May 15, 2018

Tuesday’s action in the markets saw the S&P 500 down 0.7% while Toronto was up 0.1%.

The U.S. 10 year government bond yield rose 8 basis points to 3.08% from 3.00%.

The 10-year Canadian government bond yield is at 2.42% as of yesterday. That raises the question as to why investors would accept 2.42% on the Canadian bond versus 3.00% on the U.S. (both as of yesterday). Historically Canadian government bond rates have usually been higher than the U.S. but the Canadian has been lower for I believe a few years now. I am not overly knowledgeable on why the Canadian is lower but here are some thoughts:

An individual investor in Canada or the U.S. has a choice between the two countries but faces inflation and exchange rate risks. To certainly some extent, investors tend to stay in their own currency to avoid the added risk. The lower rate in Canada could possibly suggest that investors expect the Canadian dollar to rise in value against the U.S. and make up the difference. There is something called interest rate parity. 

My recall of the math of interest rate parity is quite rusty and in any case as I recall it is another one of those things that works in theory but perhaps not in practice. As has been cleverly pointed out: In theory, practice and theory are the same, in practice they differ.

Another theory of interest rates is that the rate is caused by the supply of lenders versus the demand of borrowers. It could be that with the stronger U.S. economy there is more demand to borrow and invest or spend (including government demand) versus Canada where the demand by corporations to borrow to invest may be weaker.

I think what us clear is that interest rates have already crept higher off their historic lows and there is an expectation for this to continue. Few expect interest rates to increaase dramatically but there is an expectation of increases. At some point that is definitely negative for stock valuations. Possibly there is a sort of dead area where the increaases so far have not had an impact on stock P/E ratios since government bond yields remain faint competition to expected stock returns.

Meanwhile…

Boston Pizza was down 1.1%. In the morning there was no reaction to the earnings report. But during and after the conference call there was some reaction it seems. As noted in my last post the results were weak. On the conference call, I learned that they expect to raise menu prices another 1 to 3% in June. That may help. The 0.8% decline in same-store franchise (royalty-eligible) sales was disappointing. This is the biggest driver of distributable cash per unit by far over time. A further 1.4% or so decline came from a higher income tax rate, but that should be a one-time event as far as growth in distributable cash goes. On the other hand, this is entity that can really only be expected to grow distributions per unit at about the rate of menu inflation. It’s all about same-store growth. The restaurants are mature and in general it is not realistic to expect heavier volumes of customers. If these units can deliver 1 or 2% growth in distributable cash per unit over the long term then I think despite somewhat higher interest rates it continues to look like a pretty good investment given the 6.9% current yield.

Toll Brothers was down 4.4%. This prompted me to add some to my position although I did not get the lowest price of the day. Interest rate fears weigh on home builders. But it seems to me that home prices remain very affordable in the U.S. (certainly compared to Canada) and their economy is strong. We shall see how Toll is doing when they report one week from today.