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Quarterly Checkup

As we enter the fourth quarter of 2023, the global economy is now well into the second-order effects of the inflation cycle, triggered by wage pressures, rising input costs, and higher interest rates as central banks try to contain price increases. On balance, the more time passes at higher inflation and borrowing rates, the more stress it puts on consumers and the economy. In this update, we review our YTD performance, consider the health of the U.S. and Canadian consumer, and outline how we are navigating current market risks.

On balance, the more time passes at high interest rates, the more stress it puts on consumers and the economy. In this note, we review our YTD performance, take the pulse of the Canadian and U.S. consumer, and outline how we are navigating current market risks. With consumers facing increased pressure, we are positioning our funds to weather a range of potential scenarios on the horizon, focusing our investments on well managed companies with strong balance sheets, good management teams and consistent cash flows.

2023 Performance so Far

Those who have followed Veritas, know that we make a point of taking a longer-term view on company prospects and valuations, with an emphasis on de-risking each investment rather than chasing momentum.

Often, that can mean missing some of the sector-driven rallies that hit the S&P/TSX. And it can mean periods of underperformance when the market rally is narrow and limited to a handful of sectors or stocks. Unfortunately, 2023 looks like that kind of year so far.

For the nine months ended September 30, 2023, Series F of the Veritas Canadian Equity Fund returned-0.8% versus +3.38% for the S&P/TSX. All of our underperformance this year is due to our:

Overweight positioning in Real Estate and Utilities: Within the S&P/TSX, the REIT and Utilities sectors fell by a market-weighted 5.9% YTD. We averaged 17.7% of our NAV in these sectors YTD vs. 6.9% for the S&P/TSX.
Underweight positioning in Information Technology: Within the S&P/TSX, IT rose by 37.7%. We averaged 3.2% of NAV in IT YTD vs. 7.0% for the S&P/TSX.

These same decisions – underweighting IT and overweighting our selections in REITs and Utilities – are what allowed us to avoid a major decline in 2022, when the S&P/TSX fell -5.8% and Series F of the Veritas Canadian Equity Fund returned -1.0%.

In the Veritas Absolute Return Fund (VAR), similar sector positioning and year-to-date performance on the long side of the portfolio and rising share prices for the short book in the first half of the year have contributed to a -4.9% performance year-to-date.

As investors in the funds ourselves, we are never happy with a negative return. The VAR portfolio is constructed based on Veritas’ long-term views on individual stocks, both long and short. Underlying portfolio values can take time to be realized, however. We are sticking to our stock selection discipline on both sides of the book, which has produced positive month-to-date performance in October versus a decline of more than 2% for the index.

With the global economy still navigating the fallout from higher interest rates, we think that investment discipline and managing downside risks should be top of mind. Economic conditions have become particularly dependent on consumer spending and fiscal deficits, significantly increasing equity market risks.

The Consumer Is the Lynchpin

Can the interest rate increases we have experienced break the inflation cycle without breaking the economy? We think the answer ultimately comes down to the strength of the consumer. Personal Consumption Expenditures (PCE) drive ~68% of GDP in the United States, with the equivalent figure in Canada ~58% of GDP. There is no slowing of inflation without a slowing of consumer spending.

In a best case, households absorb higher interest rates by reducing their consumption, saving more and carefully managing their debts. Productivity gains deliver modest GDP growth even as labour market pressures ease off. Inflation comes down gradually, interest rates moderate, and the global economy expands, albeit more slowly.

In a bearish case, consumers cannot absorb the higher rates and costs without a more dramatic slowdown in consumption. Debt levels and default rates begin to rise. Companies scale back spending and pursue layoffs. Worsening employment conditions trigger a deeper decline.

We are watching three key areas to evaluate consumer health: retail and durables spending; consumer savings rates; and debt servicing trends. Based on the results thus far, the Canadian consumer is in a much tougher spot that their U.S. peers.

