Lawrence Ullman is the chief executive of Ullman Wealth Management Inc., which provides private capital-management services to high-net-worth individuals, endowments, charities and foundations.
Being in interest-rate-sensitive stocks has been a challenging proposition for some time. Rates have risen sharply since early 2022, and rate-sensitive sectors such as utilities and telecoms have fallen in response. While we can’t know exactly when the central bank’s monetary-policy tightening cycle will come to an end, we can say with high confidence that every cycle does indeed conclude. This one may be a little long in the tooth.
While monetary-policy actions do take time to have their desired effect on the economy, typically between six and eight quarters, we believe there is mounting evidence that such a slowdown is occurring. The time to take another look at some of these beaten-down equity sectors is now. Why? It’s all about what a pause in hikes implies for economic growth going forward. The pause, which we are currently in for both the Bank of Canada and the U.S. Federal Reserve, often warns of an imminent recession and a considerable shift in performance across asset classes. And when it’s time for central banks to pause, we have historically seen these defensive sectors perform well.
Flipping through our history books, we notice that of the past 14 U.S. hiking cycles, 11 ended in an official recession. Rates do matter, and the reality of this recent hiking cycle is that some areas of the economy won’t ultimately be able to cope with drastically higher borrowing costs. The central bank’s pause may partially be a recognition that the economic cycle could be in its final innings.
If the slowdown is nearly upon us, it could spell trouble for the more economically sensitive parts of the market and even some of the companies that have propped up major large-capitalization indexes for much of this year. U.S. information-technology behemoths are by and large trading well above their 10-year average price-to-earnings multiple (PE) – Apple Inc. APPL-Q is 39.4 per cent higher and not an inexpensive stock. How badly will someone need the new iPhone 15 when they are worried about a variable- or fixed-rate mortgage that has increased by multiples in the past year and a half? These names could continue to hold some interest, but if the economy continues to slow, we may begin to question overexposure to more economically sensitive companies.
Another realization will come for savers who have added to the multitrillion-dollar cash hoard sitting in money market accounts. At the moment they are happy to be finally earning something risk-free. The challenge to this will come when central banks begin to cut rates in the face of moderating inflation, a heavily indebted consumer and slowing growth. The high-rate bonanza may prove to be fleeting as interest rates begin to move back down, as we expect they will some time in 2024. Canada’s economy seems to be slowing more rapidly than that of the United States, which may convince the Bank of Canada to cut rates sooner rather than later.
So where should investors begin to position themselves? We believe they could look to areas that have suffered as interest rates soared: in traditional defensive sectors such as utilities and telecoms. From a valuation perspective we are seeing some merit to these sectors. For example, relative to its 10-year average price-to-earnings multiple we see BCE Inc. BCE-T trading 5.6 per cent lower, while Rogers Communications Inc. RCI-B-T trades 31.8 per cent lower. Enbridge Inc. ENB-T is 19.2 per cent lower, while Emera Inc. EMA-T trades 22.5 per cent lower. Additionally, current dividend yields in these names are comfortably above their 10-year average. For example, the yield on Enbridge is 47.3 per cent above its 10-year average, while the yield on BCE is 40.3 per cent higher.
One note of caution is that given the rate environment, future debt financings and debt rollovers could put pressure on dividend payouts for some of these companies. This possibility would likely be company-specific, implying that careful research is required when selecting these kinds of investments.
Considering the sell-off in these assets and the unfolding economic outlook, an allocation to these areas may prove profitable for investors who would like to combine equity exposure with attractive dividend income. For certain, it can be challenging to buy assets that are out of favour, but it’s precisely in these times that opportunity often comes knocking.