Materials Stocks Set to Shine With Poloz Preparing Rate Hikes

Updated on
  • Materials stocks tend to outperform following rate increases
  • Financials and energy have been laggards in tightening cycles

Materials to Shine as Poloz Eyes Rate Hikes

If Governor Stephen Poloz does the expected and raises Canadian interest rates on Wednesday, it may be time to load up on potash, copper and gold stocks.

A review of equity performances following Bank of Canada tightening cycles over the past dozen years shows that materials stocks including Lundin Mining Corp. and Potash Corp. of Saskatchewan Inc. significantly outperform all other sectors of the Canadian market.

Over five periods of higher interest rates, including 2010, 2007 and an extended eight-month cycle in 2005 and 2006, the S&P/TSX materials index has returned an average of 9.7 percent in the three months following a rate hike, according to data compiled by Bloomberg. By contrast, financials have gained 1.8 percent, energy has returned 0.6 percent and the benchmark index has added 2.4 percent.

The historical gains in the face of higher borrowing costs suggest that Canada’s resource-laden broader index may be poised for a second-half rally, after lagging every other developed market gauge in the second quarter and declining 1.5 percent on the year.

Canadian investors should avoid most domestic equities in the current rates environment except for resource stocks, said Martin Roberge, North American portfolio strategist at Canaccord Genuity Group Inc.

“Only the bombed-out resource sectors are buyable here," Roberge wrote in a recent strategy note. He recommends investors go long on base metals and short on utilities as central banks around the world adopt a more hawkish stance.

The best-performing materials stocks tend to be those that benefit from a stronger economy that triggers rate increases, including base-metal miners Hudbay Minerals Inc. and Lundin Mining, and fertilizer producers like Potash Corp. Gold producers have also done well following rate hikes, which usually push the Canadian dollar higher. Agnico Eagle Mines Ltd., Alamos Gold Inc. and Guyana Goldfields Inc. have been among the best historical performers in these periods.

Still, Roberge is calling for a correction for the S&P/TSX Composite Index, as non-resource stocks such as banks and telecoms fall amid the higher rates, more than offsetting a rally in commodities shares.

"If we have the most over-valued non-resource stocks, we have almost by default the most undervalued resource stocks," Roberge said in a phone interview. "I think we’ve just stretched the rubber band too much on the pessimistic side and we need to see some sort of a snap back, especially if commodity prices rebound as I believe they will."

Canadian investors should stay away from bond proxies like utilities and telecoms, "which are totally, totally overvalued relative to their global counterparts," Roberge said.

Loonie Rally

Commodity sectors could also get a boost from the rising Canadian dollar, which has jumped 6.7 percent since its recent low in May on the potential for higher interest rates, said Brian Belski, chief investment strategist at BMO Capital Markets. The loonie is the best-performing currency among Group of 10 nations this month.

"Our work shows that Canadian equities post their best six-month forward performance following prolonged periods of weak currency, especially when the Canadian dollar is recovering from depressed levels," Belski wrote in a recent note, adding that commodity sectors tend to outperform in this environment.

Financial stocks should be avoided if the Bank of Canada moves on July 12 because higher rates could hurt the housing market, and a downturn would hurt banks, said Shailesh Kshatriya, director of Canadian strategies at Russell Investments Canada Ltd. Trading in the swaps market indicates a 92 percent chance of a rate increase on Wednesday.

"Right now one of the larger underweights we have is to the financial sector and banks in particular," he said in a phone interview. "Traditionally a steepening yield curve is better for banks but this environment is coming to fruition at a time when housing-related risks are near historic highs."

Railway Gains

Instead, Kshatriya recommends buying industrial stocks, which are benefiting from a strong economy and relative weakness in the Canadian dollar.

With a 12 percent gain year-to-date, the industrial index, which includes Canadian National Railway Co. and Bombardier Inc., has been the largest upside contributor to the S&P/TSX. By contrast, the energy index is down 17 percent, by far the largest drag on the benchmark. The materials index has fallen 4 percent in the same period.

(Updates prices throughout.)
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