If Bank of Canada Governor Stephen Poloz does the expected and raises interest rates on Wednesday, it may be time to load up on potash, copper and gold stocks.
A review of equity performances following Bank of Canada tightening cycles over the past dozen years shows that materials stocks including Lundin Mining Corp. and Potash Corp. of Saskatchewan Inc. significantly outperform all other sectors of the Canadian market.
Over five periods of higher interest rates, including 2010, 2007 and an extended eight-month cycle in 2005 and 2006, the S&P/TSX materials index has returned an average of 9.7 per cent in the three months following a rate hike, according to data compiled by Bloomberg. By contrast, financials have gained 1.8 per cent, energy has returned 0.6 per cent and the benchmark index has added 2.4 per cent.
The historical gains in the face of higher borrowing costs suggest that Canada's resource-laden broader index may be poised for a second-half rally, after lagging every other developed market gauge in the second quarter and declining 1.5 per cent on the year.
Canadian investors should avoid most domestic equities in the current rates environment except for resource stocks, said Martin Roberge, North American portfolio strategist at Canaccord Genuity Group Inc.
"Only the bombed-out resource sectors are buyable here," Mr. Roberge wrote in a recent strategy note. He recommends investors go long on base metals and short on utilities as central banks around the world adopt a more hawkish stance.
The best-performing materials stocks tend to be those that benefit from a stronger economy that triggers rate increases, including base-metal miners Hudbay Minerals Inc. and Lundin Mining, and fertilizer producers such as Potash Corp. Gold producers have also done well following rate hikes, which usually push the Canadian dollar higher. Agnico Eagle Mines Ltd., Alamos Gold Inc. and Guyana Goldfields Inc. have been among the best historical performers in these periods.
Still, Mr. Roberge is calling for a correction for the S&P/TSX composite index, as non-resource stocks such as banks and telecoms fall amid the higher rates, more than offsetting a rally in commodities shares.
"If we have the most overvalued non-resource stocks, we have almost by default the most undervalued resource stocks," Mr. Roberge said in a phone interview. "I think we've just stretched the rubber band too much on the pessimistic side and we need to see some sort of a snap back, especially if commodity prices rebound as I believe they will."
Canadian investors should stay away from bond proxies such as utilities and telecoms, "which are totally, totally overvalued relative to their global counterparts," Mr. Roberge said.
Commodity sectors could also get a boost from the rising dollar, which has jumped 6.7 per cent since its recent low in May on the potential for higher interest rates, said Brian Belski, chief investment strategist at BMO Nesbitt Burns. The loonie is the best-performing currency among Group of 10 countries this month.
"Our work shows that Canadian equities post their best six-month forward performance following prolonged periods of weak currency, especially when the Canadian dollar is recovering from depressed levels," Mr. Belski wrote in a recent note, adding that commodity sectors tend to outperform in this environment.
Financial stocks should be avoided if the Bank of Canada moves on July 12 because higher rates could hurt the housing market, and a downturn would hurt banks, said Shailesh Kshatriya, director of Canadian strategies at Russell Investments Canada Ltd. Trading in the swaps market indicates a 92 per cent chance of a rate increase on Wednesday.
"Right now one of the larger under-weights we have is to the financial sector and banks in particular," he said in a phone interview. "Traditionally a steepening yield curve is better for banks but this environment is coming to fruition at a time when housing-related risks are near historic highs."
Instead, Mr. Kshatriya recommends buying industrial stocks, which are benefiting from a strong economy and relative weakness in the Canadian dollar.
With a 12-per-cent gain year-to-date, the industrial index, which includes Canadian National Railway Co. and Bombardier Inc., has been the largest upside contributor to the S&P/TSX composite index. By contrast, the energy index is down 17 per cent, by far the largest drag on the benchmark. The materials index has fallen 4 per cent in the same period.