2022 Looking Positive for Canadian Markets

Canada’s capital markets are adapting to the changing dynamics of the pandemic, and as the economy continues to strengthen, Franklin Bissett managers see both equity and fixed income opportunities for active managers.

Canadian Stocks Adapt to Dynamics of The Pandemic

Garey J. Aitken
Chief Investment Officer
Franklin Bissett Investment Management

Tim Caulfield
Director of Equity Research
Franklin Bissett Investment Management

For Canadian stocks, the past year has mostly been characterized by a steady upward trajectory, with numerous cases of record highs for the S&P/TSX Composite Index. The COVID-19 pandemic is still very much part of our lives and remains a major concern given the new Omicron variant, but it hasn’t hindered overall equity performance to any great extent in 2021. Whether this trend can continue throughout 2022 is what most investors are asking themselves now, given inflation concerns and the prospect of interest rate hikes by both the U.S. Federal Reserve (Fed) and the Bank of Canada (BoC) at some point next year.

For the moment, Canadian stocks continue to ride high, outperforming their counterparts in the United States—the S&P/TSX Composite has a year-to-date (YTD) return of 23.4% as of October 31, 2021, compared to 20.7% (in Canadian dollars) for the S&P 500. This is quite the divergence, given that the main Canadian equity index has underperformed the S&P 500 in nine of the last 10 calendar years.

With the advance in the S&P/TSX, performance has been driven largely by the Information Technology, Consumer Discretionary and Energy sectors.

A stimulus hangover?

Inflation has become the number one issue in investment circles as a combination of pent-up consumer demand, labour shortages, higher wage demands, and international supply chain constraints have pushed prices higher.

In its October reading, the Consumer Price Index (CPI) in Canada was up 4.7% year-over-year, making it the seventh consecutive month that inflation has exceeded the Bank of Canada’s target range of 1–3%. This mirrors the trend in the U.S. where its CPI was up 6.2% year-over-year in October—the largest annual increase since 1990. These numbers have not gone unnoticed by policy makers, and both the Fed and the Bank of Canada are in the process of winding down their quantitative easing programs that have been in place throughout the COVID-19 crisis.

There has been less serious debate about the dangers of inflation over the last decade, so its reappearance is cause for concern for many investors. Inflation is necessary for the health and continuity of the business cycle, but excessive levels can have devastating compounding effects, acting as a “silent-tax” on real rates of return.

Natural resource-rich Canada has long been known as a safe-haven of sorts for investors during inflationary periods, as they can seek protection through a diverse range of commodity-based businesses.

Commodities’ moment in the sun

Although its influence is not what it once was, the Energy sector remains a vital part of the Canadian economy and equity market; there is also a strong correlation between the price of oil and the strength of the Canadian dollar. Measured against the greenback, the loonie is the best-performing currency among the G-10 countries this year, which is perhaps not surprising when you consider that the price of a barrel of crude breached US$85 in late October.

This is the highest level for oil in seven years, and a dramatic swing from the depths of spring 2020 when futures for Western Canada Select (WCS) moved into negative territory for a short spell (WCS is hovering around US$60 per barrel, as of October 31, 2021).

While demand for oil continues to grow as the global economy recovers from the pandemic, increased supply from the U.S., Saudi Arabia and Russia could mean prices stabilize somewhat in 2022. That’s one possibility, but with the longer-term trend towards reducing carbon consumption, which is already happening across different regions, the supply constraints that have marked 2021 may continue into next year and beyond, supporting higher prices for both oil and gas.

Allure of Canadian equities

Despite weak Q3 2021 growth numbers, the International Monetary Fund (IMF) recently upgraded its 2022 growth forecast for Canada (from 4.5% to 4.9%). The country’s unemployment rate also has been moving in the right direction, coming down for the fourth consecutive month in September to sit at 6.9%. Should Canada’s recent success in managing the pandemic continue into 2022, the economy and equities could benefit in kind.

"The price of Canadian stocks has also been proving attractive for international investors, with the valuation of the S&P/TSX Composite at a more attractive level than the S&P 500.”

The price of Canadian stocks has also been proving attractive for international investors, with the valuation of the S&P/TSX Composite at a more attractive level than the S&P 500. The price/earnings (P/E) ratio spread between the two indices is at its widest for the past 20 years, as of October 31, 2021.

The Canadian equity market becoming less reliant on commodities has been another positive long-term trend. Ten years ago, the Energy and Materials sectors added up to 49% of the index market cap, and now account for close to 24%. In that same period, the Information Technology sector grew by a factor of eight, while the Industrials and Utilities sectors have more than doubled. This more balanced composition has helped the Canadian six consecutive quarters of positive returns following the correction in Q1 2020.

