Why cyclical stocks, not defensives, are the place to put your money
When Greg Taylor saw the U.S. 10-year Treasury yield start to move up meaningfully in recent months, it was a trigger to become more aggressive in his asset mix shift. That meant focusing on sectors that benefit from higher interest rates.
The portfolio manager at Redwood Asset Management, a subsidiary of Purpose Investments, who has been running the Redwood Select Equity Fund (primarily at Aurion Capital Management) since 2006, believes the higher rate environment will provide a lift for cyclicals, with financials being the most obvious beneficiary.
Taylor, who also manages the Redwood Global Opportunities Fund, the Redwood High Income Fund, and the Marijuana Opportunities Fund, noted that despite the shock caused by the stock market’s recent plunge, the past few years have really been the anomaly.
“I think we’re moving back to an environment where there is going to be more volatility, more sector rotation, and higher rates will definitely change what works,” he said. “The market should not have a VIX under 10, it should be should be in the 15 to 20 range.”
The thesis behind higher rates is based on the winding down or end of various stimulus programs, and synchronized global growth for the first time in several years. Inflation hasn’t been in the market either, but hints of it have begun to surface again, which may prompt more talk about the Fed being behind the curve.
“I think they may have to start hiking more aggressively, and if that happens, we enter a new ballgame in the market where you don’t need to be in defensive sectors,” Taylor said, highlighting his short positions or zero weightings in pipelines and utilities.
One thing that could cause inflation to overshoot is U.S. President Donald Trump’s stimulus program and tax cut. Taylor thinks it’s being done at the wrong time.
“Normally, the time to do a tax cut is during a recession, or if you want to get the economy going,” he said. “It’s rare to see that when you have record-low unemployment and an ISM almost at record highs.”
Given that the economy is already healthy, and global growth is picking up, it adds more risk that inflation picks up quickly. Perhaps a bigger wild card is we don’t really know what Fed we have, as the FOMC is undergoing a massive change in membership.
Taylor thinks it’s appropriate these days to remember the old saying that bull markets don’t die of old age, they get murdered by the Fed.
“When you look at late-stage markets, you want to be in cyclicals,” he said. “The sectors that will act the best in that environment are the financials, industrials and commodities.”
“That doesn’t seem to be the case at all for Manulife, and it’s provided an opportunity to buy Manulife at a discount to some of its peers,” he said.
Goldman, meanwhile, will benefit from higher rates and strength in the market, but also from the increase in volatility.
“I’d expect the company to start making more profits on the trading desk,” Taylor said. “A lot of these companies haven’t made much from trading in the past few years, and that’s due to the low volatility environment.”
While base metals have had a good start to the year, with both copper and nickel doing well, the commodity Taylor is waiting on is gold.
“It’s a sector that’s been easy to ignore for the past few years, but as inflation starts to creep back into the system, I think you have to watch gold,” he said.
The hedge fund’s holdings include Franco Nevada Corp., which Taylor noted generalists tend to come to first as the market gets more comfortable with gold, and B2Gold Corp., which offers investors organic growth through new projects coming online.
Energy stocks have been a source of great frustration in Canada, although they would typically benefit later in the cycle. However, Taylor noted that the risk posed by pipeline delays, could cause the sector to continue to disappoint.
“We have been so late in getting pipelines built for the off-take capacity on the west coast, that spreads have really widened out,” he said. “So the discount you’re getting in Canada versus the U.S. has really made it less attractive to buy a Canadian oil producer versus a U.S. producer.”
That’s a primary reason why Taylor favours companies with international exposure, such as Parex Resources Inc. (PXT/TSX), which operates in Colombia.
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