Alitis Investment Update

June 9, 2020: No doubt about it… it’s been a tough year for investments! Nevertheless, Alitis’ conservative stance and allocation to private investments has resulted in our various investment solutions holding up well during these adverse conditions. It has been a couple months since COVID-19 had its significant impact on the markets, so an update on Alitis’ investments is due. Generally speaking, the public stock and bond markets have bounced back quite nicely since their lows in late March, which has resulted in very solid returns for Alitis’ Investment pools:

 

Time Period

Weekly Funds (Class E Units)

March

April to June 5

Year-to-June 5

Alitis Strategic Income Pool

-5.41%

+4.18%

+0.14%

Alitis Income & Growth Pool

-9.00%

+6.93%

-2.61%

Alitis Growth Pool

-9.79%

+10.40%

-4.47%

 

Time Period

Monthly Funds (Class E Units)

March

April & May

Year-to-End of May

Alitis Private Mortgage Fund

-2.68%

+2.27%

-0.22%

Alitis Private REIT

+0.17%

-0.47%

-0.43%

Alitis Private Real Estate LP

+0.14%

+0.16%

+1.56%

The following provides further information on the strategies that we employed, as well as, what we see as we look ahead:

Fixed Income

Our fixed income strategy has been to add different types of alternative fixed income investments as a means to increase returns, enhancing the relatively low yields available on traditional fixed income. The events in March did not work out well for the leveraged long/short investments and hurt our fixed income strategy but since then, these strategies have recovered significantly as central banks around the world stepped in to calm the bond markets. Now as of June 5th, the Alitis Strategic Income Pool was positive for the year.

Looking ahead:  We expect that central banks will continue to support bond liquidity which should be positive for most types of fixed income for the short to mid-term. As we look further ahead, we believe that continued low yields and the stabilization of the corporate/high yield side of the fixed income market will lessen the upside for fixed income. In this case, the Alitis Income & Growth Pool will likely shift from fixed income to stocks as the year progresses, as there will likely be more upside available in stocks.

Mortgages

A major aspect of our mortgage strategy is to shift between the private and public markets as the relative valuations change. Private mortgage investments generally have a stable net asset value price whereas public mortgage investment corporations (MICs) can trade at a premium or discount to net asset value. Through the end of 2019 and the beginning of 2020, we were reducing our public MIC exposure as values increased. After the market collapse, we once again become buyers as the expected public MIC return is greater than that of the comparable private mortgage investments.

Looking ahead:  We still expect to see some higher returns on public mortgages as prices increase. This will help to counter the slightly lower returns we expect on private mortgages – as these investments have generally increased their reserves for loan losses, which effectively lower their yields. We anticipate seeing a positive return for the year.

Stocks

Going into the market decline, Alitis’ equity strategy was quite conservative. The Alitis Income & Growth Pool held the minimum amount to stocks and the Alitis Growth Pool was only about 50% exposed to stocks. As such, the downside due to stocks was much less than the overall markets. Subsequently, stocks have recovered nicely with Alitis’ strategy doing rather well since the beginning of May.

Looking ahead:  Although the stock markets have been great for the last few weeks, we expect to see volatility, likely for the remainder of the year. That being said, we expect to see more upside to stocks relative to bonds/cash and will slowly allocate more to stocks as the year progresses.

Real Estate

Most of the real estate holdings in our investment pools are private. With the private market essentially frozen (no transactions), there is uncertainty on the impact of COVID-19 to valuations. To be conservative, we had been adjusting our valuation metrics (increased vacancy expectations and capitalization rates) which has generally resulted in lower expected completed project valuations; however, these adjustments have been offset by construction progress which have increased the current fair market value of the properties. Thus, we have built in a valuation buffer for when the multi-residential apartment real estate market thaws. After the market declines, we added our first public real estate investments in many years as the valuations were rather compelling. So far, these additions have paid off nicely.

Looking ahead:  Alitis almost exclusively invests in residential multi-family housing which is regarded as the safest category of real estate. initial reports indicate that the vast majority of tenants are paying their rent with collections >96% – a very good sign. As well, mortgage borrowing rates have dropped significantly which makes owning an apartment building more profitable. This means that the value of multi-family apartments could increase as they would be more profitable to operate. We continue to be active in our search for new investment opportunities.

* * * * *

Thank you for taking the time to read this update and if you have further questions, please feel free to contact your adviser.

Sincerely,

Alitis Investment Committee

Mitchell Prothman, Todd Blaseckie, Thomas Nowak, Kevin Kirkwood

 

Disclaimer 

This report is provided, for informational purposes only, to customers of Alitis Investment Counsel Inc. (“Alitis”) and does not constitute an offer or solicitation to buy or sell any securities discussed herein to anyone in any jurisdiction where such offer or solicitation would be prohibited. Opinions expressed in this report should not be relied upon as investment advice. This report does not take into account the investment objectives, risk tolerance, financial situation or specific needs of any particular customer of Alitis. Each individual’s investment objectives, risk tolerance, financial situation and specific needs should be evaluated before making any investment decision.

Unless otherwise noted, the indicated rates of return are the historical annual compounded returns for the period indicated, including changes in security value and the reinvestment of all distributions and do not take into account income taxes payable by any securityholder that would have reduced returns. The investments are not guaranteed; their values change frequently and past performance may not be repeated. Unless otherwise noted, risk refers to the annualized standard deviation of monthly returns for the period indicated.

The information contained in this report has been drawn from sources believed to be reliable, but is not guaranteed to be accurate or complete. Alitis assumes no duty to update any information or opinion contained in this report. Neither Alitis nor any director, officer or employee of Alitis accepts any liability whatsoever for any errors or omissions in the information, analysis or opinions contained in this report, nor for any direct, indirect or consequential damages or losses arising from any use of this report or its contents.

Everything is Changing…Evolving Amidst COVID-19

May 27, 2020: The coronavirus pandemic has crossed 5,700,000+ confirmed cases and claimed 355,000+ lives worldwide1, and a significant amount go uncounted as well.2  The loss of lives is devastating. The ripple effects of this virus have started to impact most, if not all, sectors of the economy.

At Alitis, one tool we consider often is the use of scenario analysis. How would an investment have done in a historical market crisis? Understanding how different investments react in each event is a key part in building a portfolio that is resilient across the entire market cycle.

There are a few key historical events that are typical for investors to consider and they all have earned monikers over the years: The Global Financial Crisis of 2007-2008, the Tech Bubble of 1999-2000, the Asian Crisis of 1997, and the list goes on. We believe that the COVID-19 pandemic is already earning its place in this list of scenarios that have made a mark on the investment markets for years to come, and it is still in the early stages of developing.

In this time of flux, it is important to consider the impact and outlook on some key sectors. How these sectors adapt over the next couple of years will have a significant impact on national economies, international relations, and each of our lives. We at Alitis use our outlooks to actively manage our clients’ asset allocations and cash positions. This is part of our prudent approach to realize target returns with a risk level that is lower than our market benchmarks.

A is for Airlines

Carriers worldwide are facing a dire collapse in demand for flights as governments restrict travel and consumers heed warnings to stay home. Air Canada was one of the best-performing companies in the Canadian stock markets with strong fundamentals for the decade that ended on Dec 31st, 2019. The airline expects the impact of the virus to last for at least three years and predict large job cuts as it hunkers down to survive “the darkest period ever” for the industry. Air Canada is down 68% this year (as of May 12, 2020).

Airline carriers south of the border have used terms like “apocalyptic” and “unprecedented” to describe their outlook. There are rising concerns that one or more airline companies in the United States will fail as the COVID-19 pandemic all but erases demand for flights.

Graph 1: YTD drop in stock prices of Air Canada, United Airlines, Delta Airlines and American Airlines as of May 20, 2020

Source: Bloomberg

E is for Energy

It’s hard to talk about Canadian investment markets in general without discussing oil. Energy makes up almost 14% of the S&P/TSX Composite Index, and oil is a major employer and contributor to the economy. Oil prices have plummeted in recent months, as COVID-19 caused a huge drop-off in demand for energy, and the pandemic has hit North America just as Saudi Arabia and Russia started a price war to gain world market share. Last month, for the first time in history, global crude contracts slipped into negative territory as demand collapsed due to the COVID-19 pandemic, while supply stayed steady which led to an unprecedented storage shortfall.

