MARKET COMMENTARY

Canada Puts Some Spring In Investors’ Steps

The first quarter delivered good news for Canadian industry. Darcy Briggs and Les Stelmach take a deeper dive into domestic fixed income and equities, respectively. See what they say about the opportunities and potential pitfalls ahead.

04.28.2021 - Fiduciary Trust Canada

How should investors view Canada as the tug-of-war between COVID-19 and reopening life and the economy plays out? With vaccination numbers growing and the outlook inching towards the positive side, Darcy Briggs and Les Stelmach share their insights on the opportunities and anticipated bumps ahead.

Q: How would you describe the current environment for Canadian stocks and bonds?

Les Stelmach: Forgive the cliché, but we are cautiously optimistic. Cautious, in that market valuations have generally been inflated from this extended period of extremely accommodative rates. Optimistic, in that we see pockets of value in a number of market sectors, particularly in Canada, and this is currently well-represented in our portfolios.

We know investors often do US-Canada market comparisons. For the first time in years, performance, especially to start 2021, has favoured Canadian equities. Some air has come out of the Information Technology balloon, especially among unprofitable names. This disproportionately affects the United States, due to the sector’s substantially higher weighting in that market. As the reopening unfolds, companies that clearly benefited from COVID-19 trends (i.e., shelter in place), such as Amazon and Netflix, have lagged. Canada has much higher sector weightings in Financials and Energy, both of which are off to a good start in 2021, based on an improved outlook. Lastly, if an argument is made that global growth is returning as vaccines are distributed and lockdowns are abating, then Canada’s role as a significant exporter positions it well overall.

Darcy Briggs: After seeing significant returns in Canadian fixed income last year, we expect more subdued performance in 2021. Given this year’s starting point of very low interest rates and tight credit spreads, we see corporate credit as offering the best risk-adjusted return opportunities in the current environment. As active, total return managers focused on generating income and capital gains we know bond selection will remain important this year. Small interest rate moves can lead to significantly different outcomes for different fixed income sectors.

For example, interest rates are up almost 100 basis points since the start of 2021.[1] That is a big move, which has fixed income markets posting uncharacteristically negative returns year to date. However, uncertainties remain high, and we are seeing a wide range of forecasts on how the balance of 2021 will unfold. We think interest rates may have overshot, as happens from time to time and it would not be surprising to see rates drift lower later in the year. Realistically, we expect the path ahead to be a little messy.

"For the first time in years, performance, especially to start 2021, has favoured Canadian equities." - Les Stelmach

Q: How so?

Darcy Briggs: Briefly, this is a unique recession/quasi-depression prompted by a dramatic health crisis and the resulting government-mandated shutdown. It was not caused by normal business cycle dynamics. While fiscal and monetary policy have prevented a full-blown financial crisis, those tools have limited ability to solve the current recession. We believe it will end once the pandemic subsides and the economy fully opens, functioning in a more familiar pre-pandemic way. Vaccines are key to the pace of progress.

Markets are going to have to work their way through a lot of distortions. Remember, it was the second quarter last year when everything halted, markets swooned, and numbers hit dramatic lows. As we start lapping this period, comparing year-over-year data featuring ultra-low 2020 figures, markets could easily shoot to the high side. It is also going to take time to establish what sticks. There will be an initial rush of reopening economic activity and, with that, we may see a rerating of growth and a passing inflation scare. But once those months of initial enthusiasm subside, what will the economic baseline and future prospects look like? What does the path to dealing with the debt overhang and unwinding fiscal and monetary stimulus look like? Keeping such factors in mind, we think investors should expect some volatility as the year progresses.

Q: Where are you finding opportunities?

Darcy Briggs: Looking at Canadian corporate credit, where stay-at-home sectors like Communications and Media really outperformed during the lockdown, a rotation to “reopening” bonds such as Commodity and Energy issuers is underway. For example, factoring pre-pandemic conditions and the multi-year transition to other energy sources into our analysis, we remain constructive on debt investments of Canadian energy companies over our investment horizon. There is not a lot of associated exploration or development risk; costs are fixed and, as expected demand ramps up, there will be increased incremental cash flow, making their bonds more attractive from a credit standpoint.

As part of our core plus strategy, we are also finding attractive opportunities in high yield bonds, recently introduced limited recourse capital notes (LRCN), as well as the preferred share and global loan markets. It is worth noting, the latter two have defensive properties in an environment of higher trending interest rates.

Les Stelmach: Without relying on any one “theme,” we see opportunities in several sectors. In Information Technology, we would highlight OpenText, a global provider of enterprise information management software. Over 75% of its revenues are recurring, providing stability and visibility to future cash flows. The company has an admirable track record of truly accretive mergers and acquisitions (M&A) and their increased scale has helped support growing dividends.

We see Enbridge as attractively valued. Given the ongoing need for hydrocarbons well into the future (even with climate planning scenarios that envision a faster energy transition), existing pipelines remain very valuable. Enbridge generates significant cash flows via client contracts, has a healthy balance sheet, and a very attractive, fully funded dividend. We believe these characteristics more than compensate for any uncertainty regarding terminal asset value many years out.

Within Consumer Staples, we see opportunity in Alimentation Couche-Tard (ATD). This company is an independent convenience store operator and road transportation fuel retailer with a leading market position in North America and a growing presence in Europe, Central and South America, Asia and the Middle East. A strong operator, ATD has built scale through methodical M&A activity and cost improvement (fuel sourcing, etc.). Early in 2021, the company announced its intent to acquire Carrefour, a French grocery store chain. It was a bit of a departure from ATD’s convenience store focus. Ultimately, the bid was aborted due to opposition from the French government. However, the shares traded weaker on the initial announcement and we believe they are attractively priced at current levels.

Q: What should investors consider going forward?

Darcy Briggs: Be mindful of narratives… whether related to market stories like GameStop, Bitcoin, or the pace of change in energy sources. We live in the age of spin where a change in narrative can cause violent market gyrations. However, investors will ultimately be rewarded by remaining disciplined and focused on fundamentals.

Les Stelmach: While vaccination rates are expected to continue advancing, we think improving economic conditions will come in fits and starts. Not all parts of the world will be vaccinated on the same time frame, so an opening-up recovery is likely to be uneven. We believe investors are best served by ignoring day-to-day noise and instead focusing on investing in high-quality, well-capitalized companies with valuations underpinned by real cash flows.

 

NOTES:

  1. January 1 to March 18, 2021, Bloomberg L.P., https://www.bloomberg.com.

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