Stock Market Picks as Monetary Policy Eases

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. 

Natalie Taylor, CIBC Asset Management, portfolio manager. 

The main story in the Canadian market over the last few months has been the shift in interest rate policy.  

As a reminder, the Bank of Canada embarked on a significant tightening campaign, raising rates from 25 basis points in March 2022 to 5% in July 2023 in order to fight the effects of post-pandemic inflation. By about mid-2023, inflation data had normalized to 3% and has stayed in that range over the last year. So, this was the first condition that needed to be met in order for the Bank of Canada to think about cutting rates. 

More recently, there have been indications that higher rates are also driving economic softness, particularly with regards to consumer confidence, issues with affordability, and we’re seeing a bit of a tick up in unemployment as well.  

So, with these conditions being met, this prompted the Bank of Canada to cut rates by 75 basis points at three consecutive meetings starting in June of 2024.  

While it’s arguably too soon to see a drastic improvement in economic indicators, there are potentially some green shoots emerging in Canada. So, for one, consumer confidence ticked up for the first time in seven months, while it continued to deteriorate in other nations which are lagging the Bank of Canada in terms of their rate cutting cycles.  

Perhaps the more pronounced impact has been the Canadian equity market, which is up 10% since the first Bank of Canada cut. In particular, we’ve seen interest-sensitive sectors outperform, with real estate up an impressive 22%, and financials and utilities up 14% and 11%, respectively. 

So, where are we currently seeing opportunities?  

Given the backdrop of rates coming down, we continue to see scope for interest-sensitive sectors such as the ones that I mentioned — real estate, utilities, financials — to continue to outperform.  

Firstly, valuations have been negatively impacted by the higher interest rate environment we’ve been in, and continue to sit at levels well below historical averages. We don’t expect a complete re-rating to the recent average, which was established in a very low interest-rate environment. But certainly, there’s more room for valuations to re-rate from here.  

Second, we think there’s scope for the bank Canada to continue to cut rates, as other central banks, including the ECB and more recently, the Fed, have begun their rate-cutting cycles as well.  

The strength in these sectors has so far been indiscriminate. However, going forward, stock selection is likely to be much more important.  

Our favourite name within the real estate sector continues to be Chartwell Retirement Residences. We see a long runway of demand outstripping supply, driven by favourable demographics and high construction costs. As well, we continue to see improvement in occupancy and a reduction in operating expenses after the challenges of the pandemic.  

Another area of opportunity is the telecommunications sector. While it’s also an interest-sensitive sector, it has lagged the broader market due to idiosyncratic issues. The industry has become more competitive with the entrance of a fourth national wireless player in Quebecor, after the purchase of Freedom from Rogers and Shaw. The incumbents have undercut each other on pricing in order to maintain their market shares.  

However, over the last few months, the competitive intensity has dialed down, as evidenced by benign promotional activity during the all-important back-to-school season. We’re hopeful that this is an indication of a more disciplined market. Our top pick in the sector is Quebecor, which, as the industry disruptor, has more to gain and less to lose than the incumbents. Additionally, they trade at a lower valuation and have lower leverage.  

Lastly, the consumer discretionary and industrial sectors have lagged the TSX this year and make for an interesting hunting ground.  

We believe that if interest rate cuts continue and economic data starts to stabilize and improve, these two sectors can be among the biggest beneficiaries. However, it’s a little too early to make this call.  

We will be monitoring economic data over the next few months to see if, in fact, rate cuts translate into the expected soft landing and potentially economic reacceleration.  

With the first rate cut occurring in the U.S. more recently, the opportunity in both consumer discretionary and industrials could be more pronounced south of the border. Areas of interest include housing-related sectors, durable goods and early-cycle industrials, such as transports, which tend to be well supported by low rates.  

U.S. housing is particularly interesting as a lack of supply since the global financial crisis, paired with higher mortgage rates and inflation, has resulted in significant unaffordability, to the point where the issue is moving to the forefront of the upcoming presidential election. We expect policy to be supportive to adding supply, growing up the housing stock, and driving the housing sector at some point in the future.  

Areas for potential risk within the market could be in sectors such as technology, where we’ve seen a lot of strength related to AI. And while this is a long investment cycle, there is a potential for stock prices to consolidate and valuations to consolidate in the meantime.  

With regards to companies that have benefited from the inflationary backdrop, such as certain staples or retail companies, there’s the risk that as inflation continues to ease, that those stocks and companies will be used as a source of funds into companies with more cyclical upside from a reaccelerating economy. 

What do we see for the market as a whole over the next six to 12 months?  

The trajectory of Canadian equities over the next six to 12 months will be largely determined by the effectiveness of rate cuts. The level of interest rates plays into both valuations and revisions to earnings estimates.  

If we break this down further, first looking at valuations, although markets have been strong through 2024, valuations for the most part remain below five-year averages in Canada. Lower interest rates could be supportive to further multiple expansion.  

With respect to earnings revisions, we believe we need to see an economic reacceleration to drive earnings forecasts higher. Our best assessment is the market is currently pricing in a soft landing and not a continuing deterioration, but not necessarily a reacceleration. So, there would be upside to earnings in this scenario.  

Putting this all together, we see a balanced to slightly positive market outlook going forward.  

Of course, this outlook is not without risk. There could be downside to stocks if rate cuts are deemed to be too little too late, and assessing this risk will be an iterative process for the market over the next few months.  

If growth is so strong that inflation reaccelerates, this could also be negative for equities. Although this scenario would take some time to unfold.  

The unpredictability of escalating geopolitical risk and other unknown unknowns is always a risk and is difficult to plan for. The best protection against this is good diversification in a well-managed portfolio.  

While many believe that the upcoming election is a potential risk going forward, my view is that the uncertainty currently is creating real world impacts now, and that an outcome to the election will be a positive.  

We’ve heard from a number of companies that they’re delaying strategic decisions until they have more certainty on the next administration and policies, and it’s likely consumers are doing the same.  

We think a resolution to the election will go a long way in providing clarity to the markets.