Despite the S&P 500 rising by 0.4% in May, led by a select group of large-cap growth stocks, equity returns were broadly negative this month. The Dow Jones Industrial Average, FTSE 100 Index and TSX Composite, which all have more exposure to cyclical and value sectors, generated total returns of -1.7%, -3.9% and -5% in British Pounds, respectively. May’s returns were consistent with the trend witnessed throughout the year of narrow market leadership and growth stocks outperforming value.
The outperformance that tech and consumer stocks have generated this year has been impressive but continued positive performance for the broader market is unsustainable unless market breadth improves. While we remain cognizant of lingering market risks, recent economic data supports our view that cyclical stocks should experience a catch-up trade in the near-term. Canada’s GDP grew 3.1% in Q1, much higher than consensus estimates. The strong GDP print was accompanied by several signs of broad-based economic strength, including household expenditures rising 5.7%, exports climbing 10.1% and inventories falling by C$11.7 billion.
In response to better-than-expected economic data, the Bank of Canada (BoC) raised its overnight policy rate by 25 basis points to 4.75% on 7 June. The announcement surprised most market watchers and was the first raise by the BoC since January when it signalled a conditional pause to monitor economic data. This move takes the bank’s benchmark rate to its highest level since 2001. Although the announcement disappointed many investors, it further supports our view that the Canadian economy remains on solid footing, setting the stage for cyclical stocks to outperform.
Real estate remains our biggest overweight sector relative to the benchmark as we believe it may be on the cusp of a sustained breakout. Looking back over the past five BoC rate hike cycles, REITs typically underperform the TSX leading up to the first rate hike and the six to twelve months thereafter. After twelve months, REITs start to outperform. Performance has historically been especially strong in the periods 18 months and 24 months after the first hike where REITs tend to outperform by 15 to 20% with high frequency. The BoC announced its first rate hike for the current cycle approximately 15 months ago on 3 March 2022. Put differently, we are entering a period where REITs have consistently outperformed the TSX by a significant margin.
The fund is also overweight energy relative to the benchmark. Canadian Natural Resources (CNQ) represents the fourth largest position in the Fund and is about to hit an inflection point for shareholder capital returns. CNQ is expected to start returning 100% of its free cash flow by Q1 2024 once it reaches its leverage targets, up from the current 50:50 split between shareholders and its balance sheet. The company has signaled a continued focus on share buybacks in addition to a 4.8% base dividend which has been increased for 23 consecutive years. CNQ is also expected to invest C$1 billion into strategic growth initiatives this year, leading to liquids production growth of 9% which is well above its peer group average of 2 to 3%. During the month, we also added to Suncor Energy and trimmed our exposure to Whitecap Resources. Suncor has lagged CNQ, its closest peer, by over 5% year-to-date and pays a 5.2% dividend yield. Whitecap announced in early June that it expects a slight reduction in 2023 production due to wildfires in Alberta which continue to burn across the province.