Franklin ClearBridge Canadian Equity Update: A Q&A with Garey Aitken

Garey, can you begin by commenting on the Canadian equity market in the second quarter of 2024? 

After starting the year on a strong footing, the Canadian market (as measured by the S&P/TSX Composite TRI) retreated during the second quarter, shaving off 50 basis points to finish the first half of 2024 up 6.1%.

This was in contrast to the U.S. market, which continued to advance, building on the first quarter’s notable momentum. Narrow leadership, mainly driven by extended AI-related enthusiasm, propelled the S&P 500 TRI (in Canadian-dollar terms) to a new all-time-high on June 18, generating a return of 5.3% in the second quarter to cap off a 19.4% advance for the first half of 2024 and a 30.0% return over the past three quarters. This is more than double the 14.6% return for the S&P/TSX Composite TRI over the past three quarters.

What are your views on the prevailing speculative sentiment in the markets?

Artificial intelligence-related enthusiasm continued to be the dominant global equity theme during the quarter, particularly in the U.S., driving a considerable advance for the S&P 500 TRI.

The Fabulous Four, a subset of the famous Magnificent Seven technology companies, collectively represented 62% of the S&P 500 TRI’s year-to-date ascent. Market darling NVIDIA, the chip maker, briefly surpassed both Apple and Microsoft to become the world’s most valuable company as its market cap soared to approximately US$3.4 trillion. For perspective, the market capitalization of all 220-plus constituents of the S&P/TSX Composite Index was only US$2.5 trillion at the end of quarter.

This dynamic has added to the U.S. exceptionalism narrative, whereby continued strength in the U.S. markets has left markets such as Canada struggling to maintain relevance in the eyes of global investors.

Before we get into the details of the Canadian equity market and the Fund, let’s start with a discussion of some high-level economic and market trends. What are your current thoughts on the economy? 

Although moderating, the economy continues to show resilience, with customer spending remaining healthy since economies reopened after the pandemic. While fiscal stimulus has moderated since the immediate aftermath of the pandemic outbreak, fiscal policy continues to operate at odds with monetary policy. This is particularly the case in the U.S., where the projected deficit for the year is 6.7% of GDP.

However, the once-tight labour market has stabilized more recently and is displaying signs of more gradual slowing as the pace of new hires moderates, wage growth cools and jobless claims rise.

Notwithstanding the seemingly resilient macro backdrop, we remain mindful of the typical lag between interest rate changes and their associated impact on economic growth. As such, we expect the significant rise in rates that started in 2022 to inevitably have consequences for growth.

Additionally, geopolitical risks remain top of mind as well as uncertainty surrounding upcoming U.S. elections.

Whether the inflation rate falls to 2% or stalls out at +/-3% will remain an important issue given its impact on short-term interest rates; but we expect that concerns about economic growth will take on a more important role in 2024.

The market consensus appears to be for a ‘Goldilocks’ soft landing scenario; however, for areas of the market with extreme valuations, there is considerable downside risk should the economy fare worse than expected.

Can you comment on how expectations of the pace and magnitude of central banks’ interest rate cuts have evolved over the past quarter or two?

As you may recall, markets began the year with expectations of six to seven U.S. interest rate cuts over the course of 2024. Canada was expected to follow a similar course. As the year progressed, however, sufficiently resilient economic data, combined with lingering inflation, continued to challenge the path back to the central banks’ desired 2% target. This dampened prospects for the timing and magnitude of the anxiously awaited reversal of the course for interest rates.

That said, the second quarter marked a divergence between the two central banks’ monetary policies. The Bank of Canada (BoC) officially ended its hiking cycle that began in 2022 with a 25-basis point cut in June, lowering its key rate from 5.00% to 4.75%. Relatively lacklustre economic activity and sufficient progress made towards the desired inflation target of 2% supported the central bank’s decision to cut. Although future interest rate cuts will be data dependent, approximately 50-75 basis points of additional easing are currently priced into the market by the end of this year.  

On the other hand, more robust economic growth observed south of the border marked the U.S. as a distinct outlier compared to its peers which, combined with sticky inflation, forced the U.S. Federal Reserve (Fed) to take a more hawkish stance on interest rates, holding rates steady at its most recent meeting in June and signalling only a single cut later this year.

We believe there is an increased likelihood that inflation will continue to moderate, economies will slow and labour markets will loosen, enabling central banks to accelerate the pace of rate cuts on both sides of the border in the coming months.

What are your thoughts on the outperformance of Growth versus Value in recent quarters?