To add to this, the Canadian energy sector was dealt a major blow when the world’s largest sovereign wealth fund decided to divest from four Canadian oil companies, citing “unacceptable greenhouse gas emissions”.3

Canadian energy companies are in capital preservation mode announcing capital spending cuts, employee layoffs, and lowering executive pay. The federal financing relief package for large Canadian companies was applauded and welcomed with open arms. There has been some price recovery in the last month, but the truth remains that the prices we are seeing today are by no means close to profitable for the industry. The reopening of any number of battered economies across Asia, Europe, and the Americas will be difficult and could be set back at any moment by the second wave of COVID-19 infections. The enthusiasm for cutting production shown by U.S. shale companies or OPEC+ could weaken.

Bottom line: It will take a long time for demand to recover fully and most likely won’t be until we have a vaccine.

Graph 2: WTI Crude Futures drop in mid-April 2020 and recovery over the last month 

Source: Nymex

F is for Financials

Canada’s largest banks hold more capital entering the COVID-19 pandemic than they did entering the global financial crisis in 2008. Banks in Canada have stepped up to help our country work through these difficult times and have launched comprehensive programs to make a positive difference for those who need their help and support. They are working directly with individual and small business customers to create tailored support plans to manage financial uncertainty and build a bridge to a strong future.

But as the recovery is expected to be a long and slow process, even the big banks will experience one or more of these challenges:

  • Non-performing loans will surge as consumers and businesses are unable to make loan payments
  • Rate cuts, as well as a collapse in demand, will have a top-line impact causing revenues to decrease
  • Restrictions on personal interactions will push customers toward digital channels for service and sales
  • Misaligned revenues and cost will require banks to improve operational flexibility and rethink short-term priorities

To add to this is the geographic exposure that each bank has outside Canada – including the United States, Brazil, Asia, or Europe.

Graph 3: YTD drop in stock prices of the top 5 Canadian Banks as of May 20, 2020

Source: Bloomberg

T is for Technology

The COVID-19 pandemic has revealed the extent to which we rely on technology and how it has become integrated with almost every facet of the economy and our lives. We have seen technology applied to keep “business as usual”, to replace normal social interactions and to be mobilized for good to fight the COVID-19 pandemic.

The effects of COVID-19 are having a significant impact on the technology sector, affecting raw materials supply, disrupting the electronics value chain, and causing an inflationary risk on products. More positively, the disruption has caused an acceleration of remote working, a rapid focus on evaluating and de-risking the end-to-end value chain.

Hardware, Software, IT Services, Semi-Conductors, and Network Equipment – all these technology sub-sectors have been forced to evolve to this new paradigm shift.

The delayed launch of new smartphones, increased demand for remote-working technologies, a surge in security software demand, delay in supply of raw materials, and need for ever-faster access to date and automation are just a few of the many impacts on the technology sector.

Technology will continue to play a major role in the COVID-19 pandemic. Each organization will be impacted differently based on several factors. This situation could play out for technology broadly in two waves: the current, more significant wave, that has direct consequences due to the pandemic and self-isolation measures, and a future change in the way consumers and companies interact with technology.

Graph 4: YTD drop in stock prices of Apple, IBM, Intel Corp, Alphabet and Microsoft as of May 20, 2020

Source: Bloomberg

At Alitis, we do not tend to trade sectors, or the individual stocks mentioned in this article directly4. However, we do make a point to stay informed and follow the markets, as ripple effects will impact all asset classes. If you are interested in a more thorough report of our broad economic outlook and Alitis Pools’ current investment strategy, check out this post from the end of April written by Kevin Kirkwood, our President & Chief Investment Officer.

The number of moving pieces during this pandemic is akin to a forest fire. There is no model that can predict exactly how every individual flame will burn. Even if such a model were built, the wind could change a moment later and throw it askew. In our case, the collective actions of governments, businesses, and citizens provide gusts of policy and action that can be as unpredictable as the wind.

However, we are not lost in the blaze. We can start by carefully studying the results we have from experience and history. We can adapt to the knowledge we gain at each turn. We can examine options and make predictions with the information we have available. We can respectfully balance empiric information with theoretical approaches, keeping our long-term goals, targets, and values in mind.

We will get through this period. There may be a “new normal” that we must adjust to, and some regions/sectors/asset classes may be in better shape than others. What will not change is our dedication to our process and our continued determination to strive for excellence in everything we do for our clients.  In the words of Michael Jordan, “Obstacles don’t have to stop you. If you run into a wall, don’t turn around and give up. Figure out how to climb it, go through it, or work around it.”

Thank you for your trust in Alitis.

Sincerely,

Apurva Parashar, MBA, CAIA, CIM

Chartered Investment Manager

Thomas Nowak, BComm.
Research Associate

References

  1. https://www.worldometers.info/coronavirus/
  2. https://www.reuters.com/article/us-health-coronavirus-global-cases/global-coronavirus-cases-surpass-3-5-million-amid-underreporting-fears-idUSKBN22G00Z
  3. https://business.financialpost.com/commodities/energy/why-the-worlds-largest-sovereign-wealth-funds-divestment-from-the-oilsands-could-trigger-a-bigger-fund-exodus
  4. Alitis Investment Counsel is a registered Investment Fund Manager and Portfolio Manager in British Columbia, Ontario & Quebec, and is a registered Portfolio Manager in Alberta, Saskatchewan & Manitoba. Alitis manages money through the use of mutual fund trust structures (the “Alitis Pools”) that may hold direct or indirect positions (including both long and short positions) in the individual sectors or stocks mentioned in this article. At the time of writing, the Alitis Pools did not hold any direct positions in the sectors or securities mentioned in this article. This article is not to be considered as specific investment advice or as a specific investment recommendation.

Disclaimer 

This report is provided, for informational purposes only, to customers of Alitis Investment Counsel Inc. (“Alitis”) and does not constitute an offer or solicitation to buy or sell any securities discussed herein to anyone in any jurisdiction where such offer or solicitation would be prohibited. Opinions expressed in this report should not be relied upon as investment advice. This report does not take into account the investment objectives, risk tolerance, financial situation or specific needs of any particular customer of Alitis. Each individual’s investment objectives, risk tolerance, financial situation and specific needs should be evaluated before making any investment decision.

Unless otherwise noted, the indicated rates of return are the historical annual compounded returns for the period indicated, including changes in security value and the reinvestment of all distributions and do not take into account income taxes payable by any securityholder that would have reduced returns. The investments are not guaranteed; their values change frequently and past performance may not be repeated. Unless otherwise noted, risk refers to the annualized standard deviation of monthly returns for the period indicated.

The information contained in this report has been drawn from sources believed to be reliable, but is not guaranteed to be accurate or complete. Alitis assumes no duty to update any information or opinion contained in this report. Neither Alitis nor any director, officer or employee of Alitis accepts any liability whatsoever for any errors or omissions in the information, analysis or opinions contained in this report, nor for any direct, indirect or consequential damages or losses arising from any use of this report or its contents.

Electronic Signatures at Alitis

Alitis is excited to announce that we can now accept electronic signatures on most Alitis account forms using the DocuSign platform. While we love to meet our clients in person, the social distancing measures in place for the foreseeable future mean that most of our client meetings will occur by phone or video conference. Offering electronic signatures will allow us to continue to open new accounts and make changes to your existing accounts, if necessary. We have created an FAQ section below to provide further information and details.

What is an electronic signature?

Electronic signatures allow you to legally sign documents and replace paper-based handwritten “wet” signatures.

Are electronic signatures legally binding?

Yes, electronic signatures are valid and legally binding in Canada.

What are the benefits of electronic signatures?

Electronic signatures allow clients to quickly and easily sign Alitis forms at anytime, from anywhere in the world. Electronic signatures also reduce the use of paper and envelopes making it an environmentally friendly way to process documents.

What is DocuSign?

DocuSign is an American company headquartered in San Francisco that provides a secure method of sending client documents to obtain electronic signatures. DocuSign was founded in 2003 and is one of the leading e-signature providers in North America. DocuSign is widely used in the real estate industry so if you have bought property in the last five years you may be familiar with the platform.

How will Alitis use DocuSign?

Alitis plans to use DocuSign in order to facilitate the collection of client signatures required on Alitis forms. The documents will be delivered via email, electronically signed by clients, and automatically returned to the Alitis team for processing.

Will all Alitis forms be signed with DocuSign?

