Canadian core equity: against tail risks, sustainable cash return

Key takeaways

1. We continue to monitor several tail risks, including the potential for a Canadian housing and consumer credit downturn, deflationary risks, and the potential for China’s structural imbalances to unwind and destabilize the global economy.
2. In today’s market, we believe it’s important to focus on stocks with high cash returns and lower historical dispersion of such returns. This helps identify quality companies with sustainable operations that can collectively dampen the effects of rising volatility on a portfolio and may also offer downside protection.
3. While valuations remain fair to high—even after the August 2019 market pullback—we continue to see attractive opportunities in telecommunications, mature technology firms, and select consumer names such as grocers.
4. We think there are reasons to remain cautious on the energy and financials sectors, and we see the potential attractiveness of large oil sands operators as well as property and casualty insurers and alternative asset managers.

At present, our base-case projection for the economy and markets sees low interest rates and the renewed dovishness of central banks helping to stabilize the global economy, pushing the world back into more or less synchronized low-growth mode. This would imply a modestly positive set of conditions for global stocks; however, we’re increasingly concerned that downside risks are mounting, which could severely affect equity markets.

In our era of multidecade highs in consumer leverage, we think the housing sector, the credit environment for banks, and the broader economy face a significant tail risk in a potential consumer credit downturn. Should consumers’ aggregate ability to spend and borrow hit a wall—despite flat to declining costs to service their debt—the economy would have to navigate some significant difficulties. Home builders and home improvement retailers, for example, would suffer from any deterioration in consumer credit, while the more exuberant Canadian housing markets could continue to deflate. Banks, which are generally attractive at the moment from a valuation perspective, might be particularly vulnerable in the short to medium term. At a time when declining interest rates are putting downward pressure on banks’ net interest margins, a slowdown in loan growth and a pickup in defaults would threaten more difficult conditions. With historically low loan loss provisions, the banks are poorly prepared to handle any potential spike in customer defaults or renegotiated loan terms. Lower net interest margins resulting in reduced net interest income would hinder the banks’ ability to generate earnings and attractive free cash flow.

While the risks related to an overlevered consumer are high, these tend to be overshadowed by current issues around global trade. Of course, it’s anyone’s guess what happens next in the games of brinkmanship playing out on the global stage. But as for the economic skirmishes between China and several Western nations, certain structural imbalances in China could, if pushed just enough, result in particularly strong economic tremors.

It’s not uncommon for China to represent a majority of total demand for another country’s materials and goods. For Canada, China is currently the largest trading partner after the United States. For the machinery-intensive industries, which are Canada’s forte, China is one of Canada’s top buyers after the United States in mining, automobiles, and agricultural products. If China’s demand gives way in any number of sectors, that would be bad news for Canada.

Other related tail risks that could begin to unravel in the face of a China-intensified global slowdown include the potential for substantial oil price weakness, which would not only pressure the energy sector but place the Canadian economy on much less stable footing. Against the backdrop of these risks, we think it’s important to focus on the long-term sustainability of companies’ free cash flow returns, which we think offers a prudent way to maintain both the quality and resiliency of a portfolio regardless of prevailing market conditions.

In today’s market of low interest rates and low inflation, investors haven’t totally abandoned growth, but they’re increasingly drawn to the perceived safety of utilities, real estate, and energy pipeline stocks. However, in these market segments, valuations have risen materially and appear elevated as deflationary risks continue to increase.

From our perspective, a variety of companies in property and casualty insurance, energy, and telecommunications can offer a valuation advantage over these more traditional safe havens. Companies that have demonstrated an ability to produce sustainable, robust free cash flow—and that may add something to a portfolio because they’ve shown a pattern of not performing in line with broad market fluctuations—merit close attention.

With property and casualty, we believe it’s important to assess companies’ exposure to environmental, social, and governance risks such as underwriting exposure to fossil fuels and vulnerability of commercial underwriting to entities with high exposure to physical hazard risks associated with climate change. But where these risks are properly disclosed and mitigated, the high cash-returning profile of certain insurers stands out—and this is generally underappreciated.

Another area that’s often overlooked is energy exploration and production (E&P) companies, largely because of the perceived risk in the price of oil. Oil prices are famously driven by a complex web of factors: U.S. shale markets OPEC; China’s growth; Russia’s shaky alliance with OPEC; geopolitical hotspots such as Venezuela, Libya, and Iran; carbon tax developments; electrical vehicles and changing regulations over emissions—any combination of these factors could drive oil price volatility in either direction. Given this uncertainty, investors have been drawn to Canadian pipeline stocks for their yield characteristics, but this may miss an opportunity in some E&Ps, such as major oil sands operators, which we think could prove relatively resilient to macro-driven oil price volatility.

Today, the range of outcomes for the oil price is extremely wide. For most E&Ps, this translates into a significant risk: If the price of oil drops below the marginal cost of production, the companies may be left with an unsustainable business. But when volatility spikes and the price of oil falls, the most resilient E&Ps are those that can withstand the volatility and buy attractive assets at low prices, further enhancing their resilience to future oil price fluctuations.

Among the so-called bond proxy sectors, we currently prefer some telecoms over utilities, real estate, and pipeline stocks. While investors have poured money into these market segments, telecoms have tended to offer better value, higher free cash flow yield, and lower sensitivity to yield changes than these other bond proxies, an important consideration during today’s low-yield environment, in which bond yields can quickly back up.

Against a backdrop of volatile markets, we think the most relevant tail risks to Canadian equities aren’t on the radar of many investors. In our view, the overlevered Canadian consumer is perhaps the most relevant factor putting the domestic economy at risk, while China’s structural imbalances—which an uncontrolled trade war could push toward a disastrous collapse—pose a more ominous set of challenges to the global economy than is generally appreciated.

This has made it relatively harder to find what we think of as undervalued opportunities. In this way, value-oriented investors may need to consider stocks that that are more fairly valued, but that may show the potential to outperform due to their unique features and lower overall exposure to macroeconomic risks.