https://www.cwbwealth.com/en/news-and-stories/insights/points-in-time-q3-2024
In this commentary:
Easing | Canada | U.S. | International | Fixed Income
Easing
Scott Blair, CFA
Chief Investment Officer
September marked the first time in over four years that the U.S. Federal Reserve (the Fed) cut interest rates in the U.S., and they went “big” with a 0.50% cut rather than 0.25%. The Bank of Canada (BoC) started cutting rates earlier in the year (June), while many other central banks across the world have also been lowering their policy rates. This move from tightening to easing of interest rates signals a shift in concerns for central banks and is part of a well-worn playbook on what to do when inflation is too high.
The central bank playbook
The main tool in any central bank’s toolkit is setting the level of interest rates. Weak economy—cut rates, too strong an economy or inflation too high—raise rates. It’s the last situation we’ve found ourselves in recent years. And although they were late to address the problem (remember transitory inflation?), central banks have played their playbook well this time. It goes something like this:
- Inflation rises
- Keep raising interest rates until inflation is on a reasonable downward trajectory
- Watch economic growth fall
- Watch unemployment rise
- Wait until inflation falls to a reasonable level
- Start cutting interest rates, slowly if the economy is holding in and quickly otherwise
- Hope that you aren’t too late to avoid a recession
With inflation now back in a reasonable range (2% in Canada, which is the BoC’s target), we are firmly at the cutting interest rate phase of the cycle. It took longer than expected, but we got there.
Rate cuts for days
Central bank focus has clearly shifted to the economy, and employment in particular. A couple of years ago it was almost impossible to find employees, whereas today the market is much more balanced. Canada’s unemployment rate in August hit 6.6%, which is not particularly high from a historical context, but it’s been rising steadily for over two years and is up 1.1% from a year ago. If we look at the playbook outlined above, higher unemployment was to be expected as a factor in bringing inflation down, but if it continues to rise economic activity will slow and we will get a recession. Thus, the focus on interest rate cuts.Consensus forecasts from economists see interest rates falling throughout 2025 and possibly into 2026 in Canada and the U.S. This will be much needed in Canada, as stretched consumers will have to combat higher mortgage rates as the 5-year mortgages taken out during the pandemic mature. BoC is walking a fine line, and there’s always a chance that rates aren’t cut quick enough or some sort of economic crisis happens to sink us into a recession. But at least, for now, things seem on the right path.
It doesn’t get much better than this
In our Q1 write-up, we wrote about the uncertain economic environment: “…as we’ve seen over the past several years, uncertainty doesn’t necessarily mean poor markets. In fact, it can lead to outstanding outcomes.” Which turned out to be surprisingly accurate. Returns this year for global markets have been spectacular through to the end of September (see figure 1).Figure 1: Strong growth in global markets YTD as of September 30, 2024Source: Bloomberg
Will this strength continue to the end of December? It’s hard to say, and we’d never make a prediction over such a short time horizon. There are too many unknowns and potential headwinds outside of the economy, such as the U.S. election and widening conflict in the Middle East. Overall, markets tend to lead the economy. It’s hard to imagine the next nine months looking as good as the last nine in terms of returns. But if we can stay out of a recession then uncertainty could once again be a friend.
Sources: FactSet, Bloomberg
Canada
Gil Lamothe, CFA
Head of Canadian Equities, Senior Portfolio Manager
Watching
The S&P/TSX Index was up 10.5% in this 3rd quarter of 2024, despite having had a 5.5% pullback in early August. Two more 25 basis point cuts by the Bank of Canada (BoC) have now brought their overnight rate down to 4.25%. As a result, financials ranked as one of the best performing sectors in Q3, ending the quarter up 17.0%. The banking sector had been under pressure for most of 2024, with concerns that high rates might trigger a recession and possibly result in large loan defaults. Now that we’re in an easing cycle, these concerns have been muted and the sector is rebounding. Some notable financials companies this quarter were CIBC, up 28.9%, and Brookfield Corporation, up 26.4%.
Similarly, the utilities sector has benefited from lower rates. These companies rely on debt to fund revenue producing projects, so lower rates help with their profitability. Fortis, a regulated utility operating in eastern North America, was up 16.7% in the quarter, while Brookfield Infrastructure Partners was up a healthy 28.8%.
