The Canadian economy and equity markets are resource-rich and export-dependent, and this made domestic growth perfectly positioned for the increase in U.S. growth and inflation expectations that began in mid 2016. Higher growth forecasts led to rising prices for cyclical, economically sensitive stocks (such as commodity producers) that form large portions of the S&P/TSX composite index, and also for the manufacturing and industrial companies that drive economic growth.
The last six months of 2016 saw a dramatic outperformance of cyclical stocks relative to defensive market sectors. The trend of cyclical stock outperformance, however, stalled out and to some extent reversed in 2017. Whether this is just a pause or a return to the slow growth environment that previously boosted conservative, high-quality defensive sectors stocks such as telecoms and utilities, will be a major determinant of both portfolio positioning and investment returns for Canadian investors.
The first chart below shows the relative performance of global cyclical and defensive stocks. The line is simply the value of the FTSE all-world cyclicals index divided by the price of the FTSE all-world defensives index. A rising line indicates outperformance by cyclical stocks.
The rally in economically sensitive stocks began in early July, 2016, well before the U.S. elections, and continued until Dec. 8. Since then, cyclical sectors have underperformed defensive sectors.
The second, lower chart illustrates S&P/TSX composite sector performance during both phases. The purple bars show major sector returns from July to December, when global cyclical stocks led the market. The salmon-coloured bars show the returns in the subsequent December to the present time frame when, for the most part, defensive sectors re-assumed market leadership.
It should be noted that gold mining stocks skewed the results for the domestic materials sector. The S&P/TSX materials index would be expected to benefit from the rally in cyclical stocks during the second half of last year, but an average 31 per cent decline in gold stocks sunk returns for the materials sector as a whole. The S&P/TSX diversified mining index – another subset of the broader materials index, formed primarily from industrial metals producers – did benefit from cyclical sector strength, rising 52 per cent for the period.
The top performing TSX sectors during the cyclical rally were industrials, financials (lenders benefit from the steeper yield curve that accompanies rising inflation forecasts), consumer discretionary, technology and energy. This makes perfect sense, as these sectors historically benefit most from expectations for accelerating economic growth.
The worst performing market sectors during the cyclical rally – telecommunications, utilities and real estate – have been the best performing sectors in 2017, when defensive sectors outperformed.
The bar chart provides important strategic advice for Canadian portfolios. Investors should favour sectors that performed well in the second half of 2016 as long as an accelerating economy is the consensus forecast. If growth expectations fade, the defensive sectors that have led performance in 2017 should be emphasized.
Scott Barlow