Canadian equity outlook: Rate pause could spark rotation

Key Takeaways

• While inflation has moderated, we believe a hard landing for the Canadian economy is a likely scenario, given the magnitude of monetary tightening over the past 18 months. This stance has yet to be discounted by Canadian equity markets.
• We believe selling due to rate tightening has been overdone in the most defensive areas of the market, which include communication services, utilities and real estate. With valuations down and the economy still fragile, we have become more constructive on these sectors as well as midstream energy.
• We are more bearish on cyclical sectors such as materials and energy, due to the potential for weakening global demand, and financials, which are already discounting a recession. We expect to remain underweight these sectors, but will continue to monitor them for selective opportunities.

Path of Inflation a Key Determinant for Rate Cycle

Equities have withstood persistent inflation and high levels of interest rates to produce positive performance year to date in 2023. Whether that resilience can continue into the new year will likely be determined by economic growth as well as the path of inflation and its influence on short-term interest rates. Recent inflation data has been on an encouraging trajectory and we are well past the highest levels for the cycle. Whether inflation remains sticky in the 3% to 4% range or declines closer to the 2% target of central bankers will be a key indicator to follow into 2024.

While better-than-expected GDP growth has caused the soft landing chorus to grow louder in the U.S., the Canadian economy is in a meaningfully weaker position. We remain of the view that a hard landing is a likely scenario, given the magnitude of monetary tightening over the past year and a half, a stance yet to be discounted by Canadian equity markets (Exhibit 1).

It’s important to remember that monetary policy impacts economic activity with long and uncertain lags. Policy could take even longer to manifest itself in the current cycle due to the unique nature of the COVID-19 pandemic where generous government outlays enabled consumers to save more while spending less due to pandemic restrictions, building up large cash balances just now being worked off. Fiscal deficit spending has continued, partially neutralizing the effect of higher rates, but we expect the weight of tightening will ultimately prevail.

Selloff in Income-Oriented Sectors May be Overdone

The sharp rise in rates has already been felt among the more defensive areas of the equity market. Among the 11 sectors in the S&P/TSX Composite, communication services, utilities, real estate, materials and financials have suffered losses year to date through October. The first three sectors are among the most interest-rate sensitive in the market and we believe the selling due to rate tightening has been overdone. With valuations down and the economy still fragile, we have become more constructive on these sectors as well midstream/pipelines portion of the energy sector. As inflation abates and growth slows, rates do not need to come down much for these companies to see a re-rating of their stock prices.

Utility stocks, in particular, look attractive heading into 2024. Utilities have seen steady growth over the years, and we expect this growth to continue, including the increasing buildout necessary to support the transition to renewable energy. We expect to see consistent increases in their rate bases and opportunities for companies to invest at attractive rates, which we believe should lead to more profitable growth for the sector than the market anticipates.

We are more bearish on cyclical sectors, including materials, energy and financials. The energy sector significantly outperformed the market in the third quarter of 2023 and has been among the strongest performers for the year, boosted by a strong move in crude oil prices that fueled returns for upstream producers and integrated oil companies. Energy and materials are resource sectors with greater sensitivity to the global economy. With China struggling and growth sluggish in other major regions including Europe, a demand slowdown could pressure these stocks. Banks, meanwhile, have sold off over the last six quarters and are trading at valuations that already discount a more challenging environment, but their valuation is not discounting a significant recession. While we expect to remain underweight these sectors relative to the benchmark, as bottom-up stock pickers we will continue to monitor these sectors for opportunistic additions.

Our investment approach is grounded in a 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 when there are discrepancies between expectations and underlying fundamentals. While certain segments of the stock market may seem susceptible to us, 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 selectivity in pursuing growth.