The energy sector lagged in the quarter and was only up 1.9%. Energy infrastructure companies such as Enbridge (+14.8%), TC Energy (+25.8%), and PPL (+11.2%) performed well on the back of rate cuts, but those increases were offset by significant underperformance amongst the commodity producers. The price of oil fell steadily throughout the quarter, troughing in early September near a three-year low of $65/barrel and exiting the quarter at $68/barrel. Given Suncor’s momentum and great quarterly results, that stock held up better than most of its peers, falling by 3.3% in the quarter.
Thinking
The price of gold has been climbing steadily since October of 2023, from below $1800/oz to above $2600/oz currently. As a result, gold mining companies have been the stronger performers within the materials sector, pushing it to a +12.2% return in the 3rd quarter. Unrest in the Middle East is the main driver here, and the situation shows no signs of easing in the near term. We continue to hold Agnico Eagle in the portfolios, with that stock up 22.4% over the last three months.
Figure 2: Gold on the rise
Source: FactSet
Market watchers expect another two cuts of 25 basis point each in Canada before year end, with another two expected in the first quarter of 2025. Most of this is likely already reflected in stock prices, but it nonetheless should provide a steady tailwind for utilities and financial stocks, should the cuts come about.
Doing
We’ve been fairly active in the portfolios recently. Early in the quarter we sold our position in Saputo, in both our Core Canadian Equity strategy, as well as our Canadian Dividend strategy. The company had been executing on a business efficiency plan, but results were mixed and we came to believe that the global nature of their business provided more risks than opportunities. In our dividend portfolios, we purchased Enghouse, a multi-industry technology company that has been growing its dividend more than 15.0%/year.
Within our core portfolios, we also sold the balance of our Bank of Nova Scotia position, the funds used to increase our exposure to CP Kansas City Rail, Shopify, and Equitable. We’ve also added Precision Drilling to this portfolio. Though we expect the stock to be volatile with the price of oil, there’s a fundamental undersupply of the advance drilling rigs necessary to produce oil and gas from the larger North American deposits. We feel this will help underpin the demand for Precision’s services.
Late in the quarter we added to Methanex and Nutrien. The chemical industry stocks have been weak and we’re confident in these companies, both leaders in their respective spaces, over the long term.
Sources: FactSet, Bloomberg
Q3 2024 Dividend Performance Summary
Canadian Dividend Portfolio | |
Number of companies in the equity portfolio |
31 |
Number of companies that declared an increased dividend | 19 |
% of companies that declared an increased dividend | 61.3% |
Weighted average of dividend increase |
3.11% |
Consumer Price Index increase (YoY*) |
2.00% |
Equity portfolio dividend yield** |
4.26% |
S&P/TSX dividend yield |
3.08% |
** The dividend yield is based on the Leon Frazer Canadian Dividend Fund using the target weight for cash. Dividend performance numbers are year to date and express growth statistics only. These are not rates of return (as with the other portfolios).
Top 10 Dividend Growers | |
Brookfield Asset Management | 18.80% |
Intact Financial Corp | 10.00% |
Manulife Financial Corp | 9.60% |
CCL Industries | 9.40% |
Canadian National Railway | 7.00% |
Brookfield Renewable Corp | 5.20% |
Canadian National Resources | 5.00% |
Russel Metals | 5.00% |
Open Text Corp | 5.00% |
Fortis Inc | 4.20% |
Source: CWB Wealth
U.S.
Liliana Tzvetkova, CFA
Co-Head of U.S. Equities, Senior Portfolio Manager
Saket Mundra, CFA, MBA
Co-Head of U.S. Equities, Senior Portfolio Manager
Watching
Despite uncertainties around the U.S. elections, tensions in the Middle East and Eastern Europe, and the endless debate about soft or hard landing, the S&P 500 notched up impressive ~24% total returns year to date. This includes returns of over 4% during Q3 (returns in CAD).As the top performers (aka the “Magnificent 7”) took a breather, the mantle of performance was passed on from a select few to a much broader group of stocks. Figure 3 shows performance of S&P 500 stocks excluding Magnificent 7 stocks, compared to the Magnificent 7 during Q3 2024. This divergence was driven by better-than-expected earnings from broader markets versus elevated expectations from the Magnificent 7.
Figure 3: S&P 500 Index outperforms Magnificent 7 in Q3 (CAD)
Source: Bloomberg
Utilities, which was one of the worst performing sectors last year, takes the top spot in terms of performance this year with significant gains during the quarter. Information technology and communication services were the second and third best performers respectively. At the other end, consumer demand-sensitive sectors such as energy, consumer discretionary and materials have lagged the market. With a broad-based rally in the market, our U.S. funds couldn’t keep up with the market and gave up their lead versus the market on year-to-date basis. While this lag is short term in nature, we’re cognizant of our portfolio positioning and always seek ways to enhance returns over our investment horizon.
