The second half of 2018 has been painful for many Canadian investors, at least to date. Since the beginning of July, the S&P/TSX Composite Index has reported more down days than up days, taking the S&P/TSX into negative return territory year-to-date. The S&P/TSX is trading at an attractive valuation with a forward price-to-earnings multiple of about 13 times the 2019 consensus estimate.
Is this market weakness a buying opportunity?
In a recent interview with The Globe and Mail, Kurt Reiman, BlackRock Inc.’s chief investment strategist for Canada, shared his latest thoughts on equity markets and how investors should position themselves in the face of heightened market volatility.
Do you believe midterm elections results will affect equity markets?
There is all this research out there about presidential election cycles, midterm elections and what it means for stocks. Typically, the third-year of a presidential election cycle is the best of the four years, which would be 2019. You also see that the quarter after the midterms and the first quarter of the new year typically are good periods for stocks, but that’s not always the case.
What this market is going to be following more than anything is: Are we going to get earnings growth and will the economy remain resilient? I don’t think that hinges on the U.S. midterm congressional election cycle.
Where do you see investment opportunities?
When it comes to stocks, we are still favouring a pro-risk stance. We believe some of the best opportunities are still in the U.S., where earnings growth is the strongest and economic growth is also likewise one of the best of the bunch and there is still room for more upside revisions to economic forecasts. We also see that there is a move higher in investment activity, which is skewed toward technology. I would focus on exposures where you can see upside to the economy, where earnings growth is strong and where you are not paying demanding multiples – and the U.S. equity market stands out.
Aside from the United States, what other markets are you betting on?
An area where I think investors are rightly concerned is emerging markets, which have significantly underperformed global markets [over all], and a lot of this is related to trade tensions. A few countries have accounted for most of the drawdown. Our view is that emerging markets are areas that appear attractive and also have a large share of the market in new economy and high-growth sectors.
So pick your spots, and for us, that would be emerging markets and the U.S.
We are focused on the highest-quality companies so we want to get exposure to companies with good cash flow, low debt, higher return on equity – that to us is the sweet spot.
How should investors view the heightened market volatility?
We may be overweight stocks and overweight emerging markets and technology – and that may sound like a pro-growth bias – but we are also recommending that investors look to the front end of the yield curve [short-term bonds] to build resilience in their portfolio.
You have short-term interest rates that have risen that reflects already a fair amount of the future tightening in monetary policy and that is generating real returns of roughly three-quarters of a per cent, so inflation adjusted you are making money in the front end of the bond market.
Investors can build a short-term bond ladder, you can go with exchange-traded funds that focus on the front end of the yield curve, you can also look to floating rate, investment-grade corporate bonds also in an ETF wrapper.
I think that is a really important piece of ballast that can give a portfolio more resilience at times like these when markets are more volatile. This is so important because we know behaviourally when the equity market has a bit of indigestion like it had over the past couple of weeks, the risk is that investors may, if they have too much volatility in the portfolio, they may run the risk of selling out at an inopportune time. This balance helps to smooth the ride if you will.
What are your return expectations for the S&P/TSX Composite Index?
Mid-single-digits.
The Canadian market is at one of the cheapest levels versus the U.S. looking back over the past 30 years. The NAFTA uncertainty was a headwind, but it wasn’t the only factor. It has been a function of relatively higher tax rates in Canada, and in energy, we see deep discounts for Western Canadian Select. It’s been a function of a lower return on equity in the Canadian marketplace. It’s also partially a function of high household indebtedness. I think all of these forces together explain why the Canadian equity market is where it is relative to the U.S.
We can’t ignore the fact that we still have 20 per cent of the Canadian stock market in energy so if global oil prices are moving up and Canadian oil prices are moving down, that’s going to be a problem and that is what we have seen so far this year. Brent and WTI [West Texas Intermediate] are higher and Western Canadian Select is lower.
Given the fact that a lot of bad news is already priced into the Canadian equity market, I would say mid-to-high single digits seems reasonable as a potential return, but it could be higher. If the earnings growth numbers come through as expected and we get a little bit of multiple expansion [such as price-to-earnings] in the Canadian market, then I think we could do better but I think a lot hinges on the monetary policy framework and the domestic policy framework, especially around energy, that part to me is really critical.
What are your thoughts on the largest sector in the S&P/TSX – financials?
For next year, it would be reasonable to expect mid-single-digit or higher earnings growth. What we have seen is that earnings numbers have been revised higher over the past three months and the multiple for financials is not stretched relative to the overall market. Also, if you consider the higher rate structure, that is likewise good for banks.
What has been holding [the sector] back are persistent concerns that tighter monetary policy and tighter financial conditions will somehow short-circuit the economic recovery process and the expansion – we don’t see that happening.
We see the economy in Canada as being reasonably healthy over the course of the next 12 months. The rate backdrop is supportive. Valuations are not stretched. Earnings are growing, not as fast in the next couple of years as has been the case this year, but still decent. I think financials, not just in Canada but globally, should begin to participate but it requires the persistent worry to fade.
What sectors in the S&P/TSX are you favouring?
I prefer the financials sector. I think there is room for the energy sector to move higher because I think these discounts are just so wide and they reflect a lot of negativity. I favour technology globally.
What sectors in the S&P/TSX should investors avoid?
If we see resilient economic growth and the back up in interest rates is mostly related to firming economic activity, the parts of the market that are going to underperform are the ones that are paying consistently high dividend yields but in general don’t see much forward growth in their earnings. That would be the rate-sensitive bond proxies like utilities and telecoms, and I would also add consumer staples. I don’t think that they are necessarily posting negative returns, I just don’t think they will able to keep up [with the S&P/TSX].
Do you think deceleration in earnings can be cited as a cause for some of the weakness to start off the fourth quarter?
The deceleration in earnings growth, I think, is well reflected in market forecasts already. We hit the high-water mark in terms of earnings growth in the U.S. in the second quarter that's coming down ever so slightly but it’s still high teens earnings growth in the third quarter. Next year, earnings growth will be more modest as the effects of the tax cuts roll off, something in the order of low teens.
I do think the higher trade uncertainty and tighter financial conditions are factors [for the market weakness]. I think you can argue that trade concerns have been reflected in markets but we can also say that earnings growth and economic growth have been quite strong and the market hasn't fully reflected those.
What rate increases do you except the Bank of Canada will announce?
I anticipate one more rate hike from the Bank of Canada and two more from the U.S. Federal Reserve over the next 12 months. I don’t see any reason for them to move off this gradual pace. I would expect this go-slow approach would continue and eventually pause in order to assess the impact of higher rates on the overall economy.
Where do you believe the Canadian dollar is headed?
I think it's going to be hovering in this range that it has set for itself for what seems like the last couple of years with the potential for some modest upside.
The loonie tends to be a pro cyclical currency, meaning when investors become more risk averse, the loonie weakens and vice versa. We do think over the next six months, next 12 months, we are going to see higher equity markets. We are going to see a return to positive sentiment about earnings and the economy.
Our forward looking indicators for economic growth into next year suggests that economic activity in the United States is going to remain fairly healthy at a level that is close to 3 per cent. That is not too different for Canada either, the level is lower at just over two per cent. That’s pretty solid.
If we get some narrowing in the discount on Western Canadian Select that could provide a bit of a lift to the Canadian dollar. So I think the Canadian dollar is range-bound but with some bias to strengthening versus the U.S. dollar.
This interview has been edited and condensed.
Jennifer Dowty is an investment reporter and equities analyst with The Globe and Mail.
Jennifer Dowty