As Russia-Ukraine conflict complicates central banks' rate-hiking path, what sectors should investors consider?
Yesterday, the Bank of Canada took a hawkish turn as it announced a 25-basis point increase in its policy rate. Aside from being the central bank’s first hike since 2018, the move was its first step away from the extremely supportive 0.25% it has maintained since the onset of the Covid pandemic in 2020.
As significant as it was, the announcement was no surprise. Wolfgang Klein, Senior Portfolio Manager & Senior Investment Advisor with Canaccord Genuity, said market participants and analysts have been speculating about rising interest rates for months amid historic levels of inflation in North America and elsewhere.
“If it wasn't for the war in Ukraine initiated by Russia, there would have been a fait accompli,” Klein said in an interview with Wealth Professional. “That was the only fly in the rates-rising ointment.”
Russia’s war a wild card
The BoC is following events closely, but with the economy currently on a path of expansion and inflation remaining elevated, it expects that interest rates will need to rise further. While some have suggested that the central bank was behind the curve, Klein argues it had to make sure the economy was on solid footing before putting on the brakes, even if it meant letting inflation run a little bit ahead.
“The consensus has been that the BoC will hike probably three or four more times this year,” he says. “Rate increases here aren’t as relevant as south of the border, and the consensus there was that the Federal Reserve will be raising rates four to six times this year.”
Chhad Aul, Chief Investment Officer and Head of Multi-Asset Solutions at SLGI Asset Management, also said the announcement was largely in line with their expectations. “We knew that they would probably view Ukraine-Russia situation as a new risk factor, but not necessarily take it as an overly dovish undertow.”
Weighing the overall impact of the situation in Ukraine is proving to be a challenge. As the BoC has indicated, the conflict could reverberate into a drag on economic growth, but it has also created inflationary pressures. Financial sanctions on Russia have had a chilling effect on international traders, who are now hesitating to tap the country’s commodities markets for fear of getting caught in the economic crossfire.
While he forecasts continued rate hikes for the next couple of policy meetings, Aul stresses the need for central banks to have the flexibility to pivot as more data comes in over the course of the year. That was also emphasized by Federal Reserve Chair Jerome Powell yesterday in testimony before Congress, where he backed a 0.25% hike this month for the Fed but remained open to larger increases.
“It’s a complex picture. Now you have this second exogenous shock to the economy aside from the pandemic,” Aul says. “You’ve got new supply-side pressure adding to inflation, and we believe the economy is already past peak growth coming out of the pandemic.”
Time to seek quality in equities?
So how should investors position their equity portfolios?
According to Klein, inflation is the top threat to investors at the moment, so he recommends investing in inflation-resistant sectors like Canadian resource companies. Technology stocks also showed some weakness following the announcement, which means investors might want to consider maintaining a market weight on the tech sector, if not underweight, while favouring quality technology companies.
“The Canadian dollar has gone up a little bit on the announcement versus the U.S. dollar,” Klein says. “So if you’re overweight the U.S. market, you might want to maybe bring a little bit of money home to Canada. I’m not seeing a lot of love for international markets, but they are a lot cheaper compared to the domestic market.”
From Aul’s perspective, a background of slowing economic growth makes resilient earnings growers like tech stocks relatively more attractive; the fact that they’re in correction territory adds to their appeal. And because North American markets are more removed from the concerns in Europe, he favours U.S. and Canadian stocks despite their already outperforming international markets last year.
“Against a backdrop of slowing growth, I think it’s advisable to lean towards more defensive, higher-quality parts of the market, and maybe shifting away from some of the cyclical parts that have done so well,” he says. “Obviously, energy is having an exceptional run, but now might be a time to set up your portfolio for the next stage. … All these stocks in the U.S., for example, that have been beaten down so far this year may well be the outperformers of the next stage of the economic cycle.”
Because Canada’s financial sector generally had a good year leading up to recent weeks, and they offer high quality against financials around the world, Aul has a constructive view on Canadian financial companies. Klein is also positive on the space.
“The yield curve is steep and Canadian banks are making good money. Rising rates are good for Canadian banks, and they’re good for insurance stocks as well,” he says. “You can certainly buy in there.”
