of them exceeding earnings expectations for the first quarter.  Together, the banks hit about $19 billion in profit, up from approximately $14 billion in the same period last year.  Canada’s banks have all been on similar journeys, restructuring their businesses to reduce costs and making their operations more efficient through technology and artificial intelligence.  While demand for mortgages as well as consumer and business loans has waned, market volatility has spurred activity in trading in capital markets and wealth management.  Scotia, National, TD, CIBC, RBC and BMO all beat expectations as strong wealth and capital market results were the biggest contributors.  But they also continued to cut costs and raise profitability parameters while also maintaining strong share buybacks.  National showed the best cost control and drove their ROE higher, while BMO also showed better numbers in their U.S. operations which allowed them to raise their ROE target.  They all showed slow but resilient loan growth and mixed loan loss provisions.  Scotia and RBC saw small increases in provisions LLP (Loan Loss Provisions) while National, BMO, CIBC and TD all came in lower than expected with provisions in the range of 30-40 basis points.  Either the loan books at the latter four are exceptionally strong or they are not being conservative enough in their provisions.  Looking ahead, however, loan growth could remain soft so the banks with the most upside are the ones who can continue to consolidate recent purchases (i.e. National with Canadian Western Bank, Royal still gaining from HSBC Canada and BMO with better operation profit from U.S. Bank of the West.  Our reason for being significantly underweight the sector currently is simply due to valuation.  Canadian banks are trading at over 14x next 12-month earnings, over 2.2x book value with and only an average 3.3% dividend yield.  In other words, the group looks extremely expensive by historical standards, which is probably why we saw both Scotia and RBC trade down despite the strong earnings beats.  Clearly, ‘good is not good enough’ when valuations are this high!

On the economy, we are getting mixed signals.  While growth in the U.S. is still humming along despite tariffs, we have also seen much slower employment growth and rising geo-political uncertainty.  The most important economic policies (so far at least) are likely to continue to support the recovery: the President wants to “run it hot”.  Fiscal policy remains extremely accommodative, not only in the U.S. but in Canada, Europe and Japan.  This is all being reflected in the stronger performance of cyclical i.e. economically sensitive) stocks in the market and the continued backup in long term bond yields.  Presumed new U.S. Federal Reserve Chief, Kevin Warsh, has argued that we are on the cusp of an historic increase in productivity (led by AI), which will allow the Fed to ease further.  The ‘k-shaped’ economy gets even more bifurcated as the ‘K-shape’ is still intact as retail sales are struggling, even with the high-rollers spending their equity market gains.  The low- and now the middle-class household has pulled back enough that there has been zero growth in real retail sales since June.  Also, the New York Fed’s quarterly report on household debt counters the consensus view that personal balance sheets are squeaky clean and in terrific shape. That is only true for the high-end income cohort. The strains are evident in the late-payment rates, which remain on an upward trajectory.  For the overall household sector, the 90-day delinquency rate climbed to 3.12% from 2.98% to stand at the highest level since COVID-19. Recent consumer sentiment numbers in the U.S. were also illuminating.  To put the 57.3 headline consumer sentiment index (for February) into its proper context, the long-run average of this series is 84.7, so they are still well below that norm.  Not only that, but 57.3 is below the levels that defined nine of the past eleven recessions going back to 1953.  Simply put, consumer sentiment is lower now than it was at both the worst points of the Covid pandemic and the depths of the global financial crisis. No surprise then that the U.S. presidents economic approval ratings have also fallen to new lows!

The soft employment data we have seen over the past year is another worry since it undermines the idea that the consumer can continue to support the overall economy.  We have seen more ‘micro’ evidence recently that AI is having a negative impact on overall employment levels.  Jack Dorsey’s Block announced this week that it is cutting 4,000 employees, reducing its workforce by nearly half, in a move the financial technology firm is describing as a bet on artificial intelligence changing the future of labour productivity.  Dorsey, who was also the founder of Twitter (now “X” and owned by Elon Musk), said in a call with analysts that he believes many companies will ultimately have to make similar moves due to AI.  Block’s cuts are the latest case of workforce reductions across fintech and the broader technology sector, in which companies have pointed to AI as a catalyst, with companies from Amazon to Salesforce citing the technology as justification for shrinking headcounts.

