March was a turbulent month for equity markets, particularly in the financial sector. Smaller banks experienced significant deposit outflows, three U.S. regional banks closed their doors and UBS acquired Credit Suisse in a forced sale. While Financials returned -7.4% in Canada (in British Pounds), the broader market proved to be resilient with a more modest decline of 1.5%.
Although the banking challenges experienced during March seem to have abated, the outlook for banks remains uncertain. Given the cyclicality of the banking business, the lower a bank’s profitability, the less likely it can absorb higher losses and the impact of those losses almost inevitably encroaches on capital. As a result, banks with low profitability and/or low returns on equity will need to rely on external financing or, as we’ve seen with Credit Suisse, Silicon Valley Bank (SVB) and potentially Deutsche Bank, a bailout is required.
Against this backdrop, the Fund is underweight Financials by approximately 9% relative to the Benchmark. The Fund’s select exposure to Financials is in high-quality Canadian banks which are inherently more stable than their global peers. Canada’s banks benefit from higher levels of profitability and strong capital positions. Between 2017 and 2022, Canada’s banks had an average return on equity of 15.5% which compares to just 5.3% for European banks. The liquidity coverage ratios of Canada’s Big 6 banks range from approximately 120% to 150% which compares to 110% to 120% for the Big four banks in the US. In addition, Canada’s banks pay high levels of dividends which have proven to be very stable historically. Since the second world war, none of Canada’s banks have made a single dividend cut.
The stability of the Commercial Real Estate (CRE) market has also become topical since the collapse of SVB. Most of the concern stems from the office sector, which is estimated to represent approximately 40% of U.S. bank CRE portfolios. Unlike other CRE sectors, operating fundamentals for the North American office sector are weak with vacancy rates near the highs reached during the Global Financial Crisis. In Canada, the national office vacancy rate stands at 17.7%, with downtown Class B space reaching 22.7% in Q1. The Fund does not currently have any exposure to office REITs and we have no plans to step back into the sector even though office REITs are trading at steep valuation discounts.
Notwithstanding the challenges facing office, operating fundamentals across other property types in Canada remain extremely solid. Specifically, industrial, multi-family and grocery-anchored retail are very stable and we expect continued growth in net operating income in 2023. CBRE recently reported that the average market rent growth for Canadian industrial space in Q1 increased 28% compared to last year, with “every market in Canada” posting positive numbers. Demand for multi-family rentals is set to surge amid rising immigration and the high cost of housing facing many Canadians. Retail landlords will also play a key role in providing lower cost housing options through their robust mixed-use development projects. These three sub-industries represent the core of the Fund’s REIT exposure as they offer the most attractive risk/reward dynamic and trade at attractive discounts to underlying value. Canadian REITs are currently trading at a discount to net asset value exceeding 20% on average and valuations are approaching 2020 trough levels — a period when the whole country was locked down. High-quality REITs with rock solid fundamentals and conservative balance sheets look particularly attractive as they are being painted with the same brush as companies with more uncertain outlooks (such as the office sector).
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