Year-to-date Canadian equity returns of just over 2% have been lacklustre and lag emerging and developed market peers. But market and economic conditions are constantly changing. As we look forward to where tomorrow’s gains may come from, we believe Canadian equities look attractive.
All data as of September 29, unless otherwise noted.
1. Canadian equities have outpaced those in the U.S. and Europe since January 2016
Yes, the S&P/TSX Composite has underperformed its global peers recently, but only since February 21, 2017. Canada significantly outperformed its peers throughout 2016, and only recently have those other markets been catching up. In Canadian dollar terms since January 2016, the Canadian market is up 20% (price only return).
That puts Canadian equities at the top of the developed markets for performance – well ahead of the U.S. and EAFE markets, and behind only emerging markets. In other words, you need to check your recency bias.
2. Investing in Canada pays dividends
Canadian equity dividend rates are more attractive than their U.S. counterparts. The dividend yield of the S&P/TSX Composite is 2.8%. That’s 40% higher than the 2% dividend yield of the S&P 500.
Not only do dividends boost returns and help cushion market downturns, but they are tax advantaged for non-registered account holders.
3. Canadian equity valuations leave room for upside
Canadian equities are reasonably priced and valuations are attractive relative to U.S. equities. Both 12-month forward and trailing price-to-earnings ratios for the S&P/TSX Composite are well below those of the S&P 500. In fact, the gap sits near the widest levels post financial crisis (and outside of the financial crisis, it matches the widest levels in 15 years).
Starting from these levels and using 12-month forward return, models show the U.S. market appearing fully valued, while the Canadian market shows more upside potential.
4. Recent economic trends haven’t favoured Canadian equities, but trends change
The U.S. economy hasn’t grown as well as expected, and inflation has taken longer than anticipated to respond to tightening labour markets and growing global demand. As a result, low volatility and secular growth themes have generally performed best.
The sectors that have benefited most from this are information technology and health care – both have been exceptional performers over the past three years. Unfortunately, the S&P/TSX Composite only has 4% exposure to these two sectors combined. Contrast that with the S&P 500’s near 40% weight in these sectors and it goes a long way to explaining the Canadian market underperformance.
But economic conditions shift , and no one trend lasts forever. Likewise, crowded trades can become painful when the tide turns. When it comes to changing trends and turning tides – it’s not if, but when.
5. Canadian equities have performed well during periods of global economic growth and rising interest rates – like now
The sector weights of the S&P/TSX Composite have a strong cyclical growth orientation and tend to do well in periods of global economic expansion, when both interest rates and commodity prices are on the rise.
The S&P/TSX Composite has 20% more exposure to rising rates and increasing commodity demand than any other developed market. In addition, the financial sector is the largest weighted S&P/TSX Composite sector at 34%, and banks and insurers tend to benefit from higher interest rates.
The latest sag in Canadian equity performance is inconsistent with this trend, and we expect it to revert to its traditionally positive response to global economic growth and rising interest rates.
6. Canadian equities have room to catch up to other global growth-levered equity markets
The S&P/TSX Composite has historically shown a high degree of correlation to emerging market equities, which also tend to respond positively to solid global growth. Recently, this relationship has broken down.
Since the spring of 2017, a gap of over 12% has opened between emerging markets and Canadian equities in terms of how they are responding to the global economic growth. These inconsistencies don’t tend to last forever, and we expect Canada to catch up and narrow this gap.
7. Canadian banks remain a compelling investment opportunity
The S&P/TSX bank sub-index corrected 8% from February to September and remains 5% below the YTD performance of its U.S. counterparts. Valuations (e.g. price-to-earnings and price-to-book ratios) are reasonable and hovering near their 10-year average. Relative to their U.S. counterparts, Canadian banks have lower P/E multiples, higher return on equity, and nearly twice the dividend yield.
Recent concern over the health of Canadian banks is abating. The mid-year Home Capital “scare” appears to be behind us, and the hot housing market (also a worry for Canadian bank investors) is showing initial signs of rebalancing in the most stretched markets of Vancouver and Toronto.
Furthermore, Canadian banks delivered solid earnings in the latest quarter, and rising North American bond yields have the bank index perking-up. In short, we’re bullish on Canadian banks.
8. The fundamentals in oil markets are shifting back in Canada’s favour
We believe the major increases in the U.S. oil supply (a headwind to oil prices) are already factored into the price of oil. Many factors look favourable for oil prices to stabilize and move higher:
- Estimates of global oil demand have been rising, consistent with the acceleration of global growth.
- Global crude inventories are shrinking.
- U.S. oil production is back to previous peak levels.
- The rate of change in U.S. oil rig productivity has dipped into negative territory, suggesting that most productive rigs are back in use.
- OPEC has extended its production quotas once, and likely deems the tactic a (painful) success.
- A further extension of the OPEC quota would be in its best interests, especially as Saudi Arabia looks to bring the state-owned oil giant Saudi Aramco to market.
- Canadian oil producers are leaner in the aftermath of the price collapse.
Yet, current sentiment toward the energy sector remains muted. We don’t think it would take much to see a positive surprise from the energy sector.
A case for commodities
We anticipate an up-tick in demand for commodities due to the synchronization of global economic growth. Forward measures of global economic activity such as PMI survey data and other surveys of consumer and business confidence, all signal growth ahead.
Consider that for the first time since 2007, none of the 35 OECD countries are in recession, with roughly two-thirds expecting accelerated growth. The world hasn’t witnessed this type of synchronized growth since 2007, and prior to that, only once in the early 1970’s and late 1980’s. In all of those cases, Canadian equities performed strongly.
Outside of oil, many other commodities have begun to show strength. The Thomson Reuters/CRB Equal Weight Commodity Index (CCI) is up 5% from its 2017 low.
The lacklustre performance of Canadian equities has tried the patience of investors, but looking to where tomorrow’s gains will come from, we see Canadian equities as being well-positioned for growth.
If you are an investor who likes to buy on the dips to rebalance your portfolio, we think Canadian equities should be on your radar. Canadian equities have corrected 6.1% from February to late August. September’s near 3% return for the S&P/TSX Composite is consistent with our view, and represents a positive shift in sentiment toward Canadian equities.
Most importantly, we encourage investors to refrain from chasing past performance. As asset prices have shifted, balanced portfolios may need re-examining to avoid abandoning core positions and to add or rebalance back into assets that have underperformed.
Copyright 2017 GLC. You may not reproduce, distribute, or otherwise use any of this article without the prior written consent of GLC Asset Management Group Ltd. (GLC).
This commentary represents GLC’s views at the date of publication, which are subject to change without notice. Furthermore, there can be no assurance that any trends described in this material will continue or that forecasts will occur; economic and market conditions change frequently. This commentary is intended as a general source of information and is not intended to be a solicitation to buy or sell specific investments, nor tax or legal advice. Before making any investment decision, prospective investors should carefully review the relevant offering documents and seek input from their advisor.