2025 Canadian equity outlook: Opportunity amid uncertainty

Key Takeaways

• We are encouraged by the rebound in interest-rate-sensitive stocks in recent months and believe the Bank of Canada’s recent shift to a more dovish policy stance, as well as the likelihood of additional rate cuts, should pave the way for a further rotation into higher-yielding equities.
• High levels of optimism about future monetary easing, continued economic growth and a solid corporate earnings profile leave little margin for error in areas of the market with more extreme valuations. Accordingly, we maintain a relatively more defensive positioning than is typical.
• We look forward to uncertainty and increased volatility in the market as they create opportunities to shift toward a more aggressive stance and benefit from short-term market dislocations, notably in more out-of-favor cyclical and growth names.

Dovish Monetary Pivot Sparks Equity Rebound

Canadian equities reacted positively to a dovish shift in monetary policy in North America in 2024, with the S&P/TSX Composite Total Return Index outperforming the U.S. S&P 500 in the third quarter. This marked the first quarter the Canadian equity market had outperformed the U.S. since 2022. In fact, the S&P/TSX has outperformed most primary developed equity market indexes since late May 2024. Year to date through November, the index was up nearly 26%, on pace for its best performance since 2021. Returns have been supported by a decline in short-term interest rates with the Bank of Canada and U.S. Federal Reserve cutting rates by 125 basis points and 75 basis points, respectively.

Although the rally saw broad participation, with 10 of the 11 GICS sectors within the S&P/TSX posting double-digit returns, leadership was observed in information technology, financials, energy and materials. Conversely, communication services was particularly soft throughout the year.

Last year, we highlighted the oversold interest-rate-sensitive utilities, real estate and communication services sectors, as well as banks in the financials sector, as the beneficiaries of an easing cycle offering strong risk-adjusted returns. While financials, utilities and energy infrastructure have been solid participants in the surging Canadian equity market, rate sensitives and defensives have broadly lagged.

Despite their stubborn underperformance over the last two years, we are encouraged by the rebound in interest-rate-sensitive stocks in recent months in connection with declining market rates and believe these higher-yielding segments remain attractive. The Bank of Canada’s previously aggressive monetary policy attracted disproportionate fund flows into low-risk fixed income products including term deposits, money market and high-interest mutual funds and ETFs. However, the central bank’s recent shift to a more dovish policy stance and the likelihood of additional rate cuts are expected to pave the way for a further rotation into higher-yielding equities.

The economy, although still resilient, is showing signs of deceleration as the lag effects of a tight monetary policy that commenced in 2022 are starting to surface. Despite having made significant progress in controlling inflation, consumer sentiment has recently turned more cautious, leading to a slowdown in spending. This trend has been particularly evident among the middle- and low-income consumers who are facing greater financial constraints due to rising interest rates and inflationary pressures. The once tight labor market has stabilized more recently and is displaying signs of gradual slowing as the pace of new hires moderates, wage growth cools and jobless claims rise.

With the equity market still optimistic about a seemingly favorable scenario for rate cuts, continued economic growth and a solid corporate earnings profile, there appears to be little margin for error. This is especially true for areas of the market with more extreme valuations, where there is considerable downside risk should the economy fare worse than expected. Accordingly, we continue to maintain a relatively more defensive equity positioning than is typical.

Energy Well Positioned to Lead Cyclicals

That said, we have identified select opportunities outside of the defensive/interest-rate spectrum, focusing on more out-of-favor cyclical and growth names with recent purchases and additions to existing holdings in the industrials, energy, financials and materials sectors. Impacted by what we deem to be transient headwinds, the current valuations for select equities in these sectors do not reflect the quality of their underlying businesses or growth potential.

One sector to highlight is energy, particularly given recent geopolitical events. The sector has seen increased oil price volatility and weakness in Canadian natural gas prices yet still managed to deliver strong performance in 2024. While global energy demand will play a large part in dictating crude prices, the outlook for regional crude and natural gas prices in Western Canada should improve in the year ahead as the long-awaited Trans Mountain pipeline expansion is now online, and with LNG Canada expected to start exporting liquefied natural gas in 2025.

Effectively, our defensive positioning serves as dry powder that we will deploy when better opportunities arise. We look forward to uncertainty and increased volatility in the market environment, whereby our strategies could benefit from this patient and deliberate positioning. When this time comes, it should also allow us to shift toward a more aggressive stance and benefit from short-term market dislocations.

Our investment approach is grounded in bottom-up strategy that prioritizes identifying and capitalizing on market inefficiencies. This approach is supported by our patient culture, enabling us to make well-informed decisions such as when there are discrepancies between expectations and underlying fundamentals. While we view certain segments of the stock market as susceptible to volatility, we are continuously uncovering promising opportunities, particularly within sectors and securities that haven’t kept pace with the more favored areas of the market. Nevertheless, we maintain a focus on valuations and lower beta and exercise selectively in pursuing growth.