Most Alitis forms that require client signatures can be signed with DocuSign, however there are a few exceptions. For example, forms that designate an account beneficiary or make changes to a beneficiary will still require a wet signature.

Will all clients need to use DocuSign?

DocuSign will be optional for all clients. While we expect most clients will enjoy the quick and efficient collection of signatures that DocuSign provides, we will be more than happy to collect paper-based signatures upon request.

Are electronic signatures secure?

Electronic documents signed using the DocuSign platform are encrypted and tamper evident. A Certificate of Completion is provided for all documents which provides an audit trail of the process including who signed and when. More information about the security of DocuSign can be found here: https://www.docusign.com/trust/security

Will I need to create a DocuSign account?

There is no requirement to create a DocuSign account in order to sign Alitis documents. You may be given the option to create an account, however it is not required.

What if I need assistance signing the document electronically?

The Alitis Team will always be available to assist with electronic signatures. Please don’t hesitate to contact us at 1-800-667-2554 for assistance.

To download the guide, please click here.

5 Categories of Tax Planning

As we come to the end of another tax season, which is tough to admit given all the extensions, we’d like to return to some of the basics of financial planning and the value that your Alitis Wealth Management Team provides through 5 categories of tax planning:

  • Income Deferral
  • Income Splitting
  • Income Spreading
  • Tax Sheltering
  • Tax Credit/Deduction Maximization

The objective of good tax planning is to structure your affairs in a legal fashion to minimize the amount of tax you pay. While there isn’t enough space in this article to go through the detailed specifics of good tax planning, know that there is a team of professionals that are always looking for opportunities to create efficiencies and savings in your planning and, ultimately, to maximize your wealth.

As a review, Canada’s tax system is based on a graduated system meaning that as your taxable income climbs into the next bracket those dollars will be taxed progressively higher rates. The following chart illustrates these brackets in BC for 2020.

Combined Federal & Provincial (BC) Personal Taxes  – 2020 Tax Year1

Income Deferral

Income deferral is the first tax planning strategy that we consider. Given the choice of paying a tax bill today or in the future when you may be in a lower tax bracket, which would you choose? Unsurprisingly, most of us would defer the tax bill for as long as possible to take advantage of being in a lower tax bracket. Programs like Registered Retirement Savings Plans (RRSPs) fit into this category. In some cases, it may be best to defer converting your RRSPs over to a Registered Retirement Income Fund (RRIF) until it is mandatory, which is December 31st of the year you turn 71.  There are situations when earlier, gradual withdrawals will lead to a lower overall tax cost. This is a calculation we factor in when completing our Retirement Income Projections and finding the optimal balance between paying taxes today and throughout your retirement. The new 2020 COVID-19 provisions to reduce mandatory minimum RIF payments by 25% is another strategy to consider for tax deferral.

Income Splitting

Income splitting is when we look for opportunities to ensure that each dollar earned within a household is taxed at the lowest marginal rate. Because of our graduated tax system, it is more beneficial for two people to have incomes of $50,000 each than to have one spouse at $70,000 and the other at $30,000. For retired couples, income from sources such as CPP, pension income, RRIF, LIF, annuities, and joint investment accounts can be shared to ensure that as a household, you are paying the least amount of tax possible. For couples in their accumulation years, strategies such as TFSAs, prescribed rate loans (a legal way to shift income from one spouse to the other), spousal RRSPs, or having the spouse with the higher income cover household expenses and the spouse with the lower income invest are useful tactics for this life phase.

Income Spreading

Investments produce one of three types of income: interest, dividends, or capital gains. The objective of our team is to place your investments in the proper investment vehicles for the greatest tax efficiency through income spreading. The most highly-taxed form of investment income in taxable accounts is interest, as all of it is taxed at one’s top marginal rate. Eligible dividend income from Canadian corporations receives favorable tax credits and is often taxed at the lowest rate and can result in a negative tax rate by shifting the dividend tax credit to offset other income at the lower income brackets. And finally, capital gains in which you are taxed on 50% of your gain when the gain is realized. For example, generally you’d place your interest generating investments in a registered account such as an RRSP and your dividend-producing and capital gains generating investments in your non-registered, taxable, personal or corporate account. Two levels of tax saving occur with this planning:

  1. Immediate annual tax savings on the taxable (Cash) account because you’ve now allocated 100% of the eligible dividend income and capital gains in the Cash account.
  2. Lower tax on withdrawals and terminal taxes (when you pass) in the RRSP/RIF/LIF account because this taxable account only grew at 3-4% while the Cash account hopefully grew at 7-10%.

Tax Sheltering

The fourth tactic of good tax planning is to make full use of all available tax shelters to eliminate the effect of income on investments altogether. In 2009, the federal government introduced Tax Free Savings Accounts (TFSAs) and since that time we have used these accounts as an effective tool to shelter all the gains from tax and to shift the least efficient/high income (income spreading) producing investments to these accounts.

Assuming you were 18 in 2009, your total TFSA contribution room in 2020 would be $69,500. If your TFSA is fully funded and you’re looking for another tax shelter where investment earning might grow tax-free, a lesser known strategy that is often overlooked is permanent life insurance. In fact, life insurance can be a highly effective vehicle to deposit savings that can compound tax-exempt and build a considerable capital value that can be gifted to another family member or charity without any tax payable by them, the beneficiary.  Families with surplus cash flow or investment accounts can reallocate some of these taxable investments to a tax-free permanent insurance strategy that will still earn a competitive return on par with a taxable, balanced portfolio. Permanent life insurance has some similar features to a TFSA and without any annual limits; this is using life insurance as a pure investment strategy and not for family protection. The earlier you start a plan, the lower the internal cost of insurance, making the plan compound even more effectively.

Tax Credit/Deduction Maximization

Finally, we look to help you maximize available tax deductions and credits and understand the difference between these. A tax credit reduces the amount of tax owing and a tax deduction reduces the amount of your gross income that is subject to income tax. For those still immersed in their working years, maximizing your RRSPs provides a deduction that will save you money on your income tax by deferring tax at your top marginal tax rate.

Refundable tax credits are paid to anyone who qualifies for them, whether they had income or not with the most well-known being the GST/HST payment. Additionally, there are non-refundable tax credits such as Age, Pension Income, Disability Amount, Medical Expenses, Charitable Contributions, etc. that are available depending upon the phase of life you are presently in and your personal circumstances. For individuals seeking the tax and social benefits of donating to charities, it is advisable to check CRA’s website to ensure that the charity of choice is a “qualified donee” prior to making that gift and talk to your adviser and accountant to ensure that the gift is structured in the most efficient and meaningful way.

All the above illustrated examples showcase the various possibilities that an individual or a household can undertake to pay less tax. These legal tax strategies offer ways to increase after-tax returns simply by paying less tax. As your Alitis Wealth Management Team, we invite you to be curious at your next review and ask us if you are taking full advantage of the many strategies that exist for you to reduce your taxes now and in the future.  And, rest assured that as students of our industry, we continue to seek out ways to enrich your planning. This is the Alitis way.

Sincerely,

Shawn Fetter, CFP, CLU
Senior Financial Planner
Wealth Service Coordinator
Alitis Investment Counsel

Insurance Adviser
Alitis Insurance Services

Cecil Baldry-White, CIM, CFP
CEO
Portfolio Manager
Alitis Investment Counsel

CEO
Managing Director
Alitis Insurance Services

References

  1. Combined Federal & Provincial (BC) Personal Taxes; https://www.taxtips.ca/taxrates/bc.htm 
  2. Marginal tax rate for capital gains is a % of total capital gains (not taxable capital gains)
  3. Marginal tax rate for dividends is a % of actual dividends received (not grossed-up amount)
  4. BC Budget 2020 proposed the addition of a new high tax bracket for taxable incomes over $220,000 as reflected in the table. All budget proposals are subject to legislative approval. Bill 4, Budget Measures Implementation Act, 2020 was tabled on February 18, 2020 and passed first reading.

Disclaimer 

This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

Opinions expressed in this report should not be relied upon as investment advice. This report does not take into account the investment objectives, risk tolerance, financial situation or specific needs of any particular customer of Alitis. Each individual’s investment objectives, risk tolerance, financial situation and specific needs should be evaluated before making any investment decision.

The information contained in this report has been drawn from sources believed to be reliable but is not guaranteed to be accurate or complete. Alitis assumes no duty to update any information or opinion contained in this report.  Neither Alitis nor any director, officer or employee of Alitis accepts any liability whatsoever for any errors or omissions in the information, analysis or opinions contained in this report, nor for any direct, indirect or consequential damages or losses arising from any use of this report or its contents.

