Rising rates will benefit banks, BMO manager says

Canadian equity team adds to life-insurance holdings.

Diana Cawfield 22 February, 2018 | 6:00PM
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There's no question that rising interest rates will be one of the biggest drivers of the Canadian equity market this year, says Lutz Zeitler, a managing director and portfolio manager at BMO Global Asset Management Inc.

"We're seeing wage growth or wage inflation right now, and that could result in a central-bank action that is much more aggressive than what the market expects," says Zeitler, who heads the Canadian fundamental equity team. "This is the strongest wage-growth data in eight years and that's what's spooked the market a little bit."

Zeitler, based in Toronto, expects that more rate hikes, aiming at controlling inflation, will drive interest rates higher. This, in turn, will determine which sectors will perform well and which won't. Typically, valuations are negatively affected by rising interest rates, says Zeitler, but there are positive aspects as well.

For example, the financials, particularly banks and insurance companies, can profit from rising rates. With 37% of its portfolio in the financial sector, BMO Dividend is well positioned to benefit.

"It's a dividend mandate," says Zeitler, "and when you think about dividends and dividend growth, it's very difficult not to think about the Canadian banks." Currently, the top three positions in the fund are  Royal Bank of Canada (RY),  Toronto-Dominion Bank (TD) and  Bank of Nova Scotia (BNS).

BMO Dividend has always been fairly highly weighted in financials. "The Canadian banks have a spectacular history of growing their dividends," says Zeitler, "and they have a nice yield already." Most important, they meet all his bottom-up, fundamentally driven criteria. Moreover, higher interest rates enable the banks to lend at higher rates. As a result, says Zeitler, their net interest margin expands, and so do their earnings.

The BMO team of four portfolio managers and five research analysts have recently been adding to their holdings in life-insurance companies, which also benefit from rising interest rates. The current largest holding among the insurers is  Manulife Financial Corp. (MFC).

In its overall stock-selection process, the team focuses on sustainable business models with visible growth and recurring revenue streams. They look for companies with below-average volatility of earnings and cash flows during different economic cycles.

For example,  Enbridge Inc. (ENB), currently among the top five holdings, meets the stock criteria. "Enbridge, a big weight for us," says Zeitler, "is an example of getting exposure to the resource sector, energy in particular, without taking on the volatility that is apparent in those sectors."

Zeitler favours Enbridge because it transports commodities rather than producing them, and there is a greater need to move hydrocarbons out of Western Canada. "So I think there's lots of growth opportunities," says Zeitler, "in terms of new projects and pricing." In addition, the company has contracts that boost cash flows, and recurring revenue streams.

According to Zeitler, the price of oil is the other most overriding influence in the Canadian market. Part of the problem with the energy sector is that natural gas and oil production is growing rapidly, but there has not been equivalent investment in pipelines.

"A lack of pipeline capacity in Canada," says Zeitler, "has caused natural gas to be trapped in Alberta, and as a result the price of Alberta's natural gas is significantly lower than its U.S. equivalent." Natural gas has performed very poorly and that has been reflected in the prices of natural-gas stocks, he adds.

Canadian oil companies are facing similar challenges, including pipeline congestion and ongoing political debates over new pipelines. According to Zeitler, Canadian heavy oil is priced at a very deep discount to global oil markets. However it can still be shipped via rail, which is more expensive than pipelines. "It's a very Canadian-centric issue in our resource-heavy index," says Zeitler, "and there's no short-term solution for gas and an expensive stop-gap solution for heavy oil."

"If you dissect the Canadian equity market last year," says Zeitler, "the TSX performance was up about half of what the U.S. market was, or even a little less. If you dissect it a little further though, it was primarily our resource sector which lagged."

To offset the financial and resource-heavy Canadian market, the managers hold U.S. stocks in the mandate. Over the last four or five years the portfolio has moved up from a zero weight to 20% today.

"We (in the Canadian market) don't have a strong information-technology offering," says Zeitler, "and the consumer sectors are quite light. So for those two sectors particularly, we saw a lot of value in the U.S."

Other risk-mitigation measures include an underweight position of about 14% in resources, compared to about 30% in resources for the benchmark S&P/TSX Composite Index.

Beyond the impact of rising interest rates and gas prices, "there are risks of course," says Zeitler, "that will influence the direction of the markets. The clear one we see right now is NAFTA negotiations." Though the fate of the North American Free Trade Agreement will affect the Canadian equity market "it's very difficult to establish in which direction. There's so much politics involved."

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Bank of Nova Scotia65.08 CAD-1.24Rating
Enbridge Inc46.67 CAD0.04Rating
Manulife Financial Corp32.24 CAD-1.16Rating
Royal Bank of Canada130.93 CAD-0.22Rating
The Toronto-Dominion Bank80.61 CAD-0.10Rating

About Author

Diana Cawfield

Diana Cawfield  An award-winning writer who has been a regular Morningstar contributor since 2000, Diana's numerous publication credits include the Toronto StarAdvisor's Edge and Chatelaine, as well as the Canadian Securities Institute's online educational services.

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