This graph shows the U.S. MSCI Growth and Value Indices from the beginning of 2023 through to the end of the second quarter of 2024. Over this period, Growth handily outperformed Value. This is similar to most periods since the 2008 Great Financial Crisis, with 2016 and 2022 notable exceptions. Growth in the U.S. equity market, perhaps best epitomized by the Magnificent Seven (Fantastic Four more recently), experienced a remarkable run over this period as the economy was surprisingly strong. Companies generally met or exceeded expectations; Artificial Intelligence emerged as a strong investment theme; and investors felt a need to have exposure to the evolving industry leaders.

Looking at the S&P/TSX Composite Index returns in more details, can you please discuss sector returns in the second quarter?

Second quarter returns in Canadian equities varied significantly across sectors. Notably, seven of the 11 sectors posted negative returns for the quarter.

The worst-performing sector was Health Care, which reversed course from being the top-performing sector in the previous quarter. We recognize the sector’s limited relevance given its sub-1% weighting in the benchmark.

The generally interest rate-sensitive areas of the market such as Real Estate, Communication Services and Utilities remained under pressure given the seemingly higher-for-longer interest rate environment.  One exception within the Utilities space was independent power producers, which were propelled higher as surging AI-fuelled demand for data centres boosted expectations for higher load growth.

In contrast to the continued enthusiasm surrounding generative AI experienced south of the border, the Canadian Information Technology sector, lacking consequential exposure to “AI-enablers”, meaningfully lagged. Notably, sector heavyweight Shopify retreated approximately 14% during the quarter (about 26% from its 52-week-high reached in February) on weaker-than-expected quarterly results and a disappointing outlook.

In Energy, notwithstanding intra-quarter weakness following somewhat ambiguous OPEC+ market communication, crude oil prices exited the quarter more or less at the level they began, near year-to-date highs. This was reflective of still-strong U.S. economic data (a demand indicator) as well as geopolitical uncertainty related to the Israel-Hamas war and the potential for that conflict to affect shipments of Middle East production.  In contrast to the U.S. natural gas prices (NYMEX) which rose significantly on elevated data centre electricity demand, Canadian pricing (AECO) was dismal, with spot prices falling below $1/GJ recently. However, prospects for gas producers in Western Canada should improve when LNG Canada becomes operational and begins to export liquefied natural gas in 2025, as implied by the futures curve.

At the other end of the spectrum, the best-performing sector was Materials, which was buoyed by commodity price strength, with gold bullion gaining 5.5% during the quarter to US$2,340/oz (COMEX) while copper advanced 9.6% to finish at US$4.39/lb (COMEX).

Consumer Staples also demonstrated relative strength during the quarter on the back of constructive consumer trends and abating inflationary pressures.

How did Franklin ClearBridge Canadian Equity Fund perform during the quarter and what where the drivers of relative performance?

The Fund performed in line with the Index in the second quarter, declining 0.5%.

At the sector level, the Fund’s relative performance benefitted from strong selection in the Consumer Discretionary and Utilities sectors. Being overweight the outperforming Consumer Staples sector further complemented relative outperformance, but this was largely offset by unfavourable positioning in Industrials, Information Technology and Materials. Poor stock selection was the main driver of relative underperformance in Industrials with an outsized position in TIXT representing the primary detractor. Security selection in Information Technology also detracted, although the Fund’s overweight stance in Open Text, which significantly underperformed during the quarter, was partially offset by an underweight position and a partial holding period of Shopify, which entered the Fund mid-way through the review period. Relative underperformance in Materials was mainly attributed to an underweight stance in this outperforming sector.

Which individual names drove absolute performance for the quarter, both positively and negatively?

Top contributors to absolute returns in the Fund included Agnico Eagle Mines, Royal Bank of Canada, Dollarama and Saputo.

The biggest detractors from absolute returns were Open Text, Canadian Pacific Kansas City, Canadian National Railway, Toronto-Dominion Bank, Bank of Nova Scotia and Bank of Montreal.

In terms of relative performance, which names were most influential for returns in the last three months?

Top contributors to relative returns included Shopify (note that the security entered the Fund part way through the quarter), Agnico Eagle Mines, Saputo and Dollarama.

On the flipside, the Fund’s overweight positions in Open Text and TELUS International detracted from relative performance.

Any insights on the activity in the Fund during the quarter?

