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

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

The third quarter marked a strong rebound for Canadian equities following a lackluster second quarter, with the S&P/TSX Composite TRI advancing 10.5% during the quarter to reach a new all-time high, capping off a 26.7% advance for the past twelve months. The rally saw broad participation and a meaningful decline in benchmark 10-year interest rates on both sides of the border, making it a consequential contributor to the market’s advance.

Against this backdrop, Canadian equity leadership was provided by the interest rate-sensitive sectors and higher-yielding equities, with Real Estate, Utilities and Financials the top-performing sectors.

The U.S. market experienced a similar phenomenon, leading to a shift in investor attention away from the overarching theme of Artificial Intelligence that has dominated the market over the past several quarters.

When we look at Canada versus the U.S., although the S&P 500 TRI advanced 5.9% (4.6% in Canadian-dollar terms) during the quarter—also reaching a new all-time-high—the U.S. index underperformed its Canadian counterpart for the first time in seven quarters.

What are your current thoughts on the Canadian economy?

Although still resilient, the economy is showing signs of deceleration as the lag effects of the tight monetary policy that began in 2022 are starting to surface.

Despite significant progress made to control 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.

Business optimism is also mixed. Corporate earnings have delivered so far this year but guidance for the remainder of the year is more cautious, reflecting growing concerns about the state of the economy.

The once-tight labour 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.

Intensified geopolitical risks and the uncertainty surrounding the upcoming U.S. elections are further contributing to unease.

Inflation’s drift towards the desired 2% target has been welcome. Combined with growing uncertainty about the health of the economy, central bankers have now been able to pivot away from their hawkish monetary policy. Both the U.S. Federal Reserve and the Bank of Canada have now embarked on a rate-cutting cycle.

With the view that the risks between inflation and unemployment are roughly balanced, the market consensus appears to be discounting a soft landing scenario. Should the economy fare worse than expected, however, there is considerable downside risk for areas of the market with more extreme valuations.

How have expectations of the pace and magnitude of central banks’ interest rate cuts evolved over the past quarter or two?

With the passage of time, the two economies diverged more meaningfully. Lackluster economic activity in Canada combined with a financially strained consumer forced the Bank of Canada to officially end its hiking cycle, which began in 2022, with a 25-basis point cut in June. This was followed by two additional quarter-point cuts in July and September and most recently, a further 50-basis point cut on October 23^rd.

More robust economic growth observed south of the border, along with sticky inflation, compelled the U.S. Federal Reserve to hold rates steady slightly longer, but softening labour dynamics prompted an outsized 50 bps rate cut in September.

Although future interest rate cuts will be data dependent, inflation nearing the 2% target, cooling labour markets and slowing economies should prompt central banks to further accelerate the pace of rate cuts on both sides of the border. Approximately 50 basis points of additional easing is currently priced into the markets by the end of the year, with more cuts expected in 2025.

Garey, can you comment on the performance of Growth versus Value in recent quarters?

This graph below shows the U.S. MSCI Growth and Value Indices from the beginning of 2023 through to the end of the third quarter of 2024.

Growth handily outperformed Value through the end of the second quarter, which is similar to most periods since post the Great Financial Crisis (2016 and 2022 were notable exceptions). Growth in the U.S. equity market, perhaps best epitomized by the Magnificent Seven, experienced a remarkable run over this period as the economy was surprisingly strong; companies generally met or exceeded expectations; artificial intelligence (AI) emerged as a strong investment theme; and investors felt a need to have exposure to the evolving industry leaders.

The third quarter marked a notable shift away from this trend, with market returns broadening and AI lagging. During this period, Value outperformed Growth, with Value gaining 9.7% and Growth advancing 2.6%.

Please discuss the sector returns for the S&P/TSX Composite Index in Q3, 2024.

Third-quarter returns in Canadian equities varied across sectors. All 11 major sectors advanced, with seven sectors posting double-digit returns.

Declining interest rates played a role in the divergence between sector returns, with the generally interest rate-sensitive areas of the market such as Real Estate and Utilities delivering the best returns during the quarter. The Financials sector was also very strong.

At the other end of the spectrum, the more defensive Consumer Staples and cyclically oriented Industrials and Energy sectors delivered the weakest returns.

The Canadian Information Technology sector posted strong returns, despite lacking consequential exposure to what we refer to the “AI-enablers” of the U.S. equity market. Canadian sector heavyweight Shopify (SHOP) advanced nearly 20% on improving investor sentiment.

Strength in Materials was buoyed by robust commodity prices. Gold bullion gained 12.7% during the quarter to US$2,636/oz (COMEX), hitting a new all-time high of $2,670/oz in late September, while copper advanced 3.7% to finish at US$4.55/lb (COMEX).

In Energy, crude oil prices continued their slide, ending the third quarter down 16.4% to US$68.17/bbl (West Texas Intermediate). The significant bifurcation in North American natural gas prices remained in the third quarter, with NYMEX natural gas prices increasing 12.4% to US$2.92/mmbtu (NYMEX) while local Alberta (AECO) prices languished. Noteworthy for the Canadian Energy sector, the long-awaited Trans Mountain pipeline expansion is now online. With LNG Canada expected to start exporting liquefied natural gas in 2025, prospects have improved for regional crude oil and natural gas prices in Western Canada.

