Mackenzie North American Equities Team
2017 was a difficult year for Canadian equities as commodity stocks and energy in particular dramatically underperformed. As well, the technology sector led the charge in the U.S. and served as another point of Canadian underperformance given weak technology representation in the Canadian benchmark. The underperformance in smaller cap names was less so in the fourth quarter as Canadian stocks rallied, netting most of the years’ performance in the last three months on broad-based strength across the market. Many of the trends that shaped 2017 have continued early in 2018 so far, with the exception of energy, which has reversed course and has outperformed on the back of much stronger oil pricing.
Commodity prices are responding to a general lack of investment reducing supply while at the same time demand remains strong. Of course, just as the best remedy for weak prices is weak prices, as the saying goes, the reverse is also true. Strong commodity pricing will attract capital to resources and lead to increased supply, serving to reduce pricing and profitability as the cycle plays out. However, it remains early innings for the energy sector, which had been out of favour for a few years. Investors had shifted capital from energy to technology and some of this capital flow may reverse.
Trade disputes and the reworking or nixing of NAFTA have been issues at the forefront of Canadian industry. While we are not going to predict the behaviour of President Trump and negotiators working on his behalf, most likely the Canadian markets and currency would weaken on any announcement that NAFTA is to be dissolved. However, this would likely present an opportunity to increase exposure to Canadian stocks given how intertwined the Canadian and U.S. economies are. In other words, the bark of the announcement is likely to be greater than the bite of reality when it comes to implementation of any revised accord that may create the initial perception of the U.S. “winning”.
We continue to experience a period of synchronized global economic growth which should benefit the Canadian economy. This economic backdrop gives us confidence in our expectations for strong earnings growth which ultimately should be positive for equity market returns. We believe earnings growth will drive equity market returns going forward as valuations are generally back to historical averages and the market is no longer cheap.
Our expectations for accelerating global economic growth should result in higher interest rates as real rates and inflation expectations rise. Bank and life insurance company earnings should benefit from higher interest rates. For banks, strong employment trends should limit consumer loan and residential mortgage losses however we are likely entering a period of slower loan growth which will also limit profit growth. We expect select life insurance stocks to rerate higher while seeing less opportunity for a rerating at the banks. In the near term we are constructive on the outlook for oil prices given declining global production coupled with resilient global demand growth. However over the medium term we recognize the risks presented by US shale production growth. With this outlook our stock selection is focused on undervalued companies with low cost production and a strong cash flow profile.
As markets have continued to march higher and valuations have extended, we are finding fewer and fewer absolute value opportunities and have become increasingly selective in our stock holdings. We will continue to take advantage of opportunities as they arise. As a result we have reduced several smaller cap stock holdings while adding to what we view to be undervalued stocks of higher quality companies. As we have stated in previous commentaries, it is always difficult to predict a market top and one must act prudently as the cycle continues to mature.