We hold a neutral view on Canadian equity. At the index level, Canadian equities look relatively cheap and sport reasonable earnings growth expectations (see U.S. Equity Earnings Growth and Forward Price-to-Earnings Ratio charts). The 12-month forward P/E ratio is at its 10-year average, with price-to-cash flow and price-to-book slightly below the 10-year average. Return on equity is rising and sits one standard deviation above the 10-year average. However, Canadian equities suffer under the surface from sector segmentation, with the overall index picture being made up of three groups of sectors: those that are expensive, those that are heavily discounted and a few that come with a mix of fundamentals.
Roughly one-quarter of the S&P/TSX Index (23%) sits at the expensive end of the range in the Utilities, Real Estate, Communication Services, Consumer Staples and Information Technology sectors. Of these, Communication Services and Consumer Staples are stable businesses with solid earnings growth and stability that generally command elevated valuations (and have done so for quite some time). The Information Technology sector is a story of a handful of companies whose fortunes are linked to their unique competitive advantages. Utilities and Real Estate have been beneficiaries of a declining yield environment and the popularity of investors seeking a defensive stance. We are concerned these two sectors will suffer when the appetite for defense wanes, as would be the case under our improving 2020 scenario. Thankfully these two sectors represent a mere 9% of the market.
In the ‘mixed fundamentals’ category sits the Materials, Industrials and Consumer Discretionary sectors, another quarter of the benchmark (26%). Materials is a two-sided story: gold companies have done well and have benefitted from the declining yield environment and defensive trade (similar to Real Estate and Utilities). We’re concerned that gold miners will suffer once the defensive trade goes out of favour. Outside of gold, Materials are home to forest products and base metals, both of which would respond positively to our improving 2020 base-case scenario. Industrials are cheap on a price-to-cash flow basis yet