Market Outlook and Investment Strategy

It has been about six weeks since much of the world went into lockdown to stop the spread of COVID-19. While things are certainly not normal, it would seem like we have adapted to the new reality and are doing as much as we can to slow the spread. From an investment perspective, it also gives us the opportunity to shift from managing the immediate crisis to looking forward and gaining some perspective on how this new reality will affect Alitis’ investments.

It is only in the last few weeks that estimates of the economic impact of COVID-19 have started to appear. Regardless of the source, all these analyses are trying to make some estimates around the three main drivers of economic impact:

  1. How deep is the disruption?
  2. How long will the disruption last?
  3. How fast will the economy recover?

We simply do not know the answers to these questions, nor will we until after the fact. However, the one thing that must happen to get back to normal is for the COVID-19 virus to stop spreading, and that will require a vaccine, a good proportion of the population to be immune, or proof that another approach works. Most likely, we will need to wait until a vaccine is developed and that appears to be at least a year away.

We will not know what the right course of action would be until this is all behind us, but the rest of this report is a very high-level view of our expectations, the implications for investments, and our likely strategy in navigating this situation.

Likely Scenarios Regarding the Spread of COVID-19

The one nice thing about living in British Columbia is that the government and health officers appear to have been ahead of most others in North America in preparing for COVID-19; controlling its spread through active measures and preparing for the lifting of some of the restrictions that we have all had to endure. As well, they have been forthcoming with information based on reasonable assumptions, estimates, and models. On April 17, an excellent report entitled “COVID 19: Where we are. Considerations for next steps”1 was released. The report gave many of the usual statistics, but the most useful information started on slide 30 which outlined their next steps and scenarios going forward.

In slide 32 of this document, the stated goal for the government is to “control transmission and growth in new cases while monitoring and minimizing unintended consequences of necessary public health measures.”  There are many unintended consequences, but the most obvious one being referred to are the economic consequences. Slide 34 shows one model that relates the expected number of patients in critical care to the strictness of social distancing measures in place as time progresses. As we have heard repeatedly in the news, there is a limited supply of critical care beds available, so keeping well below this limit is a primary consideration. The chart below shows some of the expected outcomes (I have annotated the lines to the right with my interpretation, so it is easier to understand):

According to this chart, we are presently at about 30% of our normal contacts due to all the social distancing requirements that are presently in effect. If we returned to normal, or even 80% of normal, the number of critical care patients would soar and soon overwhelm the health care system. Obviously, this is not a reasonable option. However, their model does seem to indicate that 60% of normal contacts is likely sustainable. Given a chart of this nature, it would appear that the BC government is in the process of reducing social distancing restrictions, but it is also clear that it will not be a return to normal or close to normal. Restrictions of some sort will likely remain in place until a vaccine has been developed and we will have to wait a few more weeks to see what restrictions will be lifted by BC’s health officers and the provincial government.

Economic Impact

If we assume that the BC model, or something similar, will be used in other areas of the world, it is reasonable to assume that the largest impact to the economy is occurring now in the second quarter of 2020 (Q2F) and that the situation will improve as restrictions are eased. Given that some restrictions are going to be in place until a vaccine is ready for use in (hopefully) a year, it is also reasonable to assume that the economy will take somewhat longer to return to its previous high that occurred at the beginning of 2020. Perhaps two years from now, in the second quarter of 2022, the economy will have fully recovered, and this appears to be the expectation of some of the big banks in Canada who have recently released their GDP growth forecasts:

Canada – Expected Change in GDP (%)2

Q1F Q2F Q3F Q4F 2020F 2021F
Royal Bank -4.0 -32.0 20.0 8.0 -4.9 3.4
Scotiabank -10.1 -43.9 21.3 17.8 -9.1 6.5
TD -9.7 -42.0 32.6 15.8 -7.5 7.3
CIBC -10.2 -40.5 33.4 18.5 -6.9 6.8
Average -8.5 -39.6 26.8 15.0 -7.1 6.0

United States – Expected Change in GDP (%)

Q1F Q2F Q3F Q4F 2020F 2021F
Royal Bank -3.0 -35.0 10.0 20.0 -5.5 5.1
Scotiabank -7.5 -39.0 25.9 16.3 -6.3 7.0
TD -4.2 -41.4 25.1 16.1 -6.2 6.6
CIBC -5.8 -39.4 25.8 12.3 -6.2 7.0
Average -5.1 -38.7 21.7 16.2 -6.1 6.4

The numbers indicate that these banks, on average, expect the Canadian economy to shrink by 7.1% in 2020 while the US is expected to shrink by 6.1%. This is not going to spread out evenly, as the decline in this current quarter is expected to be almost 40% on an annualized basis. (Do note that all the quarterly results are presented on an annualized basis which makes for much larger numbers, particularly in extreme situations like we have right now.)

On a global scale, the International Monetary Fund released its forecast of GDP growth, which shows a similar pattern, although not as steep of a drop and not as fast of a recovery:

Global – Expected Change in GDP (%)3

2019 2020F 2021F
World 2.9 -3.0 5.8
Canada 1.6 -6.2 4.2
US 1.7 -5.9 4.7
Euro Area 1.2 -7.5 4.7
UK 1.4 -6.5 4.0
Japan 0.7 -5.2 3.0
China 6.1 1.2 9.2
India 4.2 1.9 7.4
Latin America 0.1 -5.2 3.4

It is not a pretty picture. Except for China and India, most economies around the world are expected to shrink in 2020. However, there is some good news contained in these numbers. As shown in the first two tables above, it is expected that the pain will end in the second quarter and then turn to improvement thereafter.

To minimize the economic downside and help to ensure a recovery, governments around the world are sending vast sums of money to their citizens and businesses. In conjunction, central banks are pumping money into the financial system by buying a variety of bonds, mortgages, and other types of fixed income assets. Governments and central banks are buying time to help their economies survive as well as possible until a vaccine is developed for the virus. The following table, from the International Monetary Fund, shows how government deficits are expected to explode this year which will result in government debt increasing:

Expected Government Deficits and Debt as a Percentage of GDP (%)4

Government Fiscal Deficit Government Net Debt
2019 2020F 2019 2020F
World -3.7 -9.9 69.4 85.3
Canada -0.4 -11.8 25.9 40.7
US -5.8 -15.4 84.1 107.0
Euro Area -0.7 -7.5 69.1 81.3
UK -2.1 -8.3 75.5 85.9
Japan -2.8 -7.1 154.3 168.9
China -6.4 -11.2
India -7.4 -7.4
Latin America -4.0 -6.7 45.3 51.7

Given the current unprecedented situation, governments have little option but to borrow and spend money to avoid an economic disaster. For Canada in 2020, government deficits are expected to approach 12% of GDP and increase Canada’s net debt by almost 15% of GDP. If this was a one-time event it would not be much of a concern, however, the longer-term issue is that deficits are likely to continue for some years which will result is even more debt being accumulated. If debt is used for productive uses within the economy then this course of action may be sustainable; if, however, it is simply paid out with no productive use – just to help people and companies survive – then the longer-term implication may be the return of inflation. Inflation is not an issue now, but it is a concern for the future and one that we will be keeping an eye on.

Eventually, debts need to be repaid and that will involve generating a fiscal surplus rather than a deficit. Two options are available – raise taxes or cut spending – and it is likely that a combination of the two will occur. Canada has been through this before when it had accumulated a significant debt through to the early 1990s that needed to be paid down. Much of this was accomplished by not indexing government payments to the rate of inflation. As such, revenues increased as taxpayers slowly moved up to higher tax brackets while expenses grew at a rate that was less than the rate of inflation. The net effect was that the budget deficit slowly turned into a surplus thanks to inflation. Expect this playbook to be dusted off and put to use once the economy has recovered.

Political Considerations

In times of crisis you get to see the true nature of our elected leaders and of our friends around the world. It has been quite comforting and reassuring that, for the most part, Canadian political leaders have followed the advice of health officers and acted fairly uniformly to contain COVID-19. The health of Canadians has come first, and political squabbling has been put aside for now. Mistakes will surely be made, and these mistakes may only come to light in hindsight, but I think it is fair to say that Canada’s response has been good.