Looking at 2021, performance has been strong YTD, although this momentum slowed considerably in Q3. A return of 0.3% for the third quarter was well below the average quarterly increase of 9.5% for the previous five quarters. Growth/concept stocks’ strength for much of the quarter dissipated in September in favour of defensive/non- cyclicals and value/cyclicals. The rebound in bond yields in September had an impact on this shift, as 10-year benchmark yields in both Canada and the U.S. ended the quarter at 1.51% and 1.49%, respectively, versus their summertime 2020 lows of 0.43% and 0.51%. Nevertheless, this slight increase for Q3 meant the S&P/TSX had six consecutive quarters of positive returns following the correction in Q1 2020.

Is TINA turning?

The 21-month period since March 2020 representing the new bull market has brought significant returns for investors. As shown in the table below, the Canadian equity market now stands 17.6% higher than the pre-pandemic, all-time high reached on February 20, 2020. This current bull market has generally been led by either growth/concept or value/cyclical stocks, while defensive/non-cyclical names have lagged.

A major factor in the performance of growth/concept and value/cyclical stocks during the pandemic has been the massive levels of fiscal and monetary stimulus. With near-zero interest rates making fixed income much less attractive as an investment, capital has flowed into certain sections of the equity market instead. This phenomenon has been referred to as TINA or “There is No Alternative”. TINA has also exacerbated the general disregard for fundamentals and valuation that was commonplace in the years leading up to the pandemic, in favour of stocks with momentum and growth potential. In Q3 2021, the TINA effect appeared to be slipping, and results were more mixed as defensive/non-cyclical and value/cyclicals outpaced growth/concept stocks.


Source: Bloomberg, Franklin Templeton Investments; *As of September 30, 2021

"…the digital transformation of the global economy is a long-term trend that is likely to accelerate in the months and years ahead.”

A reversal of fortunes in Q3

Analyzing the sectors that have performed best during the current bull market, it is clear which businesses have been able to adapt to the constraints of the pandemic. It’s not surprising to see Information Technology as the top performer among sectors, as companies like Shopify capitalized on the shift towards e- commerce during the various lockdowns.

On a YTD basis, IT isn’t as strong, posting a negative return for Q3 (-1.3%), but the digital transformation of the global economy is a long-term trend that is likely to accelerate in the months and years ahead. Consumer Discretionary and Energy have been the other big beneficiaries of the dynamics of the new bull market, but both saw their performance slip during the third quarter of 2021. This was more pronounced for Consumer Discretionary, which produced a negative return (- 6.5%) for the quarter, versus Energy’s 2.8%.

Adapting to the new normal

COVID-19, and pandemics in general, are certainly difficult to predict. Although we appear to be in a much stronger position than at the end of 2020, it’s always advisable to proceed with caution. In Canada, the vaccine rollout has proven effective at limiting infection rates, and almost 75% of the population is now fully vaccinated, as of November 25. The virus is nothing if not persistent though, as climbing infection rates in Europe testify. The need for booster shots looks likely, while a mass vaccination campaign for children is the next huge logistical challenge for Canada.

It appears that COVID-19, vaccines, masks and social distancing will be with us for some time yet, but that need not necessarily mean further lockdowns. This “new normal” may also encourage investors to adopt a more balanced view, particularly when it comes to valuations. Leadership by defensive/non-cyclicals in the third quarter of 2021 may prove noteworthy in this regard. The market’s dip in Q3 can be attributed in large part to the expectation for higher interest rates in 2022. Norway and South Korea both raised their interest rates in Q3 2021, and the signs point to the BoC following suit in the first half of next year. Higher rates can have both positive and negative consequences for stocks, depending on the specific business and industry.

Increasing rates typically have a negative impact on the present value of long-duration assets and businesses with levered capital structures, as well as yield-oriented equities. There is also an inverse relationship between higher interest rates and the prospects for growth/concept stocks, where value is largely predicated on cash flows well into the future.

In contrast, increasing rates can, in isolation, have a positive impact on the operating profitability of businesses in sectors such as Financials. In this instance, either a non-responsive deposit base (banks) or difficult-to- match long-duration liabilities (insurance companies) can benefit from higher rates.

Aside from monetary policy, there are a number of other factors that could negatively impact equity markets in 2022. Supply-chain disruptions, particularly with high-value goods such as semi-conductor chips, as well as current instability in the Chinese economy are other concerns right now.

