Equities: Rate pause could spark rotation

Getting bearish on cyclicals

Equities have withstood persistent inflation and high levels of interest rates to produce positive performance year to date in 2023. Whether that resilience can continue into the new year will likely be determined by economic growth as well as the path of inflation and its influence on short-term interest rates. Recent inflation data has been on an encouraging trajectory, and we are well past the highest levels for the cycle. Whether inflation remains sticky in the 3% to 4% range or declines closer to the 2% target of central bankers will be a key indicator to follow into 2024.

While better-than-expected GDP growth has caused the soft landing chorus to grow louder in the U.S., the Canadian economy is in a meaningfully weaker position. After two consecutive quarters of negative GDP growth, Canada may already be in a technical recession. We remain of the view that a hard landing is a likely scenario, given the magnitude of monetary tightening over the past year and a half, a stance yet to be discounted by Canadian equity markets (Exhibit 1).

It’s important to remember that monetary policy impacts economic activity with long and uncertain lags. Policy could take even longer to manifest itself in the current cycle due to the unique nature of the COVID-19 pandemic where generous government outlays enabled consumers to save more while spending less due to pandemic restrictions, building up large cash balances just now being worked off. Fiscal deficit spending has continued, partially neutralizing the effect of higher rates, but we expect the weight of tightening will ultimately prevail.

Selloff in income-oriented sectors may be overdone

The sharp rise in rates has already been felt among the more defensive areas of the equity market. Among the 11 sectors in the S&P/TSX Composite, communication services, utilities, real estate, materials and financials have suffered losses year to date through October. The first three sectors are among the most interest-rate sensitive in the market and we believe the selling due to rate tightening has been overdone. With valuations down and the economy still fragile, we have become more constructive on these sectors as well midstream/pipelines portion of the energy sector. As inflation abates and growth slows, rates do not need to come down much for these companies to see a re-rating of their stock prices.

Utility stocks, in particular, look attractive heading into 2024. Utilities have seen steady growth over the years, and we expect this growth to continue, including the increasing buildout necessary to support the transition to renewable energy. We expect to see consistent increases in their rate bases and opportunities for companies to invest at attractive rates, which we believe should lead to more profitable growth for the sector than the market anticipates.

We are more bearish on cyclical sectors, including materials, energy and financials. The energy sector significantly outperformed the market in the third quarter of 2023 and has been among the strongest performers for the year, boosted by a strong move in crude oil prices that fueled returns for upstream producers and integrated oil companies. Energy and materials are resource sectors with greater sensitivity to the global economy. With China struggling and growth sluggish in other major regions including Europe, a demand slowdown could pressure these stocks. Banks, meanwhile, have sold off over the last six quarters and are trading at valuations that already discount a more challenging environment, but their valuation is not discounting a significant recession. While we expect to remain underweight these sectors relative to the benchmark, as bottom-up stock pickers we will continue to monitor these sectors for opportunistic additions.

Our investment approach is grounded in a bottom-up strategy that prioritizes identifying and capitalizing on market inefficiencies. This approach is supported by our patient culture, enabling us to make well-informed decisions when there are discrepancies between expectations and underlying fundamentals. While certain segments of the stock market may seem susceptible to us, we are continuously uncovering promising opportunities, particularly within sectors and securities that haven't kept pace with the more favored areas of the market. Nevertheless, we maintain a focus on valuations and lower beta and exercise selectivity in pursuing growth.

Garey Aitken, CFA, is Head of Canadian Equities, Portfolio Manager, at Clearbridge Investments.

Disclaimer

What are the risks? All investments involve risks, including the 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. Investing in the natural resources sector involves special risks, including increased susceptibility to adverse economic and regulatory developments affecting the sector. Special risks are associated with investing in foreign securities, including risks associated with political and economic developments, trading practices, availability of information, limited markets and currency exchange rate fluctuations and policies. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments.

Important legal information. This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice.

The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market.

Data from third party sources may have been used in the preparation of this material and Franklin Templeton Investments (“FTI”) has not independently verified, validated or audited such data. FTI accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments opinions and analyses in the material is at the sole discretion of the user.

Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FTI affiliates and/or their distributors as local laws and regulation permits. Please consult your own professional adviser or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.

Issued in the U.S. by Franklin Templeton Distributors, Inc., One Franklin Parkway, San Mateo, California 94403-1906, (800) DIAL BEN/342-5236, franklintempleton.com - Franklin Templeton Distributors, Inc. is the principal distributor of Franklin Templeton Investments’ U.S. registered products, which are not FDIC insured; may lose value; and are not bank guaranteed and are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation.

Image: iStock.com/Queso