The same assessment cannot be said for some of our friends around the world, with likely the biggest disappointment being the United States. There appears to be no national strategy or coordination, lots of finger-pointing, and little concern for the rest of the world. It appears that the current US administration has little regard for other countries including their friendly neighbours and this became clear when they invoked the US’ Defense Production Act to force 3M to stop shipping N95 respirator masks to Canada.5

The rational lesson to be learned from the actions of the various countries in the world is that you cannot rely on your supposed friends to help out in a global emergency and to ensure security, a country needs to be able to provide for itself. As a result, it is likely that the concept of globalization that has guided the world for the last 30 years will suffer a setback. If countries need to ensure they can look after themselves, it will require that the capability to do so is contained within each country. It would not be surprising to see more protectionist measures being deployed under the guise of being in a country’s “national interest.”  Canada, as a smaller trade-dependent nation, could face some challenges especially if our neighbours to the south continue on their current path.

Investment Impact

Now we get to the hard part! The impact on investments occurs where health, economic and political interests intersect. Each impact the others and, ultimately, will impact the investment options that are available for use in the Alitis Pools.

It is still very early to be able to determine the impact on investments.  Circumstances are changing by the day, but the following is our longer-term view on what we expect to happen:

Health Considerations

  • Most governments around the world will act rationally and try to balance health considerations with economic impact.
  • It will take a year before a vaccine is available that will protect against COVID-19.
  • Given the above, social distancing and other restrictions (60% of normal level identified by the BC government) will be in place for another year.

Political Considerations

  • Governments will have learned that in times of crisis, you cannot rely on your friends for help.
  • Certain industries and activities will be deemed to be in the “national interest” and be shielded from foreign competition.
  • There could be a rise in protectionism around the world.

Economic Considerations

  • It is going to be a very rough year globally and there will be new economic issues that have not even been considered yet.
  • It appears that most economies will not get back to where they were before the virus appeared until 2022.
  • Government deficits will be large this year and will likely take a few years to get back to where they were before COVID-19. Government debt will increase sharply over the next few years.
  • Inflation could return in a few years’ time.
  • To pay for all the government support, countries will eventually have to tighten their belts by raising taxes and lowering expenditures.

Investment Outcomes

With respect to the various asset classes we use at Alitis, here are our expectations:

  • Cash: Given the recent lowering of interest rates, cash makes very little return. Its value lies in its ability to be deployed when opportunities arise, and this is what we have been doing since the crisis started. We expect that cash levels will continue to go up and down in order to buy investments when prices are cheaper and sell when prices head higher.
  • Fixed Income: There was a very rough patch for fixed income investments in the third week of March but since the announced measures from central banks to backstop the credit markets, fixed income products have been excellent portfolio stabilizers and are doing their job as a place of safety in distressed times. We expect that this will continue to be the case over the next several months, but we will start to slowly move to fixed income products that offer better protection as inflation starts to appear in the years ahead. Concurrently, we expect that allocations to fixed income will be lowered as inflation will make fixed income less attractive relative to other asset classes.
  • Mortgages: We expect our portfolio of mortgage investments to continue to perform decently, even though the underlying managers are being cautious and holding back some earnings as a reserve against defaults. The reports coming from these managers are that the situation in mortgages is within expectations. We are finding that opportunities have really opened up with publicly traded mortgage investments. Prices dropped significantly in March and we have been buying as the expected returns are much greater than we can get on private mortgage investments. This is the same strategy we employed in 2014/2015 which led to the very nice returns we experienced in subsequent years.
  • Real Estate: We do not foresee any significant change to our real estate stance. We have almost exclusively focused on residential real estate with multifamily apartment buildings being the majority of this exposure. Of course, there will be some hiccups along the way, but no matter what happens in the economy, people need a place to live so the demand for residential real estate will continue. One area where we do see value is with publicly traded REITs which dropped significantly in March; we have been purchasing them when excess cash is available.
  • Stocks: Obviously, stocks have had a rough time so far this year and it is likely that this turbulence will continue. Luckily, we have kept a large part of the equity strategy allocated to cash which gives us the opportunity to buy when dips in the market come along. We expect that corporate earnings will be terrible in the second quarter of 2020. Now, if we look back to the financial crisis in 2008/2009, companies put as much bad news as they could into one quarter so it would make their recovery look that much better, and we expect a similar situation to occur this year. However, this bad news may lead to a good buying opportunity if the prices of stocks get pushed down in response to the overly compressed bad news. Looking out a bit further, we will be looking to shift more money into stocks since it is our view they will provide higher returns than fixed income especially in an inflationary environment.

In summary, the situation is still very fluid, and much depends upon when physical distancing restrictions are reduced and the economy can return to normal. It will likely be a year before restrictions are dropped and another year before a return to normal. In the meantime, we are being defensive but opportunistically investing in publicly traded real estate and mortgage investments as the valuations are good. Fixed income is a good place to be right now due to the choppy markets, but as the economic and investment situation becomes clearer, fixed income allocations will be reduced. With respect to stocks, we will use cash to selectively buy and sell when appropriate and later we’ll continue adding to our stock allocations by shifting away from fixed income. In the years ahead, when inflation starts to appear, we believe there will be better opportunities in stocks over fixed income.

My Own Investments

I have heard from the advisers that some clients are asking what we are doing with our own money. As Chief Investment Officer at Alitis I thought you might find it interesting what my family owns as of March 31, 2020:

Other than cash in our chequing account, all of my family’s financial assets are invested in the Alitis alongside every Alitis client because I am a firm believer in putting my money where my mouth is. I do have some excess cash in my chequing account which I expect to add to my Alitis portfolio in phases over the next six months or so. I am not the most aggressive investor and I prefer to diversify across all the asset classes we use in order to get a decent return while keeping risk under control. I am not planning to change this mix of investments since Alitis’ Investment Committee is making changes within each of the funds to adapt to the environment as just described. As such, there is no need to move things around. This mix suits my family’s circumstances which, obviously, will be different from other families’ circumstances. There is no perfect mix of investments for everyone. Focus on your risk tolerance and future goals and try to avoid getting caught up in all the daily news – it’s simply overwhelming!   When you meet with your adviser for your regular review, routine rebalancing may be appropriate; just keep in mind that rebalancing and reallocation of investments is already occurring within each fund which may make adjustments in your portfolio unnecessary.

If you have any questions or concerns, please contact your adviser and they would be happy to help you. Thank you for reading and I hope this report has conveyed our view of the situation and how we expect to manage your money over the next year.

Sincerely,

Kevin Kirkwood, CFA
President and Chief Investment Officer

References:

  1. https://news.gov.bc.ca/files/COVID19_Update_Modelling-DIGITAL.pdf
  2. Royal Bank: Financial Markets Monthly, April 9, 2020; TD: North American Forecast Update, April 20, 2020; Scotiabank: Forecast Tables, April 17, 2020; CIBC: Economic Insights, April 16, 2020
  3. IMF World Economic Outlook, April 2020
  4. IMF Fiscal Monitor, April 2020
  5. https://news.3m.com/press-release/company-english/3m-response-defense-production-act-order

General Disclaimer 

This report is provided, for informational purposes only, to customers of Alitis Investment Counsel Inc. (“Alitis”) and does not constitute an offer or solicitation to buy or sell any securities discussed herein to anyone in any jurisdiction where such offer or solicitation would be prohibited. Opinions expressed in this report should not be relied upon as investment advice. This report does not take into account the investment objectives, risk tolerance, financial situation or specific needs of any particular customer of Alitis. Each individual’s investment objectives, risk tolerance, financial situation and specific needs should be evaluated before making any investment decision.

Unless otherwise noted, the indicated rates of return are the historical annual compounded returns for the period indicated, including changes in security value and the reinvestment of all distributions and do not take into account income taxes payable by any securityholder that would have reduced returns. The investments are not guaranteed; their values change frequently and past performance may not be repeated.  Unless otherwise noted, risk refers to the annualized standard deviation of monthly returns for the period indicated.

The information contained in this report has been drawn from sources believed to be reliable, but is not guaranteed to be accurate or complete. Alitis assumes no duty to update any information or opinion contained in this report.  Neither Alitis nor any director, officer or employee of Alitis accepts any liability whatsoever for any errors or omissions in the information, analysis or opinions contained in this report, nor for any direct, indirect or consequential damages or losses arising from any use of this report or its contents.