Retail and durables spending

U.S. retail sales: Despite being up 3.0% year-over-year for September 2023, U.S. Advance Retail Sales posted a reading below inflation, which is a concern. YoY sales had plateaued below +2% YoY in each month from March to July 2023 before recovering to +2% YoY in August. The main sub-categories of growth reflect cost inflation pass-through activity and return to work trends. Food Services and Drinking Places (+9.2%), Motor Vehicles and Parts (+6.2%), and Grocery Stores (+1.6%) were up YoY – likely due to cost inflation and return to work trends. Clothing and Accessories were roughly flat (+0.1%), and all other categories were down.
Canadian Retail Trade: In Canada, August 2023 Retail Trade was up 1.6% YoY, again well below headline inflation. Early data for September 2023 show an even flatter, potentially contracting, profile. For August, Canadian a few retail categories were up, such as Motor Vehicles and Parts (+5.5% YoY) and Food and Beverage retailers (+2.7%). Clothing, Accessories and related were much stronger than the U.S. reading at +5.7% YoY. While Building Materials, Garden Equipment and Supplies fell 7.8% YoY.
U.S. private housing starts: Housing starts have been on a steady downward trajectory since April 2022, falling 7.2% YoY in September to 1.36 million. Starts are roughly where they were in 2019, pre-pandemic, however.
U.S. light vehicle sales: U.S. light vehicle sales ran back up to 18.0 million units in April 2021 on a pandemic reopening surge (all figures annualized). Sales subsequently bottomed at 12.3 million units in September 2021, but have been on an upwards trend since then, registering at 15.7 million units in September 2023. Sales are still well below the level of 17.2 million reached pre-pandemic in September 2019.

Notably, while retail sales growth does appear to be decelerating on both sides of the border, the biggest ticket items that normally send consumer spending into retreat in a recession – housing and autos – remain at low levels and, in the U.S. at least, continue to trend higher. In Canada, the picture is similar except that housing and related spending is much weaker.

Consumer savings rates:

In Canada, household savings rates have been stable and higher than before the pandemic: Since the beginning of 2022, Canadian savings have averaged 5.5% of disposable income. Interestingly, savings rates are higher than before the pandemic, with Canadian savings rates averaging 2.2% of disposable income from 2015 to 2019. In addition, Canadian household disposable income growth has been very strong at 4.5% CAGR since the beginning of 2022. Note that disposable income is after paying interest costs.
Rising Canadian mortgage costs are likely to flatten the savings rate: For context, we calculate that a 50% rise in mortgage interest spending from 2023 Q2 levels would reduce the Canadian savings rate to 2.6%, in which case savings rates would resemble pre-pandemic levels. While the averages look manageable, we would still expect difficulties to hit many marginal borrowers.
In the United States, savings rates remain well below recent trends: From the start of 2022 through August 2023, U.S. savings rates have averaged 3.9% versus 6.2% in the five years ending 2019, pre-pandemic. The pick-up in U.S. savings rates above 5% from March to June 2023, appears to have faded for now.

Certainly, excess pandemic savings and shifting demographics explain much of the lower U.S. savings rate. The increase in Canadian savings may already reflect consumer caution, faced with higher debt servicing costs. We note that any reversion in savings rates represents a big headwind for growth and corporate earnings in both countries.

Household debt and servicing trends:

Canadian debt service ratios are back to peak levels and rising: Debt service costs as a percentage of disposable income have been trending up since Q1 2022 and reached 14.8% in Q2 2023, a level rivalling pre-financial crisis levels. With significant mortgage resets coming, we see the debt service ratio as the greatest threat to Canadian consumer spending.
U.S. debt service ratios remain low after falling consistently since the GFC: U.S. debt service as a percentage of disposable income rose to 9.8% in Q2 2023, roughly the same level as in Q2 2019, pre-pandemic. Note that Canadian disposable income is reduced by taxes that support public health care – adjusting for private heath care spending in the U.S., we estimate that the U.S. debt service ratio is ~11.5%, which is still much lower than Canadian levels.

Consumers are currently experiencing the benefits of tight labour markets and strong income growth. Still, with higher borrowing costs and persistent inflation, signs of strain are building for many consumers, particularly in Canada.

If inflation proves difficult to bring down and interest rate remain sticky or increase, we think these strains could easily turn into a full-fledged pullback in consumer spending, with very negative implications for the global economy. Companies with stretched balance sheets and weak earnings profiles are likely to come under pressure, while those with pricing power, lower debt levels and stable cash flows should fare better.

How We Are Positioned

We continue to be underweight Financials, on the view that credit losses have not yet bottomed; we are instead looking at opportunities in other sectors, including Staples, REITs and Utilities which remain attractively priced and should benefit as interest rates stabilize.

