With rising inflation and climbing interest rates wreaking havoc on markets, Canadian investors have been shifting their assets into more defensive sectors, while also staying closer to home.

Those moves have paid off so far. Since January, for instance, the S&P/TSX Capped Consumer Staples Index, which tracks grocery stores and food operations, among other companies, has climbed by 4.2%, while the S&P/TSX Capped Information Technology Index, which follows technology stocks, is down 34% year-to-date. Overall, the S&P/TSX Composite Index has declined by nearly 6%, compared to 17% for S&P 500.

With 2023 around the corner, the time may be near to shift from defence to offence and reposition for a rebound. That means looking beyond Canada ­and defensive stocks and to more diversified U.S. equity markets with their abundance of world-beating companies.

“I don’t know whether we’ve reached a capitulation moment in the markets,” says Marcus Berry, vice-president and ETF specialist at Invesco Canada. But after another decline followed last summer’s rally ­– partly because of the realization that the U.S. Federal Reserve would continue hiking interest rates to subdue inflation – cash levels have reached new highs and equity allocations, new lows, he says. “We’ve also seen valuations on stocks start to look very attractive,” Berry notes.

Stock rising scenarios 

For investors put off by last year’s high U.S. equity prices, a decent entry point to get back in and take advantage of future growth may be opening. Valuation levels for the NASDAQ 100, relative to earnings, have reverted to their long-term average.

At the same time, on November 10, the NASDAQ 100 jumped 7% following the release of the lower-than-expected monthly Consumer Price Index, leading Berry to say, “it’s not going to take much as far as good news goes for markets to bounce back quite strongly.”

Berry uses a traffic light analogy to describe how the months ahead could play out. In a red-light scenario, inflation stays elevated, and interest rates continue to rise. That would result in further downside for stocks, especially technology companies whose profits lie mostly in the future. In an amber-light situation, inflation moderates somewhat but stays above the 2% to 3% targeted by the Fed, which continues raising rates but at a slower pace. In this scenario, markets will hold their ground, especially on an equal-weighted basis, he says.

Then there’s the green-light scenario, where inflation falls meaningfully. The Fed eases rates sooner than the market currently expects. This would spark a rebound in all markets, but most strongly the NASDAQ, which is still down more than 25% from its peak.

Depending on people’s outlook, some may want to start their transition from risk-off to risk-on. But how? Picking individual stocks to ride the rebound is a challenge even for the pros; SPIVA data from S&P Dow Jones consistently shows that, after fees, few actively managed funds can match the performance of comparable indices. In the bull market of 2020 and 2021, many retail investors opted for thematic funds focused on clean energy, electric vehicles (EV) or cybersecurity, says Berry, but since the market turned, many investors have seen large drawdowns and headed for the exit.

ETFs for a risk-on environment  

Berry suggests using low-cost index funds, such as the Invesco NASDAQ 100 ETF (TSX:QQC) and Invesco S&P 500 Equal Weight Index ETF (TSX:EQL), to satisfy one’s risk-on needs. QQC and its Canadian-dollar-hedged version, QQC.F, will help investors fully benefit from a green-light scenario in 2023, he explains. It offers exposure to 18 high-growth themes, from EVs to cloud computing. Even if that scenario doesn’t play out, QQC offers a way to establish a position in the 21st-Century economy, companies that will be able to grow their earnings far ahead of the rate of inflation.

EQL (and the Canadian-dollar-hedged EQL.F) would be the better choice in an amber-light situation. The fund includes all 500 stocks in the S&P 500 but weights them equally instead of by market capitalization. The result is a broadly representative fund that will not simply track the fates of the largest 10 companies in the index. It leans more towards the size and value factors, while the disciplined quarterly rebalancing creates a buy-low/sell-high effect over time.

Allocating a bit to both funds gives investors the chance to play either scenario. And for those who are still worried about a red light, there’s a third option: the Invesco S&P 500 Low Volatility Index ETF (TSX:ULV, ULV.F). This low-vol fund gives Canadian investors exposure to U.S. equities with minimum risk. As of mid-November, the fund’s total return was down just 8% on the year, compared to 28% for the tech-heavy NASDAQ 100.

Together these funds give Canadian investors low-cost access to the markets that are likely to lead the rebound and can help grow investors’ nest eggs for years to come. “Our job as an ETF provider,” says Berry, “is not to tell advisors or investors which way we believe the markets are going, but rather to provide them with the sharpest tools to be able to do what they want with their portfolios.”

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