Volatility Is A Megaphone

April 13, 2020: COVID cases increase in the U.S. and U.S. stocks fall before the start of one of the most uncertain earnings seasons on record as the coronavirus pandemic rattles the global economy. – Equity Markets collapse with the S&P 500 index dropping 2.5%.

April 14, 2020: Donald Trump tweets “We’re very close to completing a plan to open our country.” – Stock Markets surge with signs of the coronavirus outbreak either leveling off or easing (S&P 500 is up 3.06%).

Welcome to the world of volatile financial markets.

In recent days, the increased volatility in financial markets has resulted in renewed anxiety for many investors. While it may be difficult to remain calm during a substantial market decline, it is important to remember that volatility is a normal part of investing. Additionally, for long-term investors, reacting emotionally to volatile markets may be more detrimental to portfolio performance than the market drop itself.

Greed and fear are considered the two greatest market movers in the world of investing. Contrary to popular opinion, volatility does not create greed and fear, rather it acts as an amplifier, kind of a MEGAPHONE, and raises “GREED” and “FEAR” to such prominence.

Greed and fear exist everywhere, and these two reactions play a major part in our everyday lives. In times of relative certainty and routine, we deal with greed and fear more systematically and thoughtfully. We feel calmer and have more time to consider multiple options and make rational decisions. In times of relative uncertainty and chaos, we are faced with amplified “GREED” and “FEAR”. We feel rushed and pressured to make choices, often without having all the information or time to give a decision the consideration it requires.

In some areas of our lives, this drive to action in stressful scenarios is helpful, as we take the dose of adrenaline like a hero in an action movie (Think of how James Bond knows exactly what to do in life-threatening situations to survive). But this is not always the case. In financial markets, greed and fear are not helpful.

Markets occur in cycles and will naturally have periods of higher and lower performance. Greed and fear pressure us to think that markets are linear, and we use short timeframes to extrapolate out unrealistic scenarios. Over time, financial markets are driven back to more realistic expectations.

Our job at Alitis does not involve adventuring alongside Indiana Jones or battling for the Iron Throne. We do not need to rely on greed and fear to spur us into action. We are honest about the existence of greed and fear in the market and ourselves, but we strive to not let it drive our decision-making process. Instead, we rely on analysis, experience, and the lessons of market history to guide the direction of our portfolios.

Our goal is to provide security and growth of financial assets for our clients. One of the key tools that Alitis deploys is the inclusion of alternative asset investment classes (such as Private Real Estate and Private Mortgages) to reduce the volatility of our portfolios. We reduce the power of the volatility megaphone, and this assists both our team and our clients in resisting the calls of GREED and FEAR. Let us look at our portfolios’ volatility metrics.

The most common measure of volatility in financial markets is the annualized standard deviation of monthly returns, using three-years of monthly returns as the only inputs. This can be used to estimate a range of expected future returns based on historical results. A smaller level of volatility for a comparable mandate (each fund as compared with its benchmark) is preferred.

Here are two charts showing how the Alitis Pools have performed compared with their benchmarks as of the end of March 2020.

As shown by the results, we have been successful in reducing the risk of our investment portfolios over the last three years. The lower risk mandate, the Alitis Strategic Income Pool, has had 9% less volatility than its benchmark. The balanced mandate, the Alitis Income & Growth Pool, has had 16% less volatility compared to its benchmark. The higher risk mandate, the Alitis Growth Pool, has experienced 26% less volatility than its benchmark.

For our Alitis Pools that are focused directly on specific alternative asset classes (Alitis Mortgage Plus Fund, Alitis Private REIT and Alitis Private Real Estate Limited Partnership), they indicate the reduced levels of volatility by incorporating private investments. It is important to remember that we generally view these as a component of a portfolio and not a complete portfolio in themselves, as they are concentrated on single asset classes and have different kinds of inherent risk.

Risk Level:

  Alitis Strategic Income Pool Alitis Income & Growth Pool Alitis Growth Pool
3yr Pool 3.77% 6.56% 8.09%
3yr Benchmark 4.13%1 7.76%2 10.95%3
Risk Reduction 9% 16% 26%
  Alitis Mortgage Plus Fund Alitis Private REIT Alitis Private Real Estate LP*
3yr Pool 2.50% 2.19% 1.95%
3yr Benchmark 4.91%4 17.88%5 18.10%6
Risk Reduction 49% 88% 89%

The volatility of U.S. stocks surged to record levels after benchmark indexes suffered the biggest rout since 1987 in mid-March 2020. The CBOE Volatility Index, or VIX, is a real-time market index representing the market’s expectations for volatility over the coming 30 days. Investors use the VIX to measure the level of risk, fear, or stress in the investment markets. This is not a perfect comparison to the Alitis Pools’ risk metric but provides a sense of investor sentiment and market volatility in the U.S. stock markets.


CBOE Volatility Index, better known as the VIX, spikes to new highs in March 2020

When events impact the entire world, nobody is immune to the drivers of greed and fear. Markets could continue to roil up and down for months to come, trying to shake us off balance. Perhaps the best tip for maintaining our peace of mind in these times comes from how to learn to walk on a balance beam. Do not look down, do not look at your toes; choose a focal point in front of you and move towards it.

Please reach out to us if you would like to discuss further and find your focal point. As you know, we continue to work diligently through this time and our Wealth Management Team is available via phone and email to answer your questions.

Sincerely,

Apurva Parashar, MBA, CAIA, CIM
Chartered Investment Manager

Thomas Nowak, BComm.
Research Associate

 

*Alitis Private Real Estate LP is since inception (2 years, 11 months)

  1. Benchmark may change over time. Benchmark is currently: 100% FTSE TMX Bond Universe
  2. Benchmark may change over time. Benchmark is currently: 30% FTSE TMX Bond Universe, 30% MSCI World Index (C$), 15% TSX Capped Real Estate, 5% Dow Jones Real Estate and 20% FTSE TMX All Corporate Bond
  3. Benchmark may change over time. Benchmark is currently: 100% MSCI World Index (C$)
  4. Benchmark may change over time. Benchmark is currently: 100% FTSE TMX All Corporate Bond
  5. Benchmark may change over time. Benchmark is currently: 75% TSX Capped Real Estate, 25% Dow Jones Real Estate
  6. Benchmark may change over time. Benchmark is currently: 75% TSX Capped Real Estate, 25% Dow Jones Real Estate

 

 

The value of good collateral

Real estate values are expected to remain fairly stable during these volatile markets (as discussed in our April 3 update, Real Estate Resiliency, found here), let’s take a look at how the COVID-19 crisis is affecting Alitis’ mortgage investments.

A mortgage is a loan in which real estate is used as collateral.  Lenders will lend money to a borrower based on their ability to repay the debt, as well as the value of the property securing the mortgage.  Traditional banks and credit unions focus on a borrower’s income, credit (beacon) score and other debt servicing costs to determine the risk of the borrower and the amount they are willing to lend.  Alternative lenders such as Mortgage Investment Corporations (“MICs”) look at the same metrics, but because borrowers are often self-employed, new immigrants or have had a past credit event, there is a greater focus on the value of the collateral. MICs will only lend up to a certain percentage against the value of the underlying real estate as per their own independent analysis and this plays an important role in protecting the capital we invest.

In the case of commercial mortgages, borrowers will seek alternative lenders due to their speed of execution and flexibility.  In all cases, mortgages from MICs and other alternative lenders tend to come with higher interest rates.  The weighted average yield on the Alitis Mortgage Plus Fund’s (“MPF”) holdings is 8.2%.  It is worth noting that the yield is not the same as the average borrowing rate; it is the expected income distribution on our investments.  The difference between the borrowing rate and yield is affected by leverage, management fees and other income and expenses.

The MPF currently has approximately 50% of its investments secured by residential properties, 20% commercial, 14% construction, 8% land and 8% cash.  The average loan-to-value on all mortgages is currently about 63%.  On average there is $37,000 of borrower equity per $100,000 of real estate value securing our mortgage.  If the borrower defaults, the value of the property would have to decline by 37% before our capital is at risk.  Certain lenders are being cautious and increasing mortgage loan loss provisions which does have the effect of decreasing revenues (returns) in the short-term; however, the overall impact on performance is very small.

There has been a lot of talk in the media recently about mortgage payment deferrals for people and businesses that have been negatively impacted by the COVID-19 crisis.  Similar to the rent deferrals discussed in the Real Estate Resiliency update, mortgage deferral does not mean payment forgiveness.  Rather, the interest owed is accrued to the mortgage balance and repaid when the mortgage is refinanced or paid off.  The MICs continue to earn revenue (accrued interest) and the value of the loan the borrower is required to repay increases each month.

