The start of a new rate cycle

Interest-rate-sensitive sectors poised for gains

It’s official. We’re about to embark on a new interest rate cycle, one that will have a profound effect on all investors.

In its latest rate policy announcement, the Bank of Canada served notice it will move in the same direction as the U.S. Federal Reserve Board – a “pause” now, cuts later. Exactly when “later” comes is unclear, but the market is betting on cuts by the spring or summer.

The Fed made its strategy clear at the end of its December meeting. Chair Jerome Powell said that the central bank had decided to stand pat on interest rates, and that led to a further fall in longer-term government bond yields and a rally in bond prices.

The bigger story was the Fed “dot-plot” chart. It showed three anticipated 25 basis point cuts in 2024, bringing the level down to 4.75% by the end of the year.

Investors seemed convinced that the Fed had pulled off the hardest trick in central banking, engineering a so-called “soft landing.” This happens when the economy slows down enough to bring inflation under control without tipping into recession with the attendant job losses and bankruptcies.

Rate cuts for mid-year or later

In fact, so excited were some investors that they have been betting on the Fed to start cutting interest rates in March, just two weeks away. More sober players anticipate the Fed to start cutting by mid-year or the third quarter. The most recent U.S. Consumer Price Index (CPI) and Producer Price Index (PPI) numbers for December showed inflation still running at an annual 3.4% for the CPI and 3.9% for the core CPI, which excludes volatile food and energy prices. That’s nearly double the Fed’s 2% inflation target.

Furthermore, much of the higher-than-expected core CPI was due to prices for services, including shelter, which accounts for one-third of CPI. These rose more than anticipated, while the prices of core goods, such as used cars and apparel, were also higher, despite year-end promotional activity.

Bank of Canada Governor Tiff Macklem, who has been following the Fed’s interest rate decisions both on the upside since early 2022 and now by pausing for the last six months, has held the Bank’s short-term rate at 5%. Canadian businesses are reporting slowing price pressures, and the housing market has weakened. Benchmark house prices are down 13% to $730,400, and housing sales were down by 11.1%, to 443,511 in 2023, the slowest year since 2008. Commentators now expect the Bank of Canada to cut interest rates by as much as one percentage point in 2024.

Rate-sensitive sectors poised for gains

All of this is good news for interest-rate-sensitive sectors such as those with high levels of borrowings. These include utilities, pipelines, telecoms, and REITs. Companies that are regarded as vulnerable to the economic slowdown caused by rising interest rates include financial services, such as banks and insurers.

The central banks have been trying to put the inflation genie back in its bottle for two years, having discovered that it wasn’t as “transitory” as they had thought in 2021. As a result, all of these sectors have been sold down as investors worried about the effect of higher rates on their balance sheets and the sustainability of their dividends, many of which exceeded the yield available on government bonds.

The S&P/TSX Capped REIT Index and the Capped Utilities Index are down 11.9% and 9.4%, respectively, over the last year. Interestingly, the S&P/TSX Capped Financials Index is actually up marginally (2.3%). This may be because investors are now more comfortable with the banks’ ability to withstand the credit losses expected due to a slowdown. While all the big Canadian chartered banks raised their provision for credit losses (PCLs) substantially in their year-end 2023 results released a few weeks ago, all but Scotiabank also raised their dividends, a sign of management’s confidence in the outlook.

The major factor in the banks’ recent improvement in share price performance is the likelihood that they have been overly pessimistic in their provisioning and may be able to write back some of their PCLs this year. Meanwhile, their net interest margin (NIM), the difference between what they pay their depositors and charge their borrowers, has expanded with the rise in the absolute level of interest rates.

Given this background, are there any investment opportunities in the banking sector right now? Let’s look at one of my Internet Wealth Builder selections.

Royal Bank of Canada

Royal Bank of Canada (TSX: RY) is the largest bank in Canada and one of the 10 largest in North America. It has strengths in retail, investment banking, and asset management. It has the largest share of loans in mortgages and corporate lending in Canada, a position that will be strengthened when its $13.5 billion acquisition of HSBC’s Canadian operations closes in March.

Having hit a low of $108 in late October, no higher than its price in 2018, the share price has recovered sharply to $132.99.

In the fiscal year to Oct. 31, RBC had net earnings of $14.9 billion, down 6%. Earnings per share (EPS) fell to $10.50, down 5%. Adjusted net earnings of $16.1 billion were up slightly, and adjusted EPS rose 2% to $11.38.

The results were affected by a $2 billion increase in PCLs, to $2.47 billion, on higher provisions in personal and commercial banking (P&CB) and in capital markets. This represented a 23-basis point (bps) increase to 0.29% of assets from 0.06%. P&CB earnings fell 1% as higher NIM and volume growth in loans (7%) and deposits (8%) were offset by a 1.5% increase in the corporate tax rate and higher staff expenses.

Wealth management earnings fell 24% on higher staff costs and investment in its U.S. subsidiary, City National Bank, as well as higher PCLs. Insurance earnings fell 6%, while capital markets earnings rose 24% on higher corporate investment banking and global markets. Its Brewin Dolphin acquisition in 2022 made it one of the three largest asset managers in London.

Return on equity (RoE) fell to 14.2% and adjusted RoE to 15.4%. Common equity tier 1 ratio (CET1) rose 190 bps to 14.5%.

RBC increased its quarterly dividend by $0.03 (2%) to $1.38, equivalent to a 4.2% yield.

With interest rates due to fall this year, the worst of increased PCLs is behind us. The benefits of the HSBC Canada acquisition will add 2% to RBC’s share of the Canadian banking market.

RBC remains a Buy for its market leading position and strong growth in loans and deposits as well as in asset management.

Gavin Graham is a veteran financial analyst, money manager, formerly Chief Investment Officer of BMO Financial, and a specialist in international investing, with over 35 years’ experience in global investment management.

Notes and Disclaimer

The commentaries contained herein are provided as a general source of information, and should not be considered as investment advice or an offer or solicitations to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Investors are expected to obtain professional investment advice.

The views expressed in this post are those of the author. Equity investments are subject to risk, including risk of loss. No guarantee of performance is made or implied. The foregoing is for general information purposes only. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.

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