Discipline and consistency across market cycles

Although TINA may be fading, we will keep a steady temperament through the vagaries of varying market regimes, with a focus on the long term that cuts through the ebb and flow of financial market sentiment. The discipline and consistency developed over multiple market cycles, and the patient, yet decisive temperament of the team is critical and present today.

Our robust bottom-up investment framework serves as a strong foundation for our decisions. We recognize the inefficiency of markets, especially in the short term, and alternatively keep our sights set on normalized full-cycle economics of businesses over the long run.

Additionally, the importance of owning businesses that have structural advantages to allow them to navigate through thick and thin remains key. Our investment style is therefore well suited to the changing dynamics that directly impact the handicapping of risk and reward potential that is vital to our investing success.

Fixed Income: The Known Unknowns

Tom O’Gorman
Director of Fixed Income
Franklin Bissett Investment Management

Darcy Briggs
SVP, Portfolio Manager
Franklin Bissett Investment Management

The past year has been one of the more challenging in recent memory for fixed income markets. The intersection dynamics of a “once in a lifetime” global pandemic and extraordinary stimulus programs has created macro conditions last seen a quarter of a century ago.

As the global economy lurches back from the paralysis brought on by the COVID- 19 pandemic, soaring inflation and tight labour markets are a result of stimulus- driven economic growth moving from recovery to expansion. The current constellation of macro variables leads to the million-dollar question and subject of great debate: Are current conditions transitory or permanent?

Fixed income markets have adjusted to the current set of economic conditions and the near-term outlook accompanying them, which have weighed heavily on fixed income returns in 2021.

Will 2022 be better for fixed income, or is additional pain brewing?

Finally, economic growth returns

Many developed markets moved from a pandemic-induced quasi- depression/recession to positive growth in 2021, which became more evident as very low base effects from last year’s shutdowns fell away in the second half of the year. As pandemic restrictions continue to be lifted, spending on both goods and services has bounced back.

Quick vaccine rollout in the United States helped lead economic growth in most of the developed economies during the early stages of the reopening. In comparison, Canada’s rollout was initially slower but caught up as the year progressed; in fact, in the third quarter of this year, Canada’s Gross Domestic Product (GDP) hit a respectable 5.4% annualized, which was a considerable improvement over the previous quarter’s contraction and in line with the Bank of Canada’s (BoC) forecast of 5.5%. For 2021, central bank forecasts are calling for GDP of approximately 5.0% in both countries. Growth is expected to continue in 2022, though at a somewhat slower pace.

No more easy money for you

With economic engines stoked, central banks and governments―at least in Canada and the United States―have stated their intentions to wind down some of the extraordinary stimulus programs that provided much-needed financial support during the worst months of the pandemic. Tapering of asset purchases is the first step in a bigger process of transitioning policy from accommodation to neutral.

Fiscal support from governments is also fading. Many U.S. pandemic support programs, such as pandemic-enhanced unemployment benefits and other provisions of the CARES and ARP Acts, have ended. In Canada, some business and consumer support programs (CRB, CEWS, CERS) ended in October, while others are being transformed into more targeted programs with higher thresholds for entry.

2021 financial word of the year: inflation

One consequence of the pandemic has been a bout of significant cyclical inflation. Household consumption baskets have changed over the course of the pandemic, with spending directed towards goods as outlets for service consumption were constrained. As consumers flush with cash were confined to their homes with a laptop and online home delivery, conditions were set for excess aggregate demand for goods.

In conjunction, finely tuned inventory management systems of manufacturers, shippers and ports had focused on efficiency (“just in time”) over the last 20 years, with little excess inventory (“just in case”), leaving little flexibility to deal with the extra demand. Rotating COVID- 19 outbreaks also contributed, restricting inputs such as labour and microprocessors in the manufacturing process. The net result of these two conditions has resulted in more demand than supply, raising prices in the process..

"As significant interest rate hikes are currently discounted by the market, we believe 2022 will be a better year for fixed income markets.”

Given the dynamics of the pandemic, economic reopening and rotation to services consumption has partially occurred. With demand for goods still robust, central banks have acknowledged that inflation is more persistent than originally anticipated. Inflation forecasts for the first half of 2022 are well above their 2% target.

