Volatile markets reward active management

Text transcript

Welcome to Advisor to Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject-matter experts themselves. 

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Catharine Sterritt, lead portfolio manager of Canadian equities for CIBC Asset Management 

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We are seeing opportunities for active management to add value through this period, where we are seeing quite an extraordinary number of macro events adding to the volatility in the equity market. 

We have geopolitical risks in the Iran situation, as well as the ongoing Russia-Ukraine war that is adding volatility to oil, and that is a potential contributor to inflation, and has implications to interest rates, with interest rates being, probably, by far the biggest driver of valuation in equity markets. 

We have the ongoing questions related to AI, both with respect to the opportunities that it creates, but also the risk of disruption and that there are going to be winners and losers. And certainly, through February, we were seeing some very large dislocations in the market, as people were thinking through the implications to software business models. 

And then we’ve had a more recent development in the concerns around the private credit market and some stress there, in part because that private credit market had extended quite a significant portion of exposure and capital to the software industry. And there is risk of that spilling into other markets, because where you have a lack of liquidity, but you have a capital call, investors end up having to find relief and raise capital in more liquid assets, and stock is going to be one of the first places that they go to. 

When we look at well, how do you protect yourself from all of these factors that are adding to this volatility, clearly diversification is so critical. By diversifying, you give yourself a variety of exposures. But we also think that there’s a lot of benefit from bottom-up stock picking, where you’re looking for stock-specific catalysts and situations that offer some isolation to the macro environment. 

These are companies that might have opportunities in M&A, to add synergies, to expand their product offerings. With bottom-up analysis of the AI situation, you can identify some of those winners. And also focus on companies that are the beneficiaries of longer-term trends, like the growth that we’re seeing in nuclear power, for instance. 

We think this will allow us to be well-positioned as we move through the balance of 2026, because there’s a lot of other events still coming down the pipe. We may see resolution of some of these geopolitical risks, but on the other side, we’re still entering into trade negotiations with the U.S. and Mexico for CUSMA, and we also have the U.S. primaries in November, which could directly influence further policy change and have tariff implications. 

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When we look at Canadian oil equities, we recognize that they’ve had a lot of strength in the first part of the year — strong corporate earnings, [and] they’ve had margin expansion. Across the board, we’re seeing companies with very defined shareholder return of capital initiatives, including buybacks. And we were seeing that oil prices were performing well through January and February and, as a result, the oil equities had been major contributors. 

We’re expecting energy equities would continue to perform well through the balance of the year because as global manufacturing was picking up, we had the expectation that by mid-year we were going to see the oil market move from a surplus to a deficit, and that this was going to create a tailwind. 

Since then, we’ve had this tremendous volatility in oil prices as a result of the developments that we’ve seen with Iran. But it’s very important to recognize that energy equities are by far more correlated to oil prices one year out than they are to the spot. If we look [at] what has happened since the Iran confrontation escalated, at the time, in late February, the front end of the market, the spot market was running in around $60 U.S. for WTI. And what we saw [was] the market go well through US$100, and then move back with that volatility. The longer oil futures, they only moved up 15% from US$60 towards US$68 by mid-March. 

But the equities themselves, like a bellwether Canadian stock like CNQ, was only up 5% through that same period. You wouldn’t expect that the equities, which are really trying to capture the long-term opportunity, would move with the short-term volatilities. 

Our expectation is that the oil equities — Canadian oil equities, in particular — are well-positioned to perform on a wide variety of scenarios. If we continue to have the disruption in the oil markets from the geopolitical events that are taking place, Canadian companies are a beneficiary of that because they will get the higher cash flows and the higher pricing. 

And we’re particularly well-positioned also on natural gas. 

But alternatively, if there is a return to some normalization and the pressure comes off the global economy, I think we’ll continue to see global manufacturing back on track because the strong corporate earnings that we were seeing was quite a global phenomenon. Part of it was fiscal stimulus, but there also are AI cost savings and margin expansion that we’re seeing that’s quite widespread, and so we think we’ll get back on track. 

Although it doesn’t surprise us that the energy equities have not kept pace with the movement that we’ve seen in the oil prices — because they do have a tendency to price out over the longer oil futures market — there are some areas of the equity market that have been quite dislocated, or have seen more dislocation as a result of this pickup in geopolitical risk, related directly to how strong the U.S. dollar is. 

The U.S. dollar is a safe haven. This has been reflected in our copper equities, the base metal commodities, and gold suffering weakness. We’re looking through some company-specific opportunities there, because that is contrary to the longer-term trend. If some of these geopolitical issues start to get resolved, there is a longer-term trend of U.S. dollar weakness because of the stress of the very large ongoing deficit and absolute levels of debt. So, we think that that will create some opportunities. 

Some of the other longer-term opportunities that come out of what we’ve been seeing in the Middle East are the opportunity in defence stocks. We think those investments will continue even with near-term resolution. 

And also gold. Gold is a longer-term beneficiary because the world is more unsettled, and the central bank’s push for diversification will continue, and so we do expect to see gold equities resume their prior strength. 

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We definitely are of the view that the AI technology is here to stay. But the implications of who the winners and losers are going to be is still settling out on the capex side. So we’ve certainly seen that the early equity beneficiaries of AI were in the large global majors, as they were announcing massive capex to seize this opportunity, and create the capacity that they were needing in data centres. And that’s an area where initially the market was really rewarding these companies for the expanded total market opportunity. 

But as the capex numbers grew, there started to be quite reasonable concerns that, as these companies went into the debt market to help fund the capex in this kind of arms race that we’re seeing and trying to get data centres opened up, that this was going to slow down the operating leverage of these businesses. Because now you have to contend with increased operating cost, depreciation related to the capex, and interest expense itself. 

So we have been seeing margin compression in the large caps. But the other thing that we were seeing through the course of January and February was a very sharp margin compression in the companies with software platforms. That the software as a service [SAAS] was coming under pressure, because that has been a business model that was pricing on how many people were using [it]. And the whole thing with AI is that it does create productivity savings, where AI is allowing you to reduce your hours that it takes to deliver something. 

And so there was a lot of concern that for businesses like engineering, that productivity was going to result in fewer hours to bill out. Or that you would need fewer subscriptions from your service provider because you could use AI to leverage your workforce. 

While, on one hand, we were seeing many companies having a benefit of cost reduction, there was definitely a concern on software as a service that AI could significantly disrupt their revenue streams. We do think there’s going to be opportunities, that the winners in the software area from AI are going to be the companies that have large moats with proprietary software, and have very strong customer relationships. 

That leaves some companies like Thomson that have very deep data moats, and companies on the engineering side like a WSP that have huge databases of climate studies and engineering work to draw on, that positions them well. And AI will allow them to slice and dice that and better prepare for forward bids. And companies, like Shopify, that have tremendous customer relationships will have the opportunity to roll out AI to their customers.

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