Investors everywhere have also been searching more for ‘inflation hedges’ this year as prices increase at the highest rate in over a dozen years due to supply shortages and tighter labour markets.  This has put Canada on the radar screen for international investors.  Canada’s big three stock sectors are some of the best hedges against inflationary pressures, with energy and materials doing well when commodities are in favour, while financials are benefitting from a steeper yield curve and the solid credit gains that underpin the inflation pressure.  This has shown up in money flows into Canada this year.  Canadian stocks are on pace to record the highest net inflow from overseas investors since 2017, adding more than US$22 billion as of the end of August.  The TSX is traditionally a destination for investors looking for a higher risk-reward ratio, with energy and mining stocks making up about a quarter of the index.  A rising Canadian dollar has also helped encourage capital flows from foreign investors. The ‘loonie’ is the top-performing major currency against the U.S. dollar this year, partly because of higher prices for oil, lumber and other commodities.  In another potential boost, banks, which make up a fifth of the benchmark index, are awaiting the go-ahead from the nation’s financial regulator to boost dividends and/or reinstate buybacks, after accumulating record amounts of capital during the pandemic.  With banks getting more good news and commodities strong, Canadian stocks look well-positioned to rally further into year end!

The other positive for the domestic market is that the Canadian economy is reaping the rewards of the country’s successful vaccination campaign.  With ample supplies of vaccines available and less ‘public pushback’ on than our southern neighbours, Canada has achieved the highest vaccination rates among the G20 countries.  This has helped the ‘return to work’ and ‘re-opening’ of the economy and is reflected in the employment numbers, which rose by 157,000 last month to reach its February 2020 pre-pandemic level, far earlier than the U.S, which has yet to exceed its prior peak.  Importantly, the increase reflects a nearly 200,000 gain in full-time employment which offset the decline in part time employment.  Moreover, the unemployment rate fell to 6.9% and the participation rate climbed to 65.5%.  The upbeat labor market report follows the release of the Ivey Purchasing Managers Index, which hit a recent high of 70.4 in September.  All of this helped strengthen the dollar further.

One of the biggest sectoral winners so far in 2021 has been Energy.  The 70% rise in the TSX Energy sub-index for the first 10 months of 2021 far surpasses the gains of the 25% gains of the technology and financial sectors in the numbers two and three spots.  The fact that those three sectors alone represent over 50% of the index explains why the Canadian market has outpaced the U.S. averages this year.  Of course, we have to concede that this comes after nearly a decade of under-performance for the Canadian market.  Energy has been the biggest laggard over the past twelve years, as shown in the chart of Relative Strength shown below.  However, with economic growth recovering and interest rates firming up again, we wonder if we are in for an experience similar to that of the 2002-2008 period, when Energy out-performed the market averages handily.

The training wheels are coming off!  The Bank of Canada delivered a hawkish surprise this week when it announced the end of its quantitative easing program, wherein they had been buying bonds at nearly a $100 billion annual rate to provide financial liquidity to markets and hold interest rates down.  Instead it is shifting to the ‘reinvestment phase’ whereby it will only purchase bonds to replace maturing ones and maintain its holdings of Canadian government bonds at a stable level. Moreover, Governor Tiff Macklem noted that “we will consider raising interest rates sooner than we previously thought.”  The Bank of Canada is ending its quantitative easing program and moving forward its timeline for potential interest rate hikes as supply chain disruptions and surging oil prices have forced it to reconsider its outlook for inflation.  The central bank also foresees inflation to be “higher for longer” relative to the July forecast.  The central bank kept its policy interest rate at 0.25% but said that it could start raising the benchmark rate in the “middle quarters of 2022.”  Previously, the bank said it wouldn’t consider hiking rates before the second half of 2022.  The changes put the Bank of Canada ahead of most major central banks in withdrawing stimulus put in place to support the economy through the pandemic. Central banks around the world are struggling with a surge in inflation caused by a spike in energy prices, transportation bottlenecks and shortages of manufacturing inputs, such as semiconductors. The strength and persistence of consumer price growth in recent months has caught monetary authorities by surprise, forcing some to revise their economic projections and begin tightening monetary policy.  The abrupt policy move, while a short-term surprise, actually fits in well with the Bank’s trend since late 2020 (shown below) in reducing the monetary support put in place at the worst part of the pandemic.

With interest rates starting to rise, the playbook for equity investors will continue to shift away from the trend of the past twelve years, when rates made an unprececented trip down to zero, and below that in some regions.  The implication is that sectors that are sensitive to the discount rate are poised to underperform in a rising yield environment. This is especially true when valuations are elevated.  As a corollary, short duration sectors are less vulnerable and are therefore in a better position to outperform.  Thus, a simple way to play yield upside is to favor global value equities over growth stocks. Shorter duration value stocks tend to outperform as global bond yields rise. Moreover, global value stocks currently sport attractive valuations vis-à-vis their growth peers. Finally, many strategists expect the U.S. dollar to depreciate over the cyclical investment horizon as debt levels and borrowing in that country has spiked and the dollar has acted as the ‘de facto’ safe haven for global savings. Global value stocks typically outperform growth when the greenback is weakening.  Emerging markets are still going through more internal issues due to slower rates of vaccinations and higher debt accumulations, as evidenced by recent negative currency and economic news coming out of Turkey, China and Brazil, to name a few.  Reducing U.S. growth exposure and sticking with an increased weight in the Canadian market and adding some indexed European stock exposure (where valuations are also much lower) seems like a timely strategy for most investors with a global view. 


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