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Aside from the headline moves in Energy and Materials in the first quarter, which were tied to the war in Ukraine and to post-pandemic commodity supply challenges, the Canadian market has turned extremely defensive, as shown by Q1 returns for the S&P/TSX 60:
- While Energy and Materials ran: 14 of the 17 S&P/TSX 60 Energy and Materials names posted double digit returns in Q1.
- Just over half of non-commodity names beat inflation: The list of non-commodity names whose returns beat inflation skews very defensive, with 13 of the 23 outperforming names in Communications, Staples or Utilities. The remaining names included four Big Six Banks, and two Consumer Discretionary names – Canadian Tire and Dollarama – that Canadians treat like Staples. Rounding out the list: Manulife, CP, CNR, CAE, and Waste Connections.
Communications, Staples and Utilities typically outperform when investors are gearing up for weaker economic conditions. So it is hard not to view the first quarter as a retreat from risk, despite the rebound in the second half of March.
Have markets gotten too defensive or not defensive enough?
To answer the question, we think it is worth looking back at where valuations were trading around the time of the last interest-rate tightening cycle in 2018. In the table below, we compare next fiscal year EV/EBITDA multiples from August 2018 to those currently seen in the Canadian market:
The biggest departures from 2018 multiples belong to the Consumer Discretionary (due to autos), Communications, Industrials and Utilities sectors. For every sector, when weighing multiples it is important to factor in the differences this time around, including: the continuation or roll-off of COVID effects in each industry; the flow-through of inflation into margins; and interest-rate hikes that have yet to fully hit. Taking those factors into account, in our view the biggest valuation risks are tied to:
- Information Technology: Despite current Canadian multiples appearing lower than 2018 (outside Shopify), we think consensus earnings remain too optimistic, making the actual multiple much higher. Prior experience has shown that analysts are slow to revise estimates and routinely miss turning points in the cycle, particularly for technology stocks. The downward pressure will continue to be most acute for high Price-Sales, earnings-light firms.
- Industrials: The current high multiple reflects a view that weaker Industrial earnings will be transitory as the global economy regains its footing. However, we see considerable risk that inflation and supply chain problems extend into 2023 and beyond. And, if central bankers are not careful, rate hikes could tip the global economy into recession by late 2022 or into 2023. Betting against these possibilities is not for the faint of heart.
- Financials: While in very good shape currently, we know that if economic conditions worsen and credit losses pick up through year end, the multiple in Financials is likely to contract relatively quickly.
- Utilities: With high current multiples driven by renewable energy premiums, certain Utilities may come under pressure despite their defensive characteristics.
All told, we think the current valuation backdrop continues to support a relatively defensive stance. As additional interest rate hikes weigh in over the medium term, keeping a close watch on company fundamentals will be key. We remain focused on picking our spots and sticking to high quality names in those sectors best positioned to manage through the coming uncertainty. To this end, the research provided by our affiliate Veritas Investment Research remains invaluable.
Through the end of the first quarter, the NASDAQ was down 8.9%, the S&P 500 was down 4.6% and the S&P/TSX was up 3.8%. Over the same period, our Canadian Equity Fund rose 4.5% and our Absolute Return Fund was up 0.6%. (Performance based on F series).