We have become more constructive on defensive sectors that bore the brunt of higher interest rates for most of the past year, including communication services, utilities and real estate as well as the midstream/pipelines portion of the energy sector, and will continue to seize on opportunities in these areas as they arise.
The S&P/TSX Composite Total Return Index returned 8.1% in the fourth quarter. Benchmark 10-year interest rates in Canada and the U.S. reached 2023 highs of 4.24% and 4.99%, respectively, in October before ultimately giving way in the final two months of the year to close at 3.11% and 3.88%. Following a U.S. Federal Reserve meeting in December that highlighted easing inflation and slowing economic growth, rates priced in a more dovish consensus.
The advance in Canadian equities was broad-based, with information technology (IT, +24.0%), financials (+12.7%) and real estate (+10.7%) leading the charge. In addition, the defensive/non-cyclical sectors of utilities (+8.2%), consumer staples (+8.1%) and communication services (+7.6%) all performed well, while energy was the only sector to decline (-1.3%). IT capped off a strong year buoyed by investor enthusiasm for the possibilities of artificial intelligence (‘AI’), and as lower interest rates eased pressure on valuations of equities with longer-duration projected cash flows. Weakness in energy was driven by lower commodity prices. Crude oil prices declined despite Middle East conflicts due to inconsistent global demand indicators and sufficient supply, while natural gas price weakness reflected the generally warm winter conditions experienced to date this heating season.
U.S. equities saw similarly broad gains with the S&P 500 Index (SP500, SPX) advancing 8.9% (in CAD), leaving the benchmark within earshot of January 2022’s all-time highs. During the quarter, 10 of 11 sectors advanced in absolute terms, with real estate leading the way as investors began to price in a Fed not only done raising interest rates, but also likely to cut them in the first half of 2024. IT shares also outperformed meaningfully as AI growth opportunities continued to excite investors.
Although the ClearBridge Canadian Plus Equity Strategy generated strong absolute returns in the quarter, it underperformed its broader North America equity benchmark largely due to stock selection in the U.S. health care and Canadian IT sectors which included not owning Canadian web enablement provider Shopify (SHOP).
Trading activity in the fourth quarter was surgical as dislocations in equity markets presented a limited number of some attractive opportunities. Transactions included the purchase of Oracle in the IT sector and Tourmaline Oil in the energy sector.
The Strategy also selectively added to attractive individual opportunities in more cyclical aspects of the portfolio, including in sectors with our largest underweights, such as financials and energy.
The sharp rise in rates over the first 10 months of 2023 took a toll on the more defensive areas of the equity market. Among the 11 sectors in the combined benchmark, utilities, real estate, materials and financials were among the worst performers before a year-end rally. The first two sectors are among the most interest-rate sensitive in the market and we believe the earlier selling due to rate tightening has been overdone. With valuations down and the economy still fragile, we have become more constructive on these sectors as well as communication services and the midstream/pipelines portion of the energy sector. As inflation abates and growth slows, rates do not need to come down much for these companies to see a re-rating of their stock prices.
We are more bearish on cyclical sectors, including materials, energy and financials. Energy and materials are resource sectors with greater sensitivity to the global economy. With China struggling and growth sluggish in other major regions including Europe, a demand slowdown could pressure these stocks. Banks, meanwhile, which had sold off for most of the last two years before participating in the fourth quarter rebound, are trading at valuations that already discount a more challenging environment. While we expect to remain underweight these sectors relative to the benchmark, as bottom-up stock pickers we will continue to monitor these sectors for opportunistic additions.
The Strategy has successfully navigated various market conditions characterized by both strong and weak sentiment, as well as shifts in sector leadership and economic landscapes, and is well-positioned for the uncertainties of 2024. As we acknowledge the presence of risks and uncertainties, we are confident the future will present both challenges and opportunities. We will seize on opportunities as they arise, leveraging our extensive track record of delivering superior absolute, relative, and risk-adjusted returns over the long term.
During the fourth quarter, the ClearBridge Canadian Plus Equity Strategy* underperformed its custom benchmark, comprised of a 60% allocation to the S&P/TSX Composite Total Return Index and a 40% allocation to the S&P 500 Index. On an absolute basis, the Strategy generated gains across nine of the 10 sectors in which it was invested (out of 11 sectors total) among Canadian equities and six of the nine sectors in which it was invested among U.S. equities. The primary contributors came from the Canadian financials and U.S. information technology sectors.
On a relative basis, overall security selection across both Canadian and U.S. equities detracted from performance. In Canada, stock selection in the IT, energy and industrials sectors and an underweight allocation to the financials sector weighed on results. In the U.S., selection in health care, consumer staples and IT hurt performance.
On the positive side, stock selection in the Canadian materials sector, U.S. financials sector as well as underweights to Canadian materials and energy contributed to performance.
Timothy W. Caulfield, CFA, Dir. Canadian Eq. Research
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