Thinking
Macroeconomics and geo-politics have caused short-term differences amongst performance of various stocks, sectors and commodities. What else can explain the lows in oil prices versus basket of other commodities that have been ripping higher on China stimulus? In light of this divergent performance, there are opportunities for long-term investors to benefit from and position their portfolio for long-term success.Companies don’t operate in their own bubble and are impacted by the external environment. But the way they deal with externalities differs, leading to divergence in business and stock performance. For example, with easing interest rates, portfolio companies like Home Depot and Pool Corporation may benefit more than others in the same sector, owing to their superior competitive positioning and underlying fundamentals. Similarly, companies in many cyclical sectors could benefit more if the market’s narrative around soft landing comes true. Predicting the course of the economy or markets is very difficult, and we stand ready to take advantage of any volatility resulting from excessive focus on short-term outcomes.
Doing
While our focus remains on long-term performance, this quarter’s underperformance is not taken lightly. Our positions in Intel and the dollar stores (Dollar General and Dollar Tree) have been key detractors from the portfolio’s performance. As with all our holdings, we’re focused on evolution of the underlying business and our investment thesis. We constantly validate our thesis through due diligence, including conversations with management teams, which is the course we’ve taken for these companies.During the quarter we exited our position in Gentex, a tier-1 automotive mirror supplier, in light of the cyclical headwinds in the automotive industry. We deployed capital elsewhere. Notably, we initiated two new positions in the quarter–Occidental Petroleum and Medpace Holdings. In Occidental, we’ve been able to buy a constantly improving energy company with a low-cost asset base and significant upside optionality through its portfolio of low carbon ventures, which we deem to be a free option at current prices. Medpace Holdings is a contract research organization that helps small biotech and pharmaceutical companies conduct trials and commercialize their products. We established a small position in the name as the prices corrected due to short-term cyclicality, giving us an opportunity to benefit in the long term.
Many of the macro-economic narratives that are prevalent today will give way to underlying business fundamentals in the long run. With this in mind, we continue to execute on our investment process and philosophy to benefit our portfolios over longer horizons.
Sources: Bloomberg
International
Ric Palombi, CFA
Senior Portfolio Manager, International Equities & Alternative Income
Watching
We’ve often talked about the concept of “action – reaction”. While typically used in reference to physics, Newton’s third law of motion applies figuratively to human activity. In this case, we see yet again that when actual events become too painful for the ruling authorities, even in a country like China, the government ultimately must react.
In response to the prolonged economic challenges, in the last week of September, the Chinese government announced several stimulus measures aimed at revitalizing the economy. While piecemeal measures had been announced over the past year, they were not considered to be enough to stem the malaise. Finally, it seems that President Xi Jinping’s pain threshold has been sufficiently breached.
The People's Bank of China (PBoC) announced a tripartite stimulus package designed to boost consumer spending and counteract deflationary pressures. The PBoC's unprecedented move includes a reduction in the policy interest rate by 0.2%, a decrease in the bank’s reserve requirements by 0.5%, and a cut in existing mortgage interest rates by 0.5%. Additionally, the central bank has signaled the possibility of a further reduction in reserve requirements before the year's end, marking a departure from its traditional approach.
Furthermore, the PBoC plans to infuse more liquidity into the stock market by refinancing bank loans (CNY 300 bn; USD$42.8 bn) to enable firms to repurchase their own shares. This measure is complemented by allowing institutional investors to borrow liquid assets using their stock holdings as collateral.
Finally, it’s been reported that the Ministry of Finance is planning to issue $284 billion worth of special sovereign bonds this year, with half devoted to boosting consumption. Support measures in the form of spending vouchers for the poor were also announced.
Thinking
We believe these measures, along with the forceful communication and forward guidance by the government, are aimed squarely at undercutting the key source of pain–lack of consumer confidence driven by a slumping property market. Measures that address consumer spending, the real estate market, and the stock market help improve confidence from both an income and wealth perspective. Economists believe these measures should help China hit its 5% GDP growth target for this year.
