Financials – Insurers vs. Banks
Adding Trisura Group Ltd. (TSU-T) at 3.0%
Removing EQB Inc. (EQB-T, portfolio weight 2.6%)
U.S. equities appear to be making a rotation towards defensive lower volatility sectors in utilities, consumer staples and healthcare — three sectors which have underperformed in 2023. We believe this rotation has been furthered by underwhelming economic data over the past week, led by the larger-than-expected slowdowns in the ISM Manufacturing and Services Indices, along with signals of a loosening labour market. The decline in the Citigroup Economic Surprise Indices confirms this slowing economic momentum (exhibits 1 and 2). Together with potentially tighter credit conditions from the current global banking uncertainties, we believe that recession risks have increased and pose a threat to markets as we enter the seasonally weak spring. The relative strength in large over small-caps also supports this defensive rotation and is typical in an “end-of-cycle” scenario. However, the rally in U.S. large caps year-to-date has been primarily valuation expansion, and not earnings-driven, leading the S&P 500 forward P/E to a near 20-year high (ex- COVID-19 bubble) of 18.2x.
In an effort to reduce the economic cyclicality in our small-cap portfolio, we are removing our lone bank holding in EQB and adding to the insurers with Trisura. With heightened recession risks and economic uncertainties, yield curves (10-year less 3-year) remain deeply inverted and bond yields have moved much lower over the past month. As we show in Exhibit 3, inversions of the yield curve (2019, 2007, and 2000) have led to underperformance in the Canadian financials (i.e. banks). Although EQB continues to rank highly from a quantitative perspective (positive EPS growth and low volatility), with economic data weakening and rising banking uncertainty, we believe that banks are at risk. As a result, we are removing EQB from our portfolio following the 7.6% rally in share price over the past several days and what looks to be a potential bearish trend reversal in share price (Exhibit 4).
Within the financials, we prefer insurers (P&C) over the banks, given their lower economic sensitivity and market risk. The relative strength in the P&C sub-sector would be consistent with economic and market downturns (Exhibit 5), as we saw in 2020 (COVID-19), 2018 (economic slowdown, trade war) and again in 2015-2016 (weak ISMs, oil collapses). Trisura's earnings profile continues to trend higher with forward earnings setting new highs (Exhibit 6) and with the pullback in share price of more than 30% to start the year, Trisura is trading near what we view as technical price support (Exhibit 7). We previously held Trisura in our small-cap portfolio, but sold it in early 2022 on valuation concerns. However, presently trading at a forward P/E of 13.7x, Trisura is trading at a more than 20% discount to its five-year median of 17.5x (Exhibit 8). Given these positive views, we are adding Trisura at a 3.0% weighting. We continue to hold Definity Financial Corp. (DFY-T, portfolio 1.9% weight), which also ranks highly for its consistent earnings growth (Exhibit 9). Definity is trading at what we consider an undemanding forward P/E of 15.2x compared with 19.4x from the late-2022 peak after a 12% decline in share price (Exhibit 10).