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End of road for income trusts?
Income trusts have been roaring in Canada for several years, largely because so much money has been flowing into them from income-hungry old¬er Canadians. A form of investment trust that holds income-producing assets such as real estate, oil and gas, manufacturing operations — or business trusts that include everything from restaurants to greenhouses —and pays a ‘distribution’ or yield monthly or quarterly, income trusts typically feature dis¬tributions that are higher than income-pro¬ducing investment vehicles such as bonds or guaranteed investment certificates. It’s for this reason that thousands of yield-seeking older Canadians have besieged the income trust market for five years as interest rates fell. They needed income and were badly hurt when bond yields dropped more than 50 per cent over the period. So trusts looked like the perfect solution.
But, as Vancouver fee-only investment advisor Adrian Mastracci of KCM Wealth Management suggests, it’s easy to forget that trusts are really equities that rise and fall in value just like any stock which often negates the higher yield benefits. Apparently these risks don’t matter. To income-starved investors, yield numbers such as 10 and 15 per cent look pretty damn good and the herd has stampeded to trusts - the S&P/TSX Canadian Income Trust Index gained almost 80 per cent by March of 2005, but has been slipping ever since. As always, when there is a demand, supply follows: the investment community began forming and selling more and more trusts into this new market until late September, when Finance Minister Ralph Goodale, watching the government’s corporate tax take diminish, began musing about changing the trusts’ tax structure. That may have put a chill on the trust-conversion industry, but hasn’t affected demand much because most unit buyers don’t care about some investment banker’s problem.
For this kind of hot money, another more basic factor has come into play: trusts just aren’t offering such great returns anymore. As Murray Leith, VP at Vancouver brokerage Odlum Brown, puts it, “Income trusts had a hell of a run because interest rates stayed low for so long. But rates have bottomed out and are starting to rise. At the same time trust yields have been falling, so the spread has narrowed. When we see trusts with yields of six per cent and are looking at interest rates of 4.5 per cent, that’s not great poten¬tial. So we think the trust sector will perform only average or worse going forward. It depends on how much interest rates rise.” The hot money, it seems, has cooled on income trusts.
Will energy stocks remain high?
It’s no secret that energy has been the place to be for investors in the past few years, and so consequently has become an ever-growing tub for hot money. Anyone who has pulled up to a gas pump during the past year has probably thought it might be smart to recoup their cash by investing in the companies that produce that gas. The energy industry in Canada generated $53 billion in production in 2002 (when oil was in the US$40-a-barrel range, the last year Stats Canada analysed it). You can bet that was considerably higher in 200$ as hurricanes and other factors, such as the perception that China has insatiable energy demands, pushed the price of oil over US$60 a barrel and generated predictions that it would hit US$100. Since Canada is the largest supplier of oil to America, the world’s biggest energy hog, it’s been a bonanza in the making.
Hot money, which is always sniffing the wind for an opportunity (or threat), caught the scent of creosote-laden cash in the Canadian energy industry and moved in a couple of years ago. The TSX energy index soared nearly 40 per cent in 2005, while Barclays’ iUnits S&P/TSX Capped Energy Index — a handy measure of general investment sentiment regarding a sector — grew by 44 per cent as of November. In fact, by year end, energy stocks made up 25 per cent of the TSX top stocks index — then one that telecom giant Nortel used to dominate.
So, except for the odd dip, the hot money has flowed to energy. Sure sounds like a bubble. But is it? There has been some consolidation in the field but none of the rampant speculation that usually accompanies bubbles. Analysts have issued conflicting reports, and share prices are bouncing like yo-yos, so the big question is: Has hot money flowed out of energy yet; or is it still sitting there like a big gucky tar pit, waiting to trap the unwary? Hard to tell. The conventional wisdom is that Chinese demand for oil will keep prices in the stratosphere. Most hedge funds, those fleet-of-foot ultimate movers of hot money, are still in oil, so that should say something. Also, oil futures traders recently bought options on Athabasca Oil Sands Project 2007-2009 production for more than US$90 a barrel, which should say even more. Currency experts see a Canadian future painted with oil money. Michael Levy, a VP with CustomHouse Currency Exchange, and a regular commentator on CKNW insists the Canadian dollar has become a “petro-currency” and the loonie will soar because demand for petroleum is going to continue to rise.
But the contrarians out there feel that the China syndrome has been overblown, and that high oil prices will have the effect they always have: force consumers and companies to reduce their consumption. It may take a while, but demand will fall, and so will prices. For instance, Leith points out that U.S. oil consumption peaked during the energy crisis of 1978 and took two decades to get back to that peak. Oil is a cyclical commodity it seems, and the cycle always turns — eventually. “The U.S. economy is going to slow because of high energy prices,” Leith says. “That means that eventually, there will be less energy demand in the U.S. Unfortunately, this is not going to be great news for Canada.” Marry that to fears of inflation caused by high oil prices and corresponding action by central banks around the world to fight it, and the picture looks like this: continued short-term action in oil but hurt all around in the long term and, eventually, an end to the oil rush.
How high can the loonie fly?
Remember when the Canadian dollar was really, really sick? AUS$0.65 ‘Northern Peso’ that was the laughingstock and had pundits demanding that we dump the loonie altogether and tie our fortunes to Uncle Sam’s currency? Well, not anymore. The Canadian dollar is now the Western world’s strongest currency. For the past couple of years, the Canadian dollar has been the des¬tination for hot money among the world’s currency traders.