U.S. Growth Projections and the inflation risks.  While we have become mostly immune to ongoing comments, mostly all unsubstantiated, from the U.S. president, the recent claim that the new head of the U.S. Fed will put it in a position to achieve economic growth of as much as 15% seems to be beyond anything remotely possible.  Even in the years following the entry of China into the WTO and their massive industrialization, they were only able to achieve double-digit economic growth for a few years.  The U.S. is a mature economy and unable to grow at such elevated rates.  The only chance to achieve anything close to that number would be if it referred to nominal (not real) growth and would be achieved by having substantially higher levels of inflation from the excessive monetary ease if the new Fed chief does as the president would like.  That is one of the reasons why U.S. long term interest rates remain stubbornly high and gold continues to surge. 

 While the stumbles in the U.S. technology sector have kept the recent performance of that stock market well behind the larger industrialized markets everywhere else, the ‘rest of the world’ stock markets have a lot of catching up to do after the U.S. has outperformed that aggregate for the last 18 years.  Even after the huge recent outperformance of the ‘ex U.S.’ stock market relative to the United States, we would need to see a further ‘doubling’ of these gains before the line reverts to a long-term average.  The falling line on the chart below indicates periods when U.S. stocks outperformed the rest of the world’s markets.  There was an almost uninterrupted move in favour of the U.S. following the 2008 global financial crisis to the end of 2024.  We have doubts though that we are entering another period like 2002-2008, when ex-U.S. markets exhibited better relative strength.  That period coincided with the rampant heaviest growth years in China as they industrialized following their admittance to the World Trade Organization.  That does not seem to be the case going forward now since we are seeing a period of reduced trade and tempered growth expectations from the major industrialized economies.  We see it as more likely that once we’ve finished unwinding the exuberance of the technology trade, that sector will continue to demonstrate the best ongoing growth and that will support continued expansion of the U.S. tech sector.  Bottom line, we do not see the next few years as a repeat of what occurred following the collapse of the first technology bubble in 2001.

The one trend from the past year that we expect to continue is the move away from U.S. assets in general and continued strength in the gold market.  The reason is simple; the U.S. is moving towards a ‘near Banana Republic’ profile in terms of their gross national debt.  With budget deficits expected to remain above 6% of GDP for the foreseeable future, the share of debt to GDP will also continue to rise from the current level of over 120%.  Recall that the financial crises in both Italy and Greece occurred once their national debts cracked through the 130% level, so the U.S. is clearly headed towards that.  While some countries such as Japan (230%) and Singapore (185%) have much higher debt to GDP ratios, they also have substantially higher domestic savings rates, effectively allowing the governments to fund their debt from their own public.  The U.S. has relied much more heavily on foreigners to buy their debt, which also allowed the U.S. to run substantial trade deficits which they offset with capital inflows.  If the unwinding of these debt and equity positions by foreigners continues, then the U.S. dollar will also continue its downward path.  The biggest beneficiary of that trend will continue to be the gold market as foreign central banks diversify their reserve structures.

Despite all these misgivings, the S&P500 remains only about 3% below its all-time high, so clearly, we have not seen any overall panic in the stock market despite the individual stock volatility and heightened sentiment awareness.  In terms of investment strategies in this environment, we have not made substantial changes.  We continue to have ‘slightly below normal’ equity exposure, a slight underweight in bonds and ‘higher than normal’ cash levels.  Biggest overweight sectors continue to be defensive ones such as telecom, energy infrastructure and industrials.  We reduced some positions in long-term U.S. bonds on the rally in the past month, since we expect the inflation numbers to remain stubbornly high and the U.S. administration to continue to try to run the economy ‘hotter’, thus keeping long-term interest rates at elevated levels.  On the stock market, we had reduced technology weights earlier, selling positions in the semiconductor and hardware names.  However, with valuations becoming quite attractive in some software stocks and the longer-term story still intact, we would be looking to slowly add during this ongoing weakness to names such as Adobe, Salesforce, Constellation Software and Shopify as well as some “Mag 7’ names such as Meta, Microsoft, Amazon and Alphabet.  We continue to also see good value in the energy and gold stocks in Canada as well as some of the industrials which will benefit from ongoing infrastructure spending.  This includes names such as MDA Space, CAE Industries, AtkinsRealis and the rail companies.  On the other side, we remain underweight the financials due to both excessive valuations as well as risks from technological disruptions.

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