Following strong performance in the second quarter, Consumer Staples experienced a softer patch despite constructive consumer trends and abating inflationary pressures.

Weakness in Industrials, on the other hand, was more widespread, reflecting growing concerns about deteriorating economic conditions.

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

The Fund advanced 8.9% (gross of fees) over the quarter. Despite delivering what we consider a strong absolute return, the Fund did underperform its benchmark, the S&P/TSX Composite TRI.

Top contributors to absolute returns included Royal Bank of Canada, Toronto-Dominion Bank, Brookfield Corporation, Bank of Montreal, Fortis, ATCO and Agnico Eagle Mines, all of which contributed at least 50 bps to absolute returns.

Conversely, the biggest detractors from absolute returns were Boyd Group, Parex Resources, Cenovus, Headwater Exploration and TELUS Digital, all of which detracted at least 20 bps from absolute returns.

In terms of relative performance, which names were most influential, both positively and negatively, on returns in the first quarter?

Top contributors to relative returns included Canadian Natural Resources and ATCO, as well as the absence of Suncor Energy.

On the flip side, the Fund’s overweight positions in Boyd Group, Parex Resources, Headwater Exploration, AtkinsRealis and TELUS Digital detracted from relative performance.

Can you comment on Fund activity during the quarter?

Trading activity in the third quarter was broad-based, with buying centered around more out-of-favour cyclical and growth names (Headwater Exploration, Parex Resources, Boyd, Canadian National Railway, TELUS Digital, BMO, TD). While interest-rate sensitive names in Utilities had been a focus of our buying in recent quarters, substantial accumulated overweight positioning and recent stronger share prices negated opportunities to add further.

In addition to capitalizing on opportunities within our portfolio in terms of those existing positions, we also initiated positions in a couple of new equities, namely ATS Corp. in Industrials and iA Financial in Financials.

In the case of ATS, the Company is a global leader in providing advanced automation solutions to customers across key industries such as Life Sciences, Transportation (EVs), Food & Beverage and Consumer Products. With its deep expertise and global capabilities, ATS addresses complex manufacturing needs in sectors with high barriers to entry. The recent slowdown in the Transportation segment (related to the EV business) has led to a reduction in overall backlog and contributed to significant pressure on the share price. This created the opportunity for the Strategy to initiate a position in August 2024.

Regarding IAG, the Company is the smallest publicly traded Canadian life insurance company, providing life and health insurance products, savings and retirement plans, mutual and segregated funds, and other financial products. The Company is an incumbent in Canada’s concentrated life insurance industry, with niche focus on mid-market (high margin business relative to other life insurance segments) with a distinctly large distribution network for its size. IAG’s distribution network also benefits the wealth management side of the business, as it is the number one seller of segregated funds in Canada. The Company’s history of conservative underwriting and reserving, and organic capital generation has resulted in solid growth. 

In contrast, strong performing equities motivated us to trim Enbridge, Agnico Eagle Mines (AEM), Dollarama, Loblaw, Manulife, and Colliers International.

Selling also included three outright eliminations in the quarter, including Wheaton Precious Metals in Materials, CIBC and Sun Life Financial in Financials.

In Materials, our sole gold producer position in AEM was once again meaningfully reduced on strength in a favourable gold price/sentiment environment. Furthermore, we consolidated positioning in the recently re-introduced precious metal royalty/streaming businesses by eliminating Wheaton Precious Metals on strength in favour of a more fulsome position in what we consider is the more attractively priced Franco-Nevada (FNV).

Thanks Garey. 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 still optimistic about a seemingly favourable scenario for 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.

As you can see from this chart, the Fund remains underweight the more cyclical sectors and overweight the more defensive sectors.

The Fund has become more defensive over the past years. The largest weighting change over the last 12 months was the 380 bps increase in the Utilities sector as we purchased Canadian Utilities, Fortis Hydro One and introduced Brookfield Renewable Corporation as well as Brookfield Infrastructure Corporation. This was partially offset by the 140 bps decrease in the Consumer Staples sector as we trimmed our positions in Loblaw, Metro and Alimentation Couche-Tard. The way we view this is that our defensive positioning and cash serves as dry powder that we will deploy when better opportunities arise and we look forward to a market environment, which would possibly be a market correction, whereby our 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).

Could a declining interest rate environment create a favourable set up for high-yielding Canadian stocks, and by extension the Fund?

The higher interest rate environment, driven by the Bank of Canada aggressive monetary policy since early 2022, attracted disproportionate fund flows into low-risk fixed income products including term deposits, money market and high interest saving mutual funds and ETFs; however, the central bank’s recent shift to a more dovish policy stance and the likely prospect of further rate cuts will likely pave the way for a rotation into higher-yielding equities.

As these high interest vehicles—GICs, HISAs and others—become less attractive in a lower interest rate environment, not to mention from a tax perspective), limited alternatives available in the Canadian marketplace should motivate investors to rotate these funds back to yield-oriented sectors such as Utilities, Real Estate, Communication Services, Pipelines and pockets of Financials.

Although this rotation will ultimately depend on the trajectory of future rate cuts and may be uneven due to varying risk appetites among investors, the Fund stands to benefit significantly if this rotation occurs, given its substantial positioning in these higher-yielding sectors.