Portfolio Update

Global equity markets delivered positive returns in July, following a strong first half of the year. Since the start of 2023, returns in our equity portfolios are running ahead of their Canadian and emerging markets benchmarks but slightly behind the international equity benchmark. Over the last twelve months, all mandates have outperformed their benchmark. Year-to-date, the S&P 500 was up 17.2% (total return in C$), while the S&P/TSX rose 8.4%, MSCI Europe 14.5%, MSCI ACWI 14.7% and MSCI Emerging Markets 8.2%.

During the month of July, the Bank of Canada and the U.S. Federal Reserve hiked their respective benchmark interest rate by 25 basis points (bps). With inflation pressures continuing to decline globally, most major central banks have signaled that they are nearing the end of the current rate-hiking cycle. As we detail in our July Economic and Capital Markets Outlook, slowing economic growth is an intended consequence of monetary tightening and an essential development for inflation to return to its target.

Concerns in the Commercial Real Estate Sector

While various assets experienced notable corrections since the period of rising rates began, an area of concern that has recently emerged is commercial real estate, notably office properties. The pandemic accelerated the trend of flexible work arrangements, prompting companies to adopt hybrid or fully remote work models. This has lowered the demand for traditional office space: the vacancy rate in Canada for office space is rising and currently sits at 18.1% compared to about 10% before the pandemic, with similar figures in the US. As property owners face higher financing costs and lower rental income due to under-utilized office buildings, financial services companies face greater risks in their loan portfolios. As part of our discipline and process, we measure this risk and quantify the impact on the liquidity, solvency and profitability levels of the companies we own.

Our Canadian and US bank holdings have loan portfolios that are well-diversified by geography, business and property type. In these holdings, the commercial real estate segment represents, on average, 10% of the entire loan portfolio while the office segment is less than 2%. In the US, regional banks, an area in which we have almost no exposure, hold over 85% of office and downtown retail real estate loans in the banking system.[1] In our April Portfolio Update, we wrote about concerns in the financial system, highlighting that regional banks with a concentrated client base and poor risk management practices are most sensitive to rising rates. Ultimately, we believe these same banks face the greatest headwinds from any weakness arising in the office real estate sector. In addition, office real estate loans of large banks, several of which we own, are concentrated in higher-quality properties for which there remains stable demand. In terms of credit performance, losses for the larger banks have been immaterial, reflecting both the quality of corporate borrowers and low loan-to-value ratios. Nevertheless, Canadian and US banks have been prudently allocating growing reserves to the commercial real estate asset class. For example, Toronto-Dominion Bank, which has considerable US exposure, noted in its most recent quarterly results that it has approximately 2.5 times higher reserves for loan losses for commercial real estate as compared to pre-pandemic levels.

Our analysis leads us to conclude that our bank investments are attractively valued and offer substantial upside over the medium- to long-term. While widespread losses in their real estate portfolio would impact earnings of the banks, we believe the effect on overall profitability would be manageable. These firms are well capitalized and have robust balance sheets comprised of diversified and high-quality assets. Though banks will likely become more conservative in their lending practices, and the prospect of an overall tightening in credit conditions raises the risk of a more pronounced economic slowdown, in our view the Canadian and US financial systems are on a solid footing.

Conclusion

We believe our equity holdings provide attractive growth prospects over the long-term and are well-positioned to address any tremors in the commercial real estate sector. In our August 2022 Portfolio Update, published at a time when recession fears were high, we highlighted the risks of a short-term perspective in investing and the importance of remaining invested through periods of volatility. Investors who exhibited patience in the face of volatility and remained invested through the following year were rewarded. We continue to believe this strategy will benefit investors. Our global equity portfolio trades at an attractive 12.3 times forward earnings and provides a 3.2% dividend yield. Overall, we do not advocate for any changes in asset allocation strategy and are maintaining a tilt towards equities over cash and bonds within balanced portfolios. We remain confident our disciplined investment strategy will continue to contribute to the preservation and growth of your capital.

[1] Board of Governors of the Federal Reserve System; https://www.federalreserve.gov/publications/files/financial-stability-report-20230508.pdf