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Crystal Maloney, head of equity research at CIBC Asset Management.
Last fall, the market started to anticipate the start of an interest rate tightening cycle to fight elevated inflation levels. We saw the start of this cycle play out in January in the US and Canada followed suit in March. And we are now on the path to more normal monetary policy levels.
Taking a closer look at how that’s impacted the Canadian equity market, before and after the first interest rate cycle increase in March, we see that in the four month period, leading up to the first rate hike, the TSX composite was relatively flat, up 0.4% or 1.3%, including dividends. On a sector basis, the leaders were energy, up 15%, materials, up 14%, and communication services, up 10%. While information technology, healthcare and industrials lagged the most down 38%, 23%, and 8% respectively.
This performance was partly as expected according to the history of past rate tightening cycles, where generally speaking, cyclical sectors, including commodities and industrials, outperform defensive sectors, such as utilities and telecoms. However, this time around industrials and technologies underperformed, while defensive sectors held in better as they were less impacted by inflation levels, labour shortages, and supply chain woes.
In the first two months, since the first rate increased as expected, Canadian stocks have struggled down 1.7% as the start of the tightening cycle often sees a shift in near term sentiment. In this case, this negative shift was heightened with the invasion of Ukraine by Russia in February. Consistent with past cycles, investors continued the rotation into energy and materials, which were up a further 9% and 5% respectively. As we saw commodities reach all time highs and technology continued to sell off down another 21%. Though this time around defensive sectors, such as staples and utilities, continue to outperform up 10% and 2.5% respectively. Financials were also hit down 7.6%, in the past two months.
There are a number of areas where we continue to see opportunities in the Canadian market. Firstly, with energy producers, where higher interest rates are generally favourable for commodities. A couple of our top picks are Cenovus, which is delivering value on its existing asset base on the Husky integration on its capital allocation strategy. We see potential for further optimization of operations, ongoing balance sheet strength, and further capital return that can continue to drive the stock to out performance.
Secondly, is ARC Resources, which we believe has the potential to outperform as it continues to deliver on the integration of Cenovus’ Generation Assets as it officially sanctions the Atauchi project and it further strengthens its balance sheet and delivers on shareholder returns.
We also maintain our favourable view on financials and in particular, the banks. Historically Canadian financials have been positively correlated to interest rates and have been among the best performing sectors in the previous seven rising rate cycles. Despite slowing earnings momentum, fundamentals remain strong and we expect continued dividend growth. Our top pick in this space is the Bank of Montreal. Our call is driven by strong commercial loan growth in both Canada and the US, which we believe is not reflected in current valuation, and also its lower relative mortgage exposure.