Equity Commentary: As at December 31, 2020
Source: David Picton | Jeff Bradacs, CFA | Michael Kimmel, CFA | Michael Kuan, CFA | Travis Irwin, CFA
Publish Date: Jan 15, 2021
The Canadian equity market (S&P/TSX Composite Index) rallied 9% during the quarter with optimism on the arrival of positive news of Covid-19 vaccine leading to a rotation of leadership into cyclical and Covid recovery stocks. Nine of eleven sectors were positive with only Consumer Staples and Material sectors negative. Within Materials there was significant variance in sub-industry performance with Gold equities down 15% while economic sensitive areas like Copper equities were up 68%.
Looking into 2021, economic growth is expected to strongly rebound as Covid-19 restrictions are lifted and support from record fiscal and monetary stimulus. While equity leadership in 2020 was mostly led by companies seeing a pull forward of demand due to the pandemic (ex. e-commerce companies, consumer staples), our expectations are that cyclicals and companies seeing a recovery in their fundamentals as restrictions are lifted will lead equity markets heading in 2021.
With respect to sector and industry positioning, we are generally overweight in Material and Diversified Financials with a negative bias towards Consumer Staples and Communications. Within Material, we continue to have a positive view on base metals with a preference for Copper as both the economic and commodity cycles are favorably aligned. Within Diversified Financials, we have a favorable view on a select few positive change companies exhibiting strong growth.
We believe a new economic cycle is underway where economic data will normalize quickly. After a COVID related pause, global economic growth is likely to accelerate materially in 2021 to GDP growth rates not witnessed in decades. This is occurring against the backdrop of dramatic monetary policy stimulus and potentially more fiscal stimulus to augment the stop gap measures used to battle COVID. We believe equities have room to run. While absolute valuations are higher than normal, they are somewhat distorted by tech valuations. Stocks remain attractive relative to other asset classes, have yet to benefit from aggressive systematic positioning or outflows from still elevated balances in money market funds and can benefit from both private equity and SPAC dry powder. This constructive backdrop is well understood given positive sentiment so pullbacks are possible, but we would expect them to be shallow.
It appears as though Democrats will carry both seats in the Georgia Senate run-off. This is expected to bolster beliefs in more fiscal stimulus and thus infrastructure investments. At the same time, the bond market has reacted in a way that shows an assumption that large deficits will continue in support of improving economic growth. Technology names could lag as a result as rising yields curtail multiple expansion, not to mention the potential for increased regulation and higher taxes. All that said, we feel that exuberance on the above should be tempered. Achieving big policy change amidst such thin majorities in both the House and Senate seems likely to be a challenge.
Re-opening, an economic recovery and a weak US dollar are leading to a perfect cocktail for commodities prices. On top of this, a lack of investment over the past decade in areas like copper are likely to result in supply shortages particularly as new demand drivers emerge. Copper is used in a wide range of applications supportive of the decarbonization theme such as electric vehicles and the shift to renewable energy. From an agricultural perspective, we see attractive opportunities in the soybean value chain as the Chinese rebuild their hog herds that were decimated during the 2018 Asian Swine Fever outbreak. At the same time, new demand drivers are emerging domestically with renewable diesel expansion plans supported by generous government incentives for capacity buildout. We believe these themes have legs in 2020.
International Equities (as measured by the MSCI EAFE Index) has lagged the S&P by over 8% per annum over the past 1-, 5-, and 10-year time periods. However, the fourth quarter of 2020 may mark the reversal of this trend with both Europe and Asia outperforming the US during the quarter. There are both fundamental (weaker US dollar, resolution on Brexit, stronger earnings revisions, valuation) and flow/market structure (higher weights of cyclical stocks in International market, market underweights in Europe) reasons for this to continue in 2021.
Despite the second wave and lockdowns in Europe, the conditions suggest that cyclical stocks are likely to outperform. This style cycle is interpreted by some as in “Boom” based on leading macro data as well as changes in European bond yield and earnings revisions. This generally bodes European equities and in particular stocks that benefit from rising yield/ inflation expectations. We have increased our weight in European Industrials, Materials, and Financials funded by the reduction in our Utilities and Consumer Staples exposure. In 2020, the Chinese stock market outperformed the other Asian markets despite rising tensions between China and the US. This was partially due to the composition of the Chinese market, which like the Nasdaq is more weighted towards new technology and new economy stocks. Given our expectation of an economic recovery in 2021, markets like Taiwan and Korea should do well as many of the listed technology stocks in these markets are cyclical companies with significant operating leverage. One such company is Hynix, which is a leading global memory chip manufacturer based in Korea.
Small Cap Spotlight
Champion Iron Ltd. (CIA) is a Canadian-based iron ore company that we have talked about in the past operating the Bloom Lake mine in northern Quebec. Champion’s management team has created significant shareholder value by acquiring the Bloom Lake mine at the bottom of the iron ore price cycle with key infrastructure and installations intact. Iron ore spot prices have rallied significantly in 2020 driven by supply disruptions from COVID regulations and weather impacts and recovering global economies particularly in China who is a large consumer. During the quarter CIA also formally approved their Phase II expansion at the Bloom Lake mine, which will be financed entirely internally by cash generation and some debt. The expansion will allow CIA to nearly double its production by 2024 at attractive cash costs which will likely generate significant cash flow. We continue to remain positive in the Champion Iron Ltd.
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