As always, we favour high-quality companies with strong free cash flows, clean balance sheets, transparent accounting and capable management teams. Our affiliate, Veritas Investment Research, continues to provide us with compelling investment ideas and remains one of the best research shops on the street.

Year-to-date through September 30, 2023, the S&P/TSX was up 3.4%. Over the same period, our Canadian Equity Fund returned -0.8%, our Premium Yield Fund returned -0.5% and our Absolute Return Fund was -4.9% lower. (Performance based on F series).

We remain focused on long-term capital preservation while pursuing opportunistic investments to drive returns.

DISCLOSURES

The S&P/TSX Composite Total Return Index is a Canadian dollar denominated, capitalization-weighted index that includes the largest float-adjusted stocks trading on the Toronto Stock Exchange, subject to inclusion criteria. The index provides the broadest representation of market-weighted returns for large capitalization Canadian-listed stocks, including reinvested dividends, making it an appropriate index for diversified portfolios that invest primarily in Canadian stocks, such as the Veritas Absolute Return Fund and the Veritas Canadian Equity Fund.

While our funds are benchmarked against the S&P/TSX Composite, we may reference returns for the S&P 500 and NASDAQ Composite, as well as yields on U.S. ten-year Treasury bonds, which we view as relevant investment benchmarks for investors in North American equities. The S&P 500 represents approximately 80% of the total market capitalization of U.S. stocks, and remains the most broad-based indicator of large-cap U.S. equity returns. In contrast, the NASDAQ has a greater proportion of technology and growth stocks, which we view as providing additional insight into investors’ risk appetite. The ten-year U.S. Treasury rate is referenced as a measure of the lowest-risk investment alternative to equities (‘the risk-free rate’). Contact Veritas Asset Management Inc. for more information regarding comparative indices.

The information contained herein is for general information purposes and does not constitute a solicitation for the purchase or sale of securities. The full details of the Fund, its investment strategies and the risks are detailed in the Fund’s current simplified prospectus and fund facts document, copies of which may be obtained from Sedar, your dealer, Veritas Asset Management Inc. (“VAM”) or at Veritasfunds.com. Please read the prospectus before investing. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. All performance data assume reinvestment of all distributions or dividends and do not take into account other charges or income taxes payable by any unitholder that would have reduced returns. The performance of the Fund is not guaranteed, unit values change frequently and past performance may not be repeated. Performance is presented in Canadian dollars, unless otherwise stated, and is net of fees of Series F units of the Fund. VAM is an affiliate of Veritas Investment Research Corporation (“VIR”) by virtue of being under common control that may also from time to time have certain common directors, officers and/or employees. VIR produces and issues independent equity research regarding public issuers to investors and other capital markets participants. VAM is a client of VIR and receives research reports from VIR at the same time as VIR’s other clients. VIR and VAM have implemented policies and procedures to minimize the potential for and to address conflicts of interest, which are available upon request.

Cautionary Note Regarding Forward-Looking Statements

The information in this release may contain forward-looking statements. All statements, other than statements of historical fact, that address activities, events or developments that Veritas Asset Management Inc., the Portfolio Manager, or any affiliates thereof (the ‘Companies’) believe, expect, or anticipate will or may occur in the future (including, without limitation, statements regarding any targeted returns, projections, forecasts, statements, and future plans and objectives of the Companies) are forward-looking statements. These forward-looking statements reflect the current expectations, assumptions or beliefs of the Companies based on information currently available to the Companies. Forward-looking statements are subject to a number of risks and uncertainties that may cause the actual results of the Companies to differ materially from those discussed in the forward-looking statements, and even if such actual results are realized or substantially realized, there can be no assurance that they will have the expected consequences to, or effects on, the Companies.

For a list of factors that could cause actual results or events to differ materially from current expectations, please refer to our Prospectus and the section ‘Risk Factors’. Any forward-looking statement speaks only as of the date on which it is made and, except as may be required by applicable securities laws, the Companies disclaim any intent or obligation to update any forward-looking statement, whether as a result of new information, future events, or results or otherwise. Although the Companies believe that the assumptions inherent in the forward-looking statements are reasonable, forward-looking statements are not guarantees of future performance and accordingly undue reliance should not be put on such statements due to the inherent uncertainty therein.

Quarterly Checkup

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