Stock Picks as Monetary Policy Eases

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Crystal Maloney, CFA, CPA, CMA

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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. 

Crystal Maloney, head of equity research at CIBC Asset Management.  

Over the first few months of 2024, headline CPI came in lower than expected, with the annual inflation rate running around 2.7% midyear, down from a peak of 8.1% midyear 2022.  

And this was enough progress that the Bank of Canada felt comfortable to start its long-awaited monetary policy easing cycle. They did back-to-back interest rate cuts, first lowering from 5% to 4.75% in June, and then did a second cut in July to 4.5%.  

We could see the Bank of Canada cut at each of its next three meetings, and end the year with 4%. Overall, this easing cycle should be positive and support economic activity by making borrowing cheaper, boosting consumer and business spending, and supporting the housing market.  

Given the fast transmission mechanism of the hiking cycle in Canada, the easing cycle should similarly alleviate concerns around rate pressure in housing, banks and the overall consumer.  

With respect to housing, Canada is facing something of a wall of mortgage renewals over the next two years. So far, only around half of all homeowners with mortgages have seen their monthly payments rise since the Bank of Canada started raising rates in 2022. The other half will see their mortgages reset over the next two years, and many are in for a shock. For people with a fixed-rate mortgage, the sharpest rise will occur in 2026, with the median increase being more than 20%.  

While a rise in unemployment could exacerbate the impact on house prices and bank reserving and credit losses, based on our team’s work, we don’t believe that residential mortgages will likely be a credit issue for the banks, and that the easing cycle started by the Bank of Canada will mitigate the worst impact on mortgage renewals.  

As for the consumer, there is little doubt that credit conditions are softening in Canada. However, household resilience has surpassed our expectations. While there are areas of deterioration, such as delinquencies on unsecured debt, the overall financial health of households is better than prior to the Covid pandemic.  

That said, as mentioned, a substantial proportion of mortgage resets remains ahead, which will likely add stress to consumers as a whole. We would become more concerned if interest rates stayed at current levels for an extended period, and if unemployment materially worsened.  

The Canadian economy was off to a good start in Q1, up 1.7%, and our multi-asset team ultimately expects Canadian GDP to accelerate to 1.8% over the next 12 months, acknowledging that it will be harder for the Bank of Canada to cut below 4% for 2025 if inflation proves stickier.  

In line with history, we expect the Bank of Canada’s continued easing cycle will have a positive impact on many interest-sensitive, yield-oriented sectors. Since the 1990s the average 12-month return for the S&P/TSX, after the first Bank of Canada cut, is approximately flat, and 11% when there’s no recession. On a sector basis, cyclical sectors like technology and interest-rate-sensitive areas like financials and real estate tend to outperform during this environment.  

From a valuation perspective, we believe that yield-oriented sectors such as financials, real estate and communication services, are best positioned to benefit from easing interest rate pressures. For financials, we see pessimism at historic extremes. Lower interest rates can increase loan demand and boost lending volumes, and a steeper yield curve can increase the net interest margin for banks.  

For real estate, the sector often benefits from lower interest rates, which can lead to increased demand for residential and commercial properties, supporting growth in real estate development and related industries.  

Communication services seems excessively oversold and can benefit from lower interest rates through reduced financing costs for capex spending. 

We believe that many Canadian equities remain attractive. And that as increasingly stable and lower interest rates become clearer in the second half of 2024, fundamentals will begin to rebound faster than currently expected.  

Within financials, we like the Canadian banks. Overall, we believe that the stocks are pricing in overly pessimistic recession-like conditions, and valuations are very attractive. Scotiabank benefits the most from lower interest rates, which helps them reduce their funding costs, and we believe that their current market valuation does not reflect the benefits from lower rates coming through this year and next.  

Within real estate, we believe that the entire sector will re-rate with lower interest rates. And in particular, we like Granite REIT for its attractive valuation, and we believe that we are near an inflection point in its U.S. occupancy.  

Lastly, within communications, our top pick is Quebecor. With the Freedom Mobile purchase and support from the regulators, we believe that it is best positioned to take market share from the incumbents. Given that Quebecor used to trade at a premium to the incumbents when they were growing in Quebec, we believe there is significant upside potential from its current valuation, where it’s trading at a discount to itself and to peers.  

While lower interest rates generally stimulate economic activity, which benefits most sectors, on a relative basis, historically, energy and materials have, on average, lagged in the 12 months following the first Bank of Canada cut when there’s no recession.  

But they’ve performed more or less in line over the full easing cycle.  

For energy, we continue to see deep value and strong cash flow generation. For materials, notwithstanding gold, underlying commodities tend to lose momentum in the face of lower inflation. However, it’s worth noting that if inflation proves stickier here and limits the Bank of Canada’s ability to continue cutting rates, commodity-related sectors could provide a potential inflation hedge and some downside protection. 

We believe that Canadian equities are attractive. The Canadian equity market is comprised of more cyclical industries like financials, energy, materials and industrials than non-domestic markets. This difference in sector composition is a large driver of performance. After two years of relative underperformance, the valuation of Canadian equities is attractive, which sets the stage for a period of catch-up performance, helped by economic recovery.  

Longer term, our multi-asset team expects Canadian equities to provide an annualized return of 6.7% over the next 10 years.  

Compared to most developed markets, Canada has better demographic trends and a larger structural housing shortage, meaning that favourable tailwinds are there for both residential construction and the banking sector. The balance of risk appears tilted to the upside, reflecting the potential for strong dividend growth in two key constituent sectors of the Canadian market, being banks, which have accumulated record capital, and energy companies, which generate attractive free cash flow at current commodity prices.