This has occurred, for the most part, because oil prices have risen so dramatically, but also because the U.S. dollar has been in a tailspin for several years. It did gain last year, but the U.S. government has been running up debt — it owes, mostly to European and Asian bondholders, in the neighbourhood of US$8 trillion — and spending like drunken sailors on tax cuts and military forays. Meanwhile, U.S. consumers have been borrowing on the value gained from rising real-estate prices to buy ever-growing piles of consumer trinkets. This accumulated consumer debt now threatens the U.S. economy, because when it exhausts the consumer’s ability to pay it back, there will be a mighty reckoning.
In Canada, however, it’s been party time, especially in the West; because our economic strengths — natural resources such as oil and gas and metals — have the economy roaring. As a measure, Canadian stocks have advanced 70 per cent in the last three years, while in the U.S., they’ve gained a meagre five per cent (in Canadian dollars). That’s drawn foreign money, which converts to loonies and adds demand, which increases the dollar’s value. Couple that with the fact that Canada has been attacking its debt, racking up budget surpluses — sure, it’s all about high taxes, but currency traders don’t care — and generally doing a bang-up job of getting its fiscal house in order, and a stampede starts stirring. According to Levy, the Canadian dollar has been “disconnected” from the U.S. dollar and now stands alone as a destination for currency traders around the world. A handy mirror for this kind of action is the price of gold, which has been on an upward curve for some time and was expected to cross US$500 by the end of last year. Gold is priced in U.S. dollars, and that dollar was de facto being devalued.
All in all, it appears that the hot money has turned the Canadian dollar, in Levy’s words, into the “glamour currency.” And it looks like it will continue to flow that way as long as there’s ‘a demand for energy. Many pundits predict further highs for the loonie, currently hovering in the neighbourhood of US$0.85 (a pretty tidy gain from its 2001 low of US$0.65). In November, BMO Nesbitt Burns was calling for a US$0.87 dollar by the end of 2005, with some slight easing in 2006. “With the winter heating season coming and oil prices still elevated, there is still room for the Canadian dollar to strengthen further,” a Nesbitt report said. So it’s all about the ‘petro-dollar’ and the gamble on whether oil prices will stay high or retreat. The bullish, like Levy, see continued growth. He predicts aUS$0.90 dollar by the end of 2006, and wouldn’t be surprised to see the loonie at par with the U.S. eagle within two years. Odlum Brown is more contrarian: High oil prices always cause recessions, so a slowdown is coming in the U.S., and consequently m Canada, which is so dependent on the price of oil, it says. This means the loonie will probably settle in the US$0.85 range.
Where to stash cash in ’06
When prices climb rapidly, talk turns to bubbles and everybody starts focusing on prices, figuring to get in on a good thing. But remember that guy (me) who bought the Munster Mansion and saw its value soar over nine years? He didn’t exactly make a killing. The Munster Mansion was sold two years ago for $425,000, a $150,000 gain that works out to a 55-per-cent raw return. Although that might sound pretty good, it only works out — if you include costs — to a return of a little over seven per cent a year over seven years, which is hardly an investing home run. The new owners have probably earned a little less than 10 per cent over two years — again, hardly a rocket — but a heck of a lot better than the average real-estate return of about four per cent a year. But that’s how cycles and hot money work: quick, sudden and perilous in terms of timing.
So, now comes the million-dollar question: What’s the next flavour of the month for hot money? When it comes to predictions, of course, you pays your money and takes your chances. But we asked a few experts to go out on a limb and do some forecasting.
- Vancouver financial advisor Adrian Mastracci of KCM Wealth Management sees the beginning of a stampede to the growing private equity market such as venture capital, angel investing, or funds that invest in companies that are held privately and are not listed on stock exchanges. He may have something there: 2005 was a record year for private investing in Canada (about $3.5 billion was raised for buyouts and venture capital investing) and American private financiers moved into Canada by the carload because they saw value in Canadian companies. Also, Canadian pension funds began dabbling deeper into the high-return (but riskier) private investment market in an effort to balance the drop in their income investments. And, the National Angel Organization, a group of early stage private investors, has begun lobbying for tax incentives to pry loose some of the $5 billion in investable money it estimates is held in private hands. Here at home, those incentives already exist in the form of a newly revamped and very popular Venture Capital Corporation program, which offers investors a 30-per-cent provincial tax credit on private investments.
- Murray Leith usually avoids running with the herd, but does watch its movements. Like most contrarians, Leith looks for depressed sectors that might be ready to come back in favour. He thinks he’s found one: large-cap U.S. companies such as Wal¬Mart, Home Depot, Pfizer and Anheuser Busch, all of which have rock-bottom multiples (price-to-earnings ratios) and so are cheap. “The valuations of America’s biggest’ and best companies are a fraction of what they were five years ago and the Canadian dollar has significantly more purchasing pow¬er today, which makes the case for investing in the U.S. market compelling,” he says.
- Everybody is warming up to gold, which languished as hot money chased every¬thing else under the sun. Currently hovering in the US$500 range, gold is at 18-year highs. Although in Canadian dollar terms, the rise has been relatively flatter, gold has apparently detached itself from all currencies and formed its own momentum. Famed Canadian money manager Eric Sprott of Sprott Asset Management, thinks gold is “one of the most promising areas of investment” because it always does well in the financial crises that follow market manias such as the U.S. real-estate bubble. Other forecasters like former Goldcorp chief Rob McEwan believe gold will eventually hit US$850.
- Well-known Vancouver financial advisor Diane McCurdy thinks the next destination in the short term will be nice and simple: cash. Sure, it doesn’t pay more than a couple of per cent but there isn’t much else out there right now that’s attractive to hot-money herds. So they’ll probably park for a while, graze on rising short-term interest rates and wait for their next opportunity.
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