While trading activity during the quarter was broad-based from a sector perspective, additions centred around more attractively priced, defensive/interest-rate sensitives (BCE, Brookfield Renewable Corporation and Canadian Utilities) on continued weak sentiment fuelled by the seemingly higher-for-longer environment.  Consideration was also awarded to out-of-favour cyclical and growth names (Nutrien, Boyd Group, Open Text, Bank of Montreal, Royal Bank of Canada and Toronto-Dominion Bank) as we believe their risk/reward to be compelling at current share prices.

In addition to capitalizing on opportunities within our portfolio, we also initiated positions in a number of new equities.

Within the interest-rate sensitive area of the market, we complemented current holdings with Brookfield Infrastructure Corporation, the common-share equivalent investment to the limited partnership units of Brookfield Infrastructure Partners (BIP). BIP owns a globally diversified portfolio of high quality infrastructure assets providing essential products and services for the global economy. Similar to other interest-rate sensitive names, BIP has experienced significant share price weakness more recently. Through its sponsor, Brookfield Asset Management, BIPC has access to large pools of private capital it can deploy in attractive co-investment opportunities. BIPC’s franchises, spanning Utilities, Transport, Energy and Data Infrastructure are poised to prosper from secular tailwinds emerging in decarbonization, deglobalization and digitization.  

In Materials, we trimmed Agnico Eagle Mines on strength in favour of the reintroduction of positions in past holdings FNV and WPM, both precious metal royalty/streaming businesses. Royalty and streaming companies have no direct exposure to capital costs, operating costs, exploration costs and environmental/reclamation costs, yet in many cases they benefit from exploration upside through the royalty and/or stream on increased production. We note that WPM has demonstrated constructive portfolio growth over the past couple of years, while challenges at FNV and related share price weakness present an attractive opportunity. FNV’s largest single royalty/streaming agreement with Cobre Panama (partnership with First Quantum in Panama) was fully written off following the local government’s forced closure of the mine. Significant subsequent weakness in FNV’s shares priced in residual risk and leaves restart optionality should local conditions improve.

In Energy, we initiated a position in Parex Resources (PXT), a Canadian company with oil and gas assets in Colombia and a key partner of the Colombian state oil company Ecopetrol. We took advantage of the recent share price weakness arising from the company’s disappointing production forecast. We note that PXT has an established track record of generating excess free cash flow, from which it has pursued a multi-year share buyback program as well as more recently instituting an attractive dividend. The company’s clean balance sheet (no debt; significant cash balance) serves to further mitigate risk.

Shopify (SHOP) was introduced to the Strategy on weakness during the quarter after an 18.7% decline following Q1 reporting—its worst single trading day since the initial public offering (IPO) in 2015. Having observed the company from the sidelines over these years—its tremendous historical growth, challenges, and certain missteps—we believe SHOP has reached a level of maturity where their priorities have come into better focus, and we now have better visibility into the business model, prioritization of sustainable profitability, and alignment surrounding capital allocation. These factors, combined with improved valuation, compelled us to establish a position; however, we enter SHOP ownership with our eyes wide open.

Conversely, strength observed in select defensive/less interest-rate sensitive parts of the market motivated us to trim our holdings in Dollarama, Loblaw and Waste Connections in addition to the already-mentioned Agnico Eagle Mines.

How would you describe the current positioning of the Fund?

We manage the Fund with a consistent investment style. Importantly, the Fund maintains a much better valuation profile than its benchmark based on our free cash flow valuation approach.

With the equity market discounting a seemingly ideal/optimistic scenario of rate cuts, continued economic growth and a solid corporate earnings profile, there appears to be little margin for error. Accordingly, we continue to maintain a relatively more defensive positioning than is typical for the Fund.

The Fund remains underweight the more cyclical sectors and overweight the more defensive sectors.

Over the past twelve months, the Fund has become more defensive. The largest weighting change over the year was the 390-basis point increase in the Utilities sector as we purchased ATCO, Fortis and Hydro One, and introduced Canadian Utilities, Brookfield Renewable Corporation as well as Brookfield Infrastructure Corporation. This was partially offset by the 150-basis point decrease in the Consumer Staples sector, where we trimmed our positions in Loblaw and Alimentation Couche-Tard.

Effectively, our defensive positioning and cash serve as dry powder that we will deploy when better opportunities arise. We look forward to a market environment—possibly a market correction—in which the Fund benefits from our patient and deliberate positioning. When this time comes, it should also allow us to shift towards a more aggressive stance and transition the Fund’s beta profile from the current lower end of our targeted range (0.8) to the upper end of our target range (0.9).