As of the most recent update provided by each company, investments that focus on providing mortgages on single-family homes such as Antrim Balanced Mortgage (“Antrim”) and Ryan Mortgage Income Fund (“Ryan”) have seen a relatively low number of borrowers requesting payment deferrals.  Antrim has been contacted by just under 10% of borrowers looking for a 60-day payment deferral while Ryan has only had 200 requests out of 5,100 mortgages (3.9%).

For mortgages secured by residential multi-family assets, commercial properties, or construction mortgages, there have been very few deferral requests from higher quality corporate borrowers though lenders are standing by and willing to work with borrowers through these challenging times.  One immediate impact of the COVID-19 crisis to lenders is the closure of the courts.  Lenders use the judicial system to enforce their rights to collateral in the case of default.  There will be a backlog of cases to work through once the courts reopen, but this is not expected to have a material impact to our mortgage investments in the short-term.

The March 2020 performance of the MPF was negatively impacted by the fund’s roughly 10% weighting to publicly listed MICs, specifically MCAN Mortgage Investment Corporation (“MCAN”) and Timbercreek Financial (“TF”).

MCAN reported Q4 2019 earnings on February 26, 2020 that showed 2019 earnings were 33% higher than 2018 and a 6.25% dividend increase.  Under normal circumstances this would be been considered exceptional results; however, COVID-19 fears pushed the share price down 22% (including the dividend) from $16.01 to $12.18, hitting a low close of $10.51 on March 23.  Assuming no change to the dividend, MCAN now trades at a 11.1% dividend yield with upside potential.

It is a similar story for TF, which declined 25.4% in March.  I was encouraged after speaking with the CEO of TF, Cam Goodnough, along with the co-founder of Timbercreek Asset Management ($10 billion in assets under management), Blair Tamblyn, on March 25.  They indicated that all of their mortgages were performing and that they had not experienced any notable requests for mortgage deferrals.  Additionally, as one of the few lenders with capital available to lend, they are able to request better rates and additional collateral than they were able to get a couple weeks ago.  Finally, an added benefit is that their financing costs have been significantly reduced thanks to the Bank of Canada’s 1.50% cut to the overnight rate. As a result, Q1 2020 earnings are expected to be strong continuing from a solid Q4 2019.

As stock prices rose through January and February, we had been selling shares of TF, but with the sharp declines over the past month, see 1-year MIC stock price chart below1, we have become buyers.  We have been quite opportunistic, buying on days when selling pressure is increased.  This strategy has proved to be very profitable for the fund since its launch in 2014 and right now, public investments are offering better value than private mortgage investments.

In closing, we are living in extraordinary times.  We will no doubt have some ups and downs along the way, but it is our view that properties used as collateral for the mortgage investments will continue to provide good security.  In the short-term, we are re-positioning the portfolios to raise cash in order to take advantage of the opportunities that will inevitably come out of this crisis.

Thank you for your trust.  All the best to you and your family.

Sincerely,

Mitchell Prothman, CFA, CFP

Senior Portfolio Manager & Head of Trading

  1. Bloomberg LP

 

Central banks get set up to support bonds

March 2020 was a very challenging month for many asset classes. Canadian Bonds1 were down 2.0%, Canada’s stock market2 was down 17.4%, the US stock market3 was down 12.4% and the Canadian Publicly Traded REITs (Real Estate Investment Trust) Index4 was down 27.3% for the month. Despite all these negative returns, Alitis’ Core Investment Pools (Strategic Income, Income & Growth, Growth) performed relatively well.

Alitis Pool Series E March 2020
Alitis Strategic Income Series E -5.41%
Alitis Income & Growth Series E -9.00%
Alitis Growth Series E -9.79%

This is not to say that we did not hope for better because we did. During the month some of the investments that we expected to protect values also underwent pressure. In extreme market events like the COVID-19 crisis and the Great Recession, bonds and fixed income investments become more correlated with equity investments, at least in the short term.

The S&P 500 index fell 34% from February 20 until March 23 and that heightened investors’ fear and margin calls. Investors sold the most liquid assets including government bonds and corporate bonds to raise cash and cover these margin calls. This switch into cash from bonds drove prices down and liquidity started to dry up. It did not help that the bond dealers in New York and London had sent their staff home. To give you an idea of what this looked like, Royal Bank of Canada senior debt due in April 2022 traded at a yield of approximately 7%5.

Central banks soon came to the rescue.

On March 27, the Bank of Canada (BOC) announced its plan to support liquidity and market function within Canada’s bond market. Our neighbours to the south enacted a similar plan the week before. Here is a summary of the policies and programs that are now in place in Canada.

Interest Rates:

  • BOC dropped its key rate from 1.75% to 0.25%.

Improving Credit Liquidity:

  • Canada bonds buyback program – $5B / week
  • Canadian Mortgage Bond Purchases – $500MM / week
  • Banker Acceptance Purchase Facility – $20B / week
  • Provincial Money Market Purchase Program – up to 40% of the new issuance of provincial short-term securities
  • Commercial Paper Purchase Program (CPPP) – set to be available for 1 year

We believe that these programs and the programs announced by the Federal Reserve will support the liquidity in bond markets and we further believe that the Bank of Canada will step up again to support market function when and if it’s required. “A firefighter has never been criticized for using too much water” comment by Stephen Poloz, Governor of the Bank of Canada on March 27.

BOC’s next scheduled meeting is on April 15 and we’ll be looking for clarity and further comments on how the extraordinary actions by the Bank of Canada are improving market function and liquidity. The Bank of Canada and other monetary institutions around the world are doing all that they deem necessary to promote market function, cushion the shock of and ease the recovery from the COVID-19 crisis.

Looking forward, bonds and other fixed income investments will continue to be an important component of a diversified portfolio and in the shorter term (3-6 months) we believe that there are very good opportunities for return in these investments.

If we look to history, we find a guide of what could happen next. During the depths of the Great Recession (September 2008), the Canadian Bond Index had a negative return of -2.39%6 in just under one month, but in the 6 months that followed the return from these bonds were +5.50%6.

At Alitis, we are working hard to keep our clients informed on what we are thinking and how we are helping to protect and grow your investments. We continue to seek out the best opportunities to invest while maintaining our conviction that Alitis is well-positioned to protect and grow our clients’ capital over the long-term due to our diversified offerings and inclusion of alternative asset classes.

Should you have further questions or comments, please don’t hesitate to reach out to your Portfolio Manager or another member of the Alitis Team.

All the best,

Todd Blaseckie

Portfolio Manager

 

  1. FTSE Canada Universe Bond Index™
  2. S&P/TSX Composite Index
  3. S&P 500 Index
  4. S&P/TSX Capped REIT Index.
  5. Information courtesy of RP Investment Advisors LP
  6. S&P Canada Aggregate Bond Index Total Return™ [May 1, 2008 – April 30, 2009]

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Real Estate Resiliency

During this unprecedented time, I want to wish you and your families well as the world collectively deals with the COVID-19 virus. The speed in which the COVID-19 virus has wreaked havoc on the Canadian and global economies as well as equity markets is unprecedented. It will take time for the economy to restart and border to reopen but we will all get through this together.

Overall, there has been a concerted global effort to contain the spread of the COVID-19 virus. However, the measures taken have been extremely painful in the short-term as they have delivered a direct and immediate hit to the economy. The good news is that central banks and governments have been proactive in trying to support their economies through both monetary (interest rate cuts and quantitative easing) and fiscal policy (stimulus spending including support for families and employers). The United States, Canada, Japan and Germany have all announced stimulus packages that amount to around 10%¹ of GDP. In Canada, the Bank of Canada has cut interest rates by 1.50% with the overnight rate now at 0.25%.

These measures have provided some support to global equity markets over the past couple of weeks, but the number of COVID-19 cases is still expected to rise significantly over the coming days, weeks and months; volatility will remain heightened. There has been a lot of talk about the impact of the COVID-19 crisis on equity markets and we have endeavored to keep you up to date on the direct impact to you, but you may be wondering how has all of this affected your real estate investments?

