Narrow No More: Why Canadian Equities Might Have an Advantage as Rates Ease
Author: Stephen Duench
October 17, 2024
The “great broadening” of financial markets may have begun, and investors in Canadian equities could be among the most significant beneficiaries.
This would be a big reversal of fortune. In global markets, the headline for much of the past three years has been the concentration of returns among a few big names, especially the so-called Magnificent Seven—Apple Inc., Meta Platforms Inc., NVIDIA Corp., Microsoft Corp., Alphabet Inc., Amazon.com Inc., and Tesla Inc. In a higher interest rate environment, that handful of U.S. mega-cap tech stocks, which comprise about a third of the benchmark S&P 500 Index’s market capitalization, delivered outsized returns. In fact, through November 2023 of last year, all of the S&P 500’s year-to-date positive return was generated by the Mag 7 – the other 493 stocks in the index had a combined negative return.
This narrowing of the stock market was not just a sectoral phenomenon – it was also geographical. As the American tech giants soared, markets in other major economies, including Canada, lagged behind. The reason: higher interest rates.
Taken as a whole, non-Magnificent Seven companies in the S&P 500 and in other regions’ equity markets are far more sensitive to rising rates, simply because of the greater presence of interest-rate-sensitive sectors like banks, real estate investment trusts (REITs), telcos and utilities. These sectors are sensitive to interest rate movements because, on the one hand, they tend to be more highly leveraged and higher rates raise their cost of capital, impacting earnings; and on the other hand, companies in these sectors also tend to be dividend-payers, and the relative value of dividend yields goes down as interest rates rise. The chart below illustrates the regional differences in rate sensitivities:
Interest Rate “Sensitives” By Region
Source: AGF Investments using Bloomberg LP data as of October 10, 2024. Interest-sensitive sector weightings established using the following global indexes: S&P/TSX Composite Index (Canada), S&P 500 Index (U.S.), MSCI Europe Index (Europe), MSCI Japan Index (Japan), MSCI Emerging Markets Index (Emerging Markets). One cannot invest in an index. Past performance is not indicative of future results.
As that chart clearly shows, Canada’s equity market has a higher proportion of interest-rate-sensitive stocks than any of the world’s major regions. It follows, then, that the Canadian market would be more adversely affected by the higher rate regime of the past two-and-a-half years than others were.
And this is where the potential opportunity comes in. As central banks lower rates – a process that began in Canada in June but has since been started by the U.S. Federal Reserve, too – we would expect markets to broaden out from the so-called Magnificent Seven to other U.S. and Canadian stocks, and we have already seen that begin: in the third quarter, nearly 70% of the 723 companies listed on the S&P 500 Index and S&P/TSX Composite Index (TSX) had returns greater than the S&P 500 Index’s gain of 4.6%. Moreover, just about half of these companies also outperformed the TSX, which returned 10.5% over the same period.
If interest rates continue to fall, we would expect the broadening out of the S&P 500 and TSX to continue, with Canada as a potential prime beneficiary. This may be especially true if central banks in Canada and the U.S. can navigate a soft landing and help keep their respective economies from tumbling into recession.
Of course, there are risks to this outlook. In this uncertain post-pandemic economy, inflation could once again rear its ugly head, prompting monetary policymakers to halt or reverse course on easing. On the flip side of the economic coin, it’s possible that higher interest rates have slowed growth too much and could spark a recession – a prospect that seems more likely for Canada than the U.S. at the moment.
Our base case, however, is that rates will continue to ease over the rest of this year and into 2025. If they do, then it could position the Canadian market very well going forward – and potentially transform its interest-rate-sensitive stocks from laggards into leaders.
The views expressed in this blog are those of the author and do not necessarily represent the opinions of AGF, its subsidiaries or any of its affiliated companies, funds, or investment strategies.
Apple Inc., Meta Platforms Inc., NVIDIA Corp., Microsoft Corp., Alphabet Inc., Amazon.com Inc., and Tesla Inc. are current holdings in AGF Investments portfolios as of September 30, 2024. The information contained herein is designed to provide you with general information. It is not intended to be comprehensive investment advice applicable to the circumstances of a particular investor. References to specific securities are presented for illustration purposes only and are not to be considered recommendations by AGF Investments. It should not be assumed that investments in the securities identified were or will be profitable.
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Written by
Stephen Duench, CFA®
Co Head, Highstreet Private Client † & VP and Portfolio Manager, AGF Investments Inc.
AGF Investments Inc.
