CONTRIBUTORS
Garey J. Aitken, CFA
Head of Canadian Equities, Portfolio Manager
Key takeaways
- With North American economies girding for the end of the battle to curb inflation, we believe an active approach to Canadian equities is especially important.
- The long-term compounding of equity returns is heavily influenced by a portfolio’s downside resilience. While recent market strength may have led to investor complacency, we continue to prioritize risk management as reflected in our current defensive positioning.
- The transition from a momentum- to a fundamentals-driven equity market may already be underway. The ClearBridge Canadian Equity Strategy has historically delivered outperformance in the aftermath of these narrow leadership periods.
Volatile Inflation Readings Continue to Impact Equities
After 15 months of mostly momentum-driven equity markets in North America, resurgent inflation and a winding back of projected interest rates cuts by central banks have stocks seeking direction. Three consecutive hotter than expected U.S. inflation prints to start the year caused bond yields to surge in the U.S. and Canada, weighing the most on growth and momentum stocks. More recently, a weak U.S. payroll report in April and tamer inflation reading have put the likelihood of rate cuts in 2024 back on the table, sparking a broad equity rebound.
We believe the last mile in the battle to curb inflation, moving from an annualized rate of 3% to central banks’ target of 2%, will be a crucial one for markets. The pace of success will dictate monetary policy in Canada and the U.S., which has been perhaps the biggest driver of equity performance this cycle. While consumer spending has remained robust, supported by labor strength and wage gains, recent employment data is showing signs of hiring fatigue. Meanwhile, pockets of stubborn inflation remain, such as in shelter, energy and transport costs, with the latter two being further exacerbated by geopolitics in the Middle East. Expansive fiscal policy also remains at odds with more restrictive monetary policy. At such a crossroads, we believe an active approach to Canadian equities is especially important.
The ClearBridge Canadian Equity Strategy has persevered through a number of momentum-based markets over its history and delivered outperformance in the aftermath of these periods of narrow leadership. Two of the most notable spans of outperformance occurred following the technology/telecom bubble that popped in 2000 and in the aftermath of the commodity bubble that ended in the summer of 2008 (Exhibit 1). Given increasing uncertainties in the broader North American economy, we believe a transition from a momentum- to a fundamentals-driven equity market may already be underway. With stocks back to discounting an ideal scenario, including rate cuts, continued economic growth and a solid corporate earnings profile, there appears to be little margin for error for momentum stocks. Accordingly, our bottom-up approach has positioned the Strategy more defensively than is typical.
Exhibit 1: Outperformance Following Momentum Markets
*Average of Active Funds is the average returns of all mutual funds and their share classes in the Canadian Equity category with a 5-yr tracking error ≥ 300 bps, relative to the S&P/TSX Composite Index). All fund and category returns are net of fees. Momentum Period 1 is January 1, 1997 to June 30, 2000, and Momentum Period 2 is January 1, 2004 to June 30, 2008. Post-Bubble 1 is the period between July 1, 2000 and Dec 31, 2003, and Post-Bubble 2 is the period between July 1, 2008 and Dec 31, 2014. Source: Morningstar Direct. As of March 31, 2018.
It merits a reminder that the Strategy continues to target a trailing beta of 0.8 to 0.9 — beta being a measure of the volatility, or systematic risk, of the Strategy relative to its benchmark. In the specific circumstance of a strong market over a short period of time, such as what we have seen since the start of 2023, this generally makes for a challenging environment for the Strategy to outperform.
A Focus on Risk Management
Throughout a full market cycle, superior risk-adjusted returns can be achieved in various ways, but generally they require a combination of both offense and defense. At peaks like we have seen in the S&P/TSX Composite and the S&P 500 indexes, investors tend to be focused on the thrill of the ride and fear of missing out, with risk considerations secondary; however, downside protection has proven to be crucial through a cycle. Ultimately, the compounding of returns over time is heavily influenced by how resilient a portfolio of equities is on the downside. The recent strength of the equity market may make investors complacent regarding the value of downside protection. We believe, however, that our experience through many market regimes has proven the case for prioritizing risk management throughout the cycle.
We manage the Strategy with a distinctive growth at a reasonable price (GARP) investment style, with a particular focus on visible, high and sustainable profitability, secular growth and strong capital allocation. In addition, the Strategy maintains a better valuation profile than its benchmark based on our free cash flow valuation approach — a feature that remains critically important to our success. At any point in time, there are equities that we find fundamentally attractive, yet the valuations simply do not make sense.
This price sensitivity is a major component of our risk management and has supported the Strategy’s sturdy downside capture across cycles. Over the years, this has meant forgoing participation in narrow leadership episodes that have seen individual Canadian growth stocks surge for several years only to give back most, if not all, of their gains over longer time periods. Such was the case with Nortel Networks in the late 1990s, the commodities bubble in the mid-2000s, Blackberry a few years later and Valeant Pharmaceuticals after the global financial crisis.
While our current defensive positioning may be a headwind in a rally lacking breadth, our available cash serves as dry powder that we can deploy in a timely manner as more attractive opportunities arise. Playing defense effectively also contributes to our focus on generating consistent absolute returns. As we have effectively done in past periods of market regime change, we are prepared to shift toward a more aggressive stance and transition the Strategy’s beta profile from the current lower end of our targeted range (0.8) to the upper end (0.9). A mixed macro backdrop means the jury is still out on the fate of the current momentum market. However, when sentiment shifts, the ClearBridge Canadian Equity Strategy will be ready.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. This material may not be reproduced, distributed or published without prior written permission from Franklin Templeton.
The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The underlying assumptions and these views are subject to change based on market and other conditions and may differ from other portfolio managers or of the firm as a whole. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. There is no assurance that any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets will be realized. The value of investments and the income from them can go down as well as up and you may not get back the full amount that you invested. Past performance is not necessarily indicative nor a guarantee of future performance.