The Bank of Canada hiked rates even as the Russia-Ukraine conflict drives uncertainty about global growth. Kim Parlee speaks with Michael O’Brien, Head of Core Canadian Equities at TD Asset Management, about how the current inflationary and geopolitical conditions could impact investment assets here at home.
There's a lot going on. Here to help us understand what's material and what he was paying attention to, Michael O'Brien. He is Head of Core Canadian Equities at TD Asset Management. Mike, it's great to have you with us and talk to you again. Before we get into your outlook for Canadian equities and some interesting sectors, just your reaction to what the Bank of Canada had to say today.
- Sure, Kim, great to be here. So I think today, there were no big surprises. Look, the reality is with the economy as strong as it is right now, and with the labor market as tight as it is, and unemployment really coming down, with inflation at levels we haven't seen for several decades, I think everybody realizes that zero isn't an appropriate policy rate.
So there was, I think, some guessing around what the Bank of Canada would signal about how they're thinking about the Russia-Ukraine situation. They did make a nod to that, which I think the markets found reassuring. They'll be pragmatic about this. But I think everybody realizes that this is the first step along a path towards normalizing the policy settings, which is much needed.
- Mike, can we talk a bit about what that interest rate increase is going to mean for some of your holdings in your portfolio? As I mentioned, you run the TD Canadian Equity Fund, and financials being part of that. So what does that mean for them?
- This is good news for the financials, and particularly the Canadian banks. And if you think of our fund, the Canadian banks are just at the heart of it. And so to illustrate the setup here, the last week or so, five of the banks have reported. There's still one to go. They've all beaten expectations handily.
We've seen very low loan losses. We've seen very strong loan growth. Capital positions are outstanding. They're all humming. The only thing that's been missing is net interest margins are still squeezed. So you're not seeing the growth in net interest income. And that's really where these central bank rate hikes kick in.
So both in Canada and the US, as the Fed and the Bank of Canada start hiking rates, that's kind of the last piece of the puzzle here-- and the net interest margins really respond nicely. So we're expecting good results out of this group.
- Another core part of the portfolio, of course, is the Canadian energy stocks, which have been under a lot of pressure for a long time with the world transitioning away from fossil fuel. Does what's happening in terms of the getting back to normal, the demand for oil, which we already saw oil prices moving up, and then, of course, what's happening with Russia and Ukraine, how does that position that part of the portfolio?
- Yeah, like you say, Kim, it's just an incredible turn of events. Less than two years ago, Western Canadian blends were selling at single-digit prices per barrel-- actually went negative for a brief period of time. And today when I turned off my screen, Western Canadian Select was trading at $100 a barrel. So just an incredible improvement over the last two years and the backdrop.
So obviously, the first round effect here is that these companies, which are much leaner and much stronger than they were two years ago, they're going to generate enormous amounts of free cash flow. And that free cash flow is going to be coming back to shareholders, whether it's dividends or buybacks. So that's very constructive.
I think the other really interesting part of this too, as you mentioned, the narrative over the last number of years and really been around more ESG-related concerns where, I think unfairly, but Canada had been branded in the eyes of international investors as a supplier of dirty oil. They talked about the carbon footprint.
I think what we've seen just in the last few months is a much more pragmatic, much more realistic view of the world's energy needs where it's now shifted to energy security. And particularly with the Russia-Ukraine difficulties that stunned the world oil markets, I think Canada now has a really interesting opportunity where we can fill that role of a provider of safe barrels.
What I mean by that is we have stable supply in a very secure, stable political jurisdiction, but also one that we've very clearly expressed, or the industry has expressed, a desire to reduce its carbon footprint. So when you sort of put those two things together, I think this desire for safe barrels, Canada could play a really important role in that.
- It is interesting just to see this happen right now. And I think it'll be even more interesting to see if it makes a more permanent change in what's happening out west, not just from their fortunes changing now, but could they change in the future? But I think that's a different conversation. I know one of your holdings in your fund, Canadian Natural Resources-- what's your outlook for them?
- Well, they're extremely well-positioned for this environment. You think about where the commodity prices are going today, be it oil or natural gas, and CNQ, Canadian Natural Resources, is a major producer of both. If prices stay anywhere near where they are today, there won't be another company on the Toronto Stock Exchange that generates as much free cash flow as CNQ will this year.
And the lovely thing from a shareholder's perspective, which got me quite excited, Kim, is there are no more big megaprojects that are demanding that capital from CNQ or many of its peers in Canadian oil sands. And so what that means is they're really in a maintenance mode in terms of capital spending. So these windfall profits that they're going to generate are going to come straight back to shareholders.
There'll be lots of share buybacks, there'll be lots of dividends. We'll probably see another dividend increase tomorrow. They report earnings tomorrow. So they're exactly the type of company that's set up perfectly for this type of strong commodity price backdrop.
- I've only got about 15 seconds, Mike, but just to play devil's advocate for CNQ-- if something was to go the other way, is this just a question of just oil prices reversing their course quickly?
- Yeah, I think that really the only thing that keeps me awake at night for the Canadian producers is it would have to be something that destroys demand. In other words, we have to be looking at a recession-- a recession that would destroy demand. Otherwise, the supply-demand fundamentals for the oil market are just so strong and the companies are so well-positioned that I don't see a lot else that could derail the story in the near-term.
- Mike, thanks so much for your time today.
- No problem, Kim.