Raising rates will help at the margin

To control inflation, central banks raise the cost of borrowing, which typically leads other financial institutions to raise their rates as well―in essence, to tighten credit. Central banks in both Canada and the U.S. have indicated they intend to begin raising rates in 2022. Financial markets are forward looking. Fixed income markets have already discounted aggressive monetary policy tightening with the end of quantitative easing (QE): two or more interest rate increases from the U.S. Federal Reserve (Fed) and five interest rate hikes from the Bank of Canada (BoC). Paradoxically, the BoC believes the rate of inflation will recede over the course of the next year. In that case, would the bank still raise rates? We think so, but the rate of increases is subject to debate. As significant interest rate hikes are currently discounted by the market, we believe 2022 will be a better year for fixed income markets.

Markets in Canada began to aggressively discount a sharp tightening cycle from the BoC in October as the central bank signalled stronger-than-expected growth and more persistent inflation, combined with stronger-than-expected employment gains. The front end of the yield curve, which had been remarkably stable throughout the pandemic, rose significantly while mid- and longer-term maturities remained relatively steady. The result was a significantly flattening Canadian yield curve.

Since then, however, floods in British Columbia and the emergence of the Omicron variant have increased near- term downside risks to growth while keeping inflation risks tilted higher. Despite these risks, we believe the current economic landscape does not warrant emergency levels of monetary or fiscal stimulus.

An end to the pandemic would help rotate consumption toward services from goods, while increasing the cost of money. This would temper demand for goods, especially capital goods, which are generally financed. Both events would go toward providing much-needed time for supply to catch up.

Additionally, while Canada’s economy has almost recovered, it is still extremely imbalanced. Excessive reliance on housing/consumption has correspondingly become more interest rate-sensitive given high levels of household debt..

Considering these dynamics―and the additional tightening of financial conditions from a rise in the Canadian dollar should the BoC move more aggressively than the Fed― markets have likely overpriced the interest rate response from the BoC

A silver lining for corporate bonds

While higher interest rates give some borrowers indigestion, spreads for the most part have remained particularly well behaved. If inflation stays elevated throughout 2022, corporate fundamentals should remain strong, leading to stable- to- slightly-stronger credit spreads. The spread on corporate debt reduces interest-rate sensitivity.

We would expect corporates to outperform, as they will have more interest carry to offset the impact of rising rates. Leveraged loans are least exposed to rising rates given their floating rate structure, while select high yield bonds should also do well in a rising-rate environment. We see energy bonds outperforming, given demand/supply dynamics and generally firmer commodity prices, which hedge inflation risks.

We remain overweight corporate credit, recognizing that in relative value terms, Canadian corporate credit spreads are fair value at best, and some sectors and issues are downright expensive.

On the other hand, we also track corporate spread as a percent of yield (see chart on following page). Given the cushion corporate credit spread can provide against any further widening of government yield curves, that metric suggests there is still value in the corporate space. At 46% at the end of November, spread as a percent of yield is 8% above the post-GFC (Global Financial Crisis) average of 43%. This is encouraging.

"If inflation stays elevated throughout 2022, corporate fundamentals should remain strong, leading to stable- to- slightly-stronger credit spreads.”

Security selection to the forefront

We believe the easy money from adding to risk sectors has been made. Now security selection is key, and investment teams must be strategic in their approach.

Narrowing spreads have taken some of the shine off corporate credit. While we have reduced the credit allocation slightly in the portfolios, we continue to increase credit quality and look for name-specific opportunities. We have also been adding levered loans as those securities have limited interest-rate sensitivity.

Our Franklin Bissett Core Plus Bond strategy invests a portion of its allocation in sectors with low correlation to Canadian investment-grade bonds, such as U.S. investment-grade (IG) and High Yield (HY) bonds and bank loans, in order to generate better risk-adjusted returns.

We remain overweight credit; but given current overall market valuations, we believe it is prudent to have hedges in place should events arise which cause volatility to rise and valuations to change.

5-Year Corporate Credit Spread - % of Yield

Source: Bloomberg, Franklin Templeton. For the period from October 1, 2002 – December 1, 2021

What are the Risks?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Diversification does not guarantee profits or eliminate the risk of investment losses. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds adjust to a rise in interest rates, the share price may decline. Treasuries, if held to maturity, offer a fixed rate of return and fixed principal value; their interest payments and principal are guaranteed. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size and lesser liquidity.

The information provided is not a complete analysis of every material fact regarding any country, region, or market. Comments, opinions and analyses contained herein are those of the speaker and are for informational purposes only. Because market and economic conditions are subject to change, comments, opinions and analyses are rendered as of December 1, 2021, and may change without notice. The analysis and opinions expressed herein may differ or be contrary to those expressed by other business areas. Opinions are intended to provide insight on macroeconomic issues and commentary is not intended as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy.