The current Goldilocks environment is hurting two of Canada’s key sectors, says Michael Harber, an associate portfolio manager of Canadian equities at Picton Mahoney Asset Management, a sub-advisor of the Renaissance Canadian Growth Fund.

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That’s because energy and materials do not respond well when an economy’s “growth is comfortably above zero so [that there’s minimal] recessionary risk, but not so strong that it stokes fears of inflation,” he says.

The Canadian market has fit the Goldilocks definition for three years: “Impressive employment and the housing recovery in the U.S. have been the growth engines, delaying the U.S. rates cycle. Enhanced accommodation from the ECB and the BOJ has kept the engine fuelled with easy money.”

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Delayed inflation has also been a factor. “The maturing of the business cycle of developed markets, coupled with the maturing of emerging market economies and structural growth problems in Europe, has kept the lid on aggregate growth,” he says.

Who gains from Goldilocks

An environment with low growth, low inflation and low rates “is generally positive for risky assets such as equities; particularly, small-cap equities,” Harber says.

In the equity market, “Investors have been flocking to sectors and styles that have outsized growth potential” since growth is scarce right now. People are also choosing “beneficiaries of a low-interest-rate environment.”

For example, companies that grow through acquisition by issuing cheap debt may offer increased yield compared to the bond market. Companies may also use cheap debt to issue enhanced dividends or repurchase shares. In particular, Harber says the healthcare and technology sectors have been outperforming, as have “those sectors that offer high dividends, such as utilities and telecoms.”

To take advantage of Goldilocks conditions, he says it’s best to select small-cap funds that “have broad diversification across not only sectors but geographies. If one owns a Canadian small-cap mandate, that investor is overly exposed to sectors such as energy and materials, which do not respond favourably to the Goldilocks environment.”

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The best fund mandates “are diversified across sectors, and [include] healthcare, technology and consumer.” He adds that such sectors “are not readily available in Canadian small-cap mandates.”

The end of Goldilocks

Harber notes the current Goldilocks environment will end in one of two ways. “The first is the inflationary route, where growth starts to kick ahead of what would be non-inflationary.”

If this occurs, “the Canadian small cap environment would respond quite favourably at the onset, as it would be supportive for groups such as energy and materials. [But] ultimately, that would spur an aggressive tightening cycle from central banks, which would end that outperformance abruptly.”

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Alternatively, Goldilocks could end through deflation. “This is where the low but positive growth turns into low growth with a risk of going negative. And obviously this is a risk to all areas of the equity market if we’re to see a recessionary environment globally.”

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