There are four Alitis mandates: the Alitis Growth Pool (Growth), Income & Growth Pool (I&G), Private REIT (REIT) and Private Real Estate Limited Partnership (RELP) that have investments in real estate. The Alitis Growth Pool has a 22.5% real estate allocation while the Alitis Income & Growth Pool has a 26.5% allocation. Excluding cash, both the REIT and RELP are fully invested in real estate. Across all mandates, we are almost exclusively invested in residential investments. Residential includes multi-family rental apartments as well as “for sale” townhomes and condominiums. These real estate investments also range from being fully stabilized (income producing) to those still in the pre-construction (re-zoning & permitting) phase. The COVID-19 virus has impacted each differently, and I would like to discuss four impacts in particular:

  • Tenants requesting rent deferrals
  • Rental buildings having higher vacancies
  • Real estate values changing due to changes in capitalization rates (cap rates)
  • Projects taking longer to sell

Rent Deferrals

With many businesses effectively closing their doors for several weeks, there have been mass layoffs in many different sectors and regions. These layoffs or reduction in hours are expected to create an increase in rent deferral requests, especially since it will take time for cash to be received from new government benefits such as the Canada Emergency Response Benefit (CERB). These rent deferrals will reduce cash-flow and thus returns in the short-term. Currently, we have two core-plus investments and one value-add investment that could be impacted by rent deferrals.

  • Ironclad Developments Pembina LP (Pembina). Pembina is a partially complete 282-unit rental apartment in Winnipeg, MB with 115 units rented. So far, Ironclad has received zero requests for rent assistance.
  • RISE Properties Trust (Rise). Rise is a portfolio of rental apartments in Greater Seattle, WA totaling over 4,000 units. Less than 5% of tenants have made requests to defer rents.
  • Starlight Canadian Residential Growth Fund (Starlight). Starlight is a portfolio of 5,734 rental units in Ontario and British Columbia. As of last week, they had not received any rent deferral requests but that is likely to change.

It is important to note that a deferral is not a rent forgiveness. Tenants will be required to pay back their rent over a certain period of time which will be agreed upon on a case by case basis. Some tenants may not be able to pay their rent even after they return to work, so we are modeling higher vacancies and bad debts over the coming months.

Higher Vacancies

When we look back over the past 20 years, it is encouraging to see that vacancy rates for Canadian multi-family residential real estate peaked in late 2015 at 3.7%, see chart below. The highest multi-family vacancy rate in the past 50 years was 4.8%, which was reached in 1992. Shelter is a basic need and individuals and families will cut back on discretionary spending or take on more personal debt before they miss a rent or mortgage payment.

Cap Rates

The biggest impact to our real estate investments could come from a broad change in the value of rental apartments. Rental apartments are generally valued based on the amount of net operating income (NOI) they generate, divided by a cap rate. The cap rate is the rate of return an investor would earn on owning the property for a year assuming the property was purchased with cash and there was no change to income and expenses. As cap rates decrease, the value of real estate increases, and vice versa.

Canadian multi-family capitalization rates vary from 2.50%² (Vancouver A quality properties) to over 7.00%² in secondary markets for B quality properties. A building that generates $500,000 of NOI would have a value of $10 million assuming a 5.0% capitalization rate ($500,000 / 5% = $10,000,000). Most of the properties in which Alitis is invested have capitalization rates ranging from 4.25% – 5.25%.

There are many factors that affect capitalization rates including availability of capital including credit (demand), new construction (supply), interest rates, as well as inflation. Heading into the global financial crisis (GFC) the spread between the 10-year Government of Canada Bond and the cap rate was a little more than 2.0% while today stands at 4.93%¹, the widest it has been in over 20 years. We view this spread as a buffer to possible cap rate increases as we believe this spread would have to compress significantly before cap rates moved up. This should help to support multi-family real estate values over the near term.

For the most part, COVID-19 has caused prospective buyers and sellers to pause as they wait to see how the crisis unfolds. In looking back at the most recent recession, the GFC, cap rates for rental apartments expanded by 0.55%³ from Q1/08 to Q1/09, indicating a decline in property values. However, property values recovered quickly. Proceeding on the side of caution, Alitis has elected to make small increases to the capitalization rates used in our valuations, as we believe it will take time for cap rate to adjust in the market. Despite these adjustments, the Alitis Private REIT posted a modest gain in March of 0.17%, thanks to construction progress on our opportunistic developments.

Longer Selling Times

A smaller percentage of our investments is in the development of “for sale” townhomes and condominiums in Metro Vancouver. The current stage of the projects varies significantly from early stage pre-construction (zoning) to projects currently under construction and projects that have completed construction and are actively selling.

The Vancouver real estate market was extremely hot to start the year, with sales volumes up approximately 45%4 year-over-year and broad price increases. The impact of COVID-19 has affected each project differently. For projects that are currently selling, there has been no immediate adjustment to the selling prices. However, sales are expected to slow significantly over the coming 60-days as open houses are cancelled and Alitis’ development partners transition to only selling via private appointments.

With slower than expected absorption, project profitability has been impacted as financing costs need to be carried for a longer period of time. Again, erring on the side of caution, for projects that will begin selling later this year, expected selling prices have been decreased. Overall, construction continues to progress as sites remain open and active. Progress within our allocation to construction properties has for the most part, offset a decrease in overall expected profits.

Closing/Summary

Overall, Alitis’ real estate assets remain in very good shape and we don’t expect a material impact to the value of our private real estate investments. If the crisis persists far longer than anticipated, real estate could experience broader declines in value. Over the short-term, the REIT will hold a higher than usual cash balance which will be used to capitalize on investment opportunities that will inevitably arise. Additionally, I will look to take a small position in publicly listed REITs as they are trading at discounts to their net asset value.

The impact of COVID-19 on our projects will depend on the length and severity of the crisis, but we are optimistic that the social distancing measures and site safety measures that have been imposed will have the intended impact of flattening the curve.

Sincerely,

Mitchell Prothman, CFA, CFP

Senior Portfolio Manager & Head of Trading

 

¹Starlight Investments – “Multi-Family resiliency”, April 1, 2020

²CBRE – Q4 2019 Canadian Cap Rates & Investment Insights

³BMO – “Re-calibrating to reflect double whammy of Coronavirus pandemic and oil shock”, March 13, 2020

4Real Estate Board of Greater Vancouver – February and March 2020 monthly reports

Categories of Real Estate

Core real estate is considered to be the least risky because they often target stabilized, fully leased, secure investments in major core markets. Core Plus real estate, is similar to Core, but not quite as high quality as the property might be in the suburbs or a secondary metropolitan area, the tenants may not be quite as high quality, or it may involve a property type that is not one of the four main property types. A newly-built property may also be classified as Core Plus if the leverage is in the 40% to 70% range. Value Added real estate investments typically target properties that have in-place cash flow but seek to increase that cash flow over time by making improvements to or repositioning the property. Opportunistic strategies involve the development of raw land into residential or commercial properties. It may also involve the conversion of properties or target highly distressed properties that require major renovations.

General Disclaimer

This blog is provided, for informational purposes only, to customers of Alitis Investment Counsel Inc. (Alitis) and does not constitute an offer or solicitation to buy or sell any securities discussed herein to anyone in any jurisdiction where such offer or solicitation would be prohibited. Opinions expressed in this blog should not be relied upon as investment advice. This blog does not take into account the investment objectives, risk tolerance, financial situation or specific needs of any particular customer of Alitis. Each individual’s investment objectives, risk tolerance, financial situation and specific needs should be evaluated before making any investment decision.

The information contained in this blog has been drawn from sources believed to be reliable, but is not guaranteed to be accurate or complete. This blog may contain economic analysis and opinions, including about future economic and financial markets performance. These are based on certain assumptions and other factors, and are subject to inherent risks and uncertainties. The actual outcome may be materially different. All opinions expressed herein constitute judgements as of the date of this blog and are subject to change without notice. Alitis assumes no duty to update any information or opinion contained in this blog. This blog may contain links to third-party websites. Alitis is not responsible for the content of any third-party website or any linked content contained in a third-party website. Content contained on such third-party websites is not part of this blog and is not incorporated by reference into this blog.

Unless otherwise noted, the indicated rates of return are the historical annual compounded returns for the period indicated, including changes in security value and the reinvestment of all distributions and do not take into account income taxes payable by any securityholder that would have reduced returns. The investments are not guaranteed; their values change frequently and past performance may not be repeated.  Unless otherwise noted, risk refers to the annualized standard deviation of returns for the period indicated.

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