In reaction to the news, Chinese markets have rallied dramatically having significantly underperformed the U.S. and global markets since 2021. The underperformance of Chinese markets resulted in the MSCI China Index trading very inexpensively at 11.2x P/E (Price to Earnings), implying a recession (see figure 4). As investors shunned China, it presented a great opportunity for investors in the world’s second biggest economy. In USD terms, the MSCI China Index is up nearly 20% in just the last week of September.
Figure 4: Inexpensive Chinese market - MSCI China Index
Source: Bernstein
Our China-linked holdings, driven by the Consumer Sentiment Index, have also benefited from the sudden rush to own Chinese assets, including Alibaba, Tencent, Galaxy, and European luxury names.
Doing
Alibaba suffered a near-simultaneous onslaught of increased regulatory and competitive pressures, along with depressed consumer spending. These factors resulted in the stock bottoming out around $60 in late-2022, even below its IPO level from 2014. The company was valued at an absurdly low valuation of 7.8x P/E. As the risk-reward became compelling, we added to our position in the name.
The stock started to rally once the management team implemented performance improvement measures, and the regulators indicated that their checks were done. The biggest boost, however, has come from the policy announcements above. The stock now trades around $110, or 80% above its lows. Despite the re-rating, the stock still trades at only 12x P/E. A sustained and improved sentiment, as well as higher consumer spending, should result in both the earnings and the multiple expanding further.
Sources: Bernstein
Fixed Income
Head of Fixed Income, Senior Portfolio Manager
Ric Palombi, CFA
Senior Portfolio Manager, International Equities & Alternative Income
Watching
We saw many big headlines over the quarter: expanding conflict in the Middle East and Ukraine, economic news from China, and elections news in South America, to name a few. On a day-by-day or even week-by-week basis, markets have reacted with big swings, but over the course of months, the volatility washes out.
We’ve seen a few themes play out over the quarter. Inflation continues to trend downward in North America and Europe. Central banks, including now the U.S. Federal Reserve (the Fed), have begun to cut bank rates. We saw shorter-term yields drift downwards, while longer-term yields showed only modest movement (see figure 5). While showing some volatility during the quarter, credit spreads are largely unchanged from the beginning to the end of the quarter. Inflation in Canada has reached its 2% target, while U.S. inflation is very close to target.
Figure 5: Modest change in Canadian yields over past three quarters
Source: Bloomberg
Thinking
It may be premature to suggest that the battle over inflation has been won, but we can certainly say that the difficult battles are behind us. We feel central banks will now continue on a path of cutting the bank rate over the course of 2025. We expect the Canadian bank rate will complete this cycle somewhere in the range of 2.5% to 3.0%, while the U.S. will finish somewhere between 2.75% and 3.25%. Central banks want to move their respective bank rates to a neutral stance (i.e., neither accommodative nor restrictive). With that said, we expect shorter-term yields to still have some room to decline further. Longer-term yields are not expected to move much and may even increase modestly.
We’ve seen unemployment figures weaken slightly. Holding bank rates high for an extended period was expected to have a dampening effect on the economy. Going forward we anticipate modest growth, or at worst a modest retrenchment. This argues that credit spreads are unlikely to experience significant change over the next year or so. Spreads are largely unchanged quarter-on-quarter, and, indeed over the past six months. This suggests there may be some incremental return to be had for holding credit product. We do not expect to see excessive gains from such holdings.
We continue to see sporadic adverse events with specific non-investment grade bonds. This seems to be limited to lower quality, more highly leveraged issuers. We have not seen any contagion into the investment grade space, nor even into higher quality non-investment grade bonds.
Doing
We continue to hold shorter-term bonds for potential capital gains as short yields decline. We hold longer-term bonds for incremental coupon income. We recognize that further capital gains in shorter-term bonds may be limited. There are still reasonable returns to be had in credit bonds. Spreads are unlikely to move significantly, but offer an attractive return for the additional risk taken on.
We view the risk-reward in shorter-term bonds as more muted due to the debate around where the Fed believes the neutral rate is. Is that rate closer to 3% or 4%? The market has been pricing in a rate closer to 3%, hence the rally in short-term bonds.
We’re not convinced, however, and we see value further out the curve. To leverage this view, this quarter we initiated a position in ENEL 2.875% coupon due in 2041 at $72.18 for a yield to maturity (YTM) of 5.42%, adding it to our Diversified Fixed Income Pool. ENEL is a BBB-rated Italian utility and is a company we also own in the International Equity Pool. We believe the low bond price and the 5.42% YTM provides the optimal risk-reward combination of potential capital gain and income.
Source: Bloomberg
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