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Morgan Stanley U.S. equity strategist Michael Wilson has uncovered a market anomaly that, he argues, “makes banks and financials one of the best risk/reward [trades] left in an equity market that looks fairly picked over.”

Mr. Wilson notes that U.S. utility and bank stocks – both underperforming the S&P 500 – are priced for different interest rate environments, and one of them has to be wrong.

In the case of utilities, their poor recent performance reflects fears of rising longer-term interest rates. Utility firms are capital intensive (that’s analyst-speak for high debt) and profits suffer when borrowing costs rise while revenue grows slowly.

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But if all investors were worried about higher rates and bond yields, bank stocks would be outperforming the benchmark, not drastically underperforming.

Bank profits on loans result from the difference between the short-term rates at which they borrow money, and the long-term interest rates they charge clients on loans. Rising longer-term rates mean higher profits for lenders, and also reflect expectations for a higher growth environment when demand for loans is increasing.

The good news for bank investors is that Morgan Stanley analysts believe higher longer-term interest rates are imminent. They contend that the post-March rally reflects a new bull market and conventional economic recovery from recession conditions.

Mr. Wilson is not surprised by utilities underperforming – they historically lag during the early stages of a market cycle. Bank stocks, however, which generally perform well during the early stages of a market recovery, should be among the leading sectors, he says in a research note.

While Mr. Wilson was discussing the U.S. market, his bull case can also apply to Canadian bank stocks.

Domestically, utilities stocks have been underperforming the index for the past three months, reflecting U.S. market trends. Canadian bank stocks had been lagging for most of 2020, but are now matching S&P/TSX Composite returns after a recent rally after stronger than expected second quarter earnings.

Canadian interest rates and bond yields tend to track their U.S. counterparts. In the event longer-term rates rise as Mr. Wilson predicts, all North American bank stocks should perform well. If Morgan Stanley is wrong, however, and this is not the start of a new bull market, utilities stocks will remain the stronger bet.

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-- Scott Barlow, Globe and Mail market strategist

This is the Globe Investor newsletter, published three times each week. If someone has forwarded this e-mail newsletter to you or you’re reading this on the web, you can sign up for the newsletter and others on our newsletter signup page.

The Rundown

Canadians need to rethink their bank-heavy portfolio strategy

After so many years of sterling performance by bank stocks, multitudes of Canadian investors are now heavily invested in shares of the Big Five, confident that further gains by the financial giants will help finance their retirements. It may be time to rethink that bank-heavy strategy, says Ian McGugan. Canadian banks aren’t going to go bust, but their future is nearly certainly going to be less bright than their past. (for subscribers)

As dividend hikes keep coming, new stock purchases for the Yield Hog portfolio

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John Heinzl has been accumulating cash in his model Yield Hog Dividend Growth Portfolio, and now it’s time to go shopping. John reviews how his portfolio has been performing of late, and reveals where he his putting his cash to use. (for subscribers)

Socially responsible investing is finally becoming profitable

Impact investments, which aim to promote a social good or prevent a social ill, have significantly outperformed traditional bets during the coronavirus pandemic. And their returns are enticing hesitant investors to rework their portfolios. Paul Sullivan of The New York Times reports. (For everyone)

Investors should consider locking in some profits with September’s arrival

We are about to enter the dreaded September-October period which has, more often than not, resulted in a major down-move. Technical analyst Ron Meisels sees four scenarios about to unfold for stocks, and has a bit of advice for investors on what to do. (for everyone)

A sizzling growth portfolio

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Tech stocks have been on fire in recent months, and they have carried Gordon Pape’s Growth Portfolio to a record return as a result. The portfolio is up 55 per cent in a little less than five months. Gordon reviews his holdings, and adds a new stock. (for subscribers)

Others (for subscribers)

Monday’s analyst upgrades and downgrades

The highest yielding stocks on the TSX, plus risk data

What’s up in the days ahead

Tesla surged on Monday after its stock split. The Contra Guys will provide some thoughts on whether the company’s electrifying returns can continue.

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Click here to see the Globe Investor earnings and economic news calendar.

More Globe Investor coverage

For more Globe Investor stories, follow us on Twitter @globeinvestor

You may also be interested in our Market Update or Carrick on Money newsletters. Explore them on our newsletter signup page.

Compiled by Globe Investor Staff

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