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Where Are Canadian Equities Headed?

August 15, 2023 10 min 13 sec
Greg Zdzienicki
CIBC Asset Management
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Welcome to Advisor ToGo, brought to you by CIBC Asset Management. A podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves.

Greg Zdzienicki, client portfolio manager, CIBC Asset Management.

We’ve definitely seen a bit of a lag in the Canadian equity markets compared to the U.S. markets.

I think a big part of this is that we’ve seen a lot of market leadership from information technology and some consumer discretionary stocks. That they had a surprisingly very strong second quarter. A lot of this has been led on the backs of artificial intelligence. So everybody’s been hearing about AI and this has created a significant amount of excitement around for investors and sometimes also leads to a little bit of a dose of FOMO or some fear of missing out. And I think that drove some of the equity returns in the market that we saw during the second quarter.

Now, if you take a look at the Nasdaq, for example, it had its best first half of the year in 40 years. So all of the technology stocks in there, for example, have done extremely well, while the S&P/TSX was kind of held back a little bit. And I think that’s a result of the cyclical and the more defensive composition with things like gold stocks, REITs, consumer staples as well, we’re down a little bit in the quarter.

I believe that the reason that we’ve seen the Canadian equity markets underperform have been really a result of the leadership in the market coming from technology names as opposed to some of the more staples. Now, is that going to continue? I think there’s a few things to consider here.

Valuations in the U.S. using a forward price to earnings multiple are still well above their long-term average. And if you compare that to Canadian equity valuations, they’re substantially below their long-term average levels. Now, again, I would tribute that discrepancy in terms of valuations to the mix of expensive, say high growth mega cap technology stocks in the U.S. versus some of the more depressed cyclical energy and bank name types in Canada.

So there’s certainly an opportunity for reversion to the mean, and Canadian stocks are poised for a multiple expansion and to revert back to more of a mean level. Canada also, I think, has a number of other positives in there. Our strong banking system, our exposure to energy, which should continue to benefit if we move into some sort of a super cycle. And also Canada has a very strong immigration policy that should be go to continue for growth. So I think when you compare Canada to the U.S. and to the rest of the world, we’ve seen some underperformance, but we still remain very constructive on Canadian equities.

So we continue to be overweight in this environment and things like financials and energy industrials in some cases. If we think about the energy space where we are constructive and companies or energy producers that have growing dividends, so things like Canadian natural resources, for example, Cenovus, ARC Resources, those are all very well positioned companies for the ultimate reopening of the Chinese economy as well as they are more supportive of global supply and demand picture that we see for energy. And so we’ve selectively increased exposure to some oil producers as most exploration production companies, or better known as ENPs are quite profitable at the current commodity prices and have already significantly paid down debt. And additionally, with the energy space, we can also see higher oil prices as the strategic petroleum reserve shifts from a source of supply in the U.S. to one of demand, especially if OPEC remains disciplined with their supply cuts.

In terms of banks, there has been a lot of turmoil this year within the U.S. regional banking system throughout the first half of 2023. We certainly believe that the Canadian banking system is very different than the regional banks in the U.S., much broader exposure base, much bigger banks, much better banking system. So I think that some of the effects from the U.S. banking crisis that we saw in some of the smaller regional banks this year, the effect that that had on the Canadian financials and Canadian banks was really one more of contagion. There was just worry that whether this was going to spread to the Canadian banking system was something that we were pretty comfortable was not going to happen.

Now that being said, I think the Canadian banks also faced a number of different headwinds, things such as slowing loan growth as on the back of higher interest rates, contracting net interest margins.

We’ve also seen some rising provisions for credit losses and higher capital requirements of late we’ve seen for the banks. So that happened throughout the beginning of the quarter, and I think that during the second quarter of 2023, we started to see some of these issues ease through towards the end of the second quarter. So at the beginning of the second quarter, I think we were a little bit more bearish on the banks, but then moved a little bit more bullish as a lot of this has been priced in and factored in. And we started in some of our strategies to add weight in the banks. And we also continue in general to add, to look to companies and continue to add in our portfolios companies that have strong pricing power, companies that have good balance sheets, companies that have good growth attributes regardless of the macroeconomic backdrop.

One other area that we’ve continue to like within the market is some names within the information technology sectors. So we could add to names things like Shopify and Constellation software, for example. And if we think of Constellation Software, we’ve added a little bit of weight there. Given the company’s stronger than expected organic growth, they’ve consistently been able to beat expectations and we feel that their runway for growth is proving to be longer and greater than maybe what we expect to say 12 months ago. They’ve also had some success in spinning out some of their businesses, and that’s creating really sort of a playbook for their next leg of growth.

Also, within the information technology space, we’ve added things like Shopify, continue to increase our weight there. The company delivered a very strong quarter recently. They beat top line growth expectations, and this really shows us that they have an ability to execute when they focus on their core competencies. They also did divest similar to other companies from their Shopify fulfillment network, and that really removes, I think, the largest overhang related on the stock.

If we continue to see rate hikes or any additional rate hikes from the Bank of Canada, generally rate hikes would tend to have a negative detrimental effect on equities, certainly because your risk premium will go up. So as interest rates go up, the cost for cash investments will tend to go up, so you need to reach a higher rate of return. So that could impact equities generally speaking.

Now, I also think that the other area of the market and that could get impacted is some of the longer duration areas of the market. So in technology, for example, if you’ve got long dated cash flows, and when I say long duration, I mean, when we’re looking at a company’s growth expectations a number of years out. So when we’ve got longer duration type assets or longer dated cash flows, that could result in increasing discount rates, which will then ultimately create a lower target price.

So that could impact stocks, that could leave a bit of an overhang on equities. And also generally speaking, as interest rates go up and as consumers start spending less, corporate profitability can tend to go down and that could have a negative overhang on the markets for a period of time if we see a prolonged period and if we continue to see additional rate hikes from the Bank of Canada.

We’ve recently in the second quarter had another Bank of Canada rate hike. It was surprise of a rate hike that we had in the second quarter, and certainly a little bit more of a hawkish tone that we heard from the Bank of Canada. If rates do start to go down, I think that’ll be probably beneficial for equity markets going forward. We do see rates going down as the cost of capital for companies will go down, as consumers will start to spend more, which then to start to be supportive of company growth expectations, top line expectations.

So I think that if we do start seeing equity rates come down… Now, that being said, in terms of recession, I don’t think we’ve actually avoided the recession. We’ve probably just delayed the recession to some point in the future. Once we do start seeing rate cuts from the Bank of Canada, I think that will be very supportive of equities generally speaking, as consumers will start spending more, as companies’ cost of capital will tend to start getting lower and overall expectations and forward expectations for economic growth start to increase. And I think that that will be beneficial and supportive for the equity markets as we start to see those rates come down.

There are always a number of different risks that we are going to consider. There are still some overhangs of political risk with what’s going to happen with Russia and the Ukraine, although it seems to be out of the headlines now, but that can always certainly spark some contagion. If there is any risks or concerns about any sort of geopolitical conflict, I think that will have potentially a negative impact at first on equity markets.

There’s also the risk that the recession will come harder than expected. I know we’re expecting a recession at some point, it’s probably been the most well telecast recession ever as everybody has been expecting a recession. But I think we’re expecting a mild recession, if it does impact us much more severely, I think that that would be very negative for the equity markets.

And of course, the final point is if we do get any surprises within earnings, corporate earnings, companies continue to deliver on their expectations and continue to meet expectations. I think that’s great and it will be supportive for equity markets.

But as companies, especially large index constituents, if they do tend to surprise to the downside, that could have a much larger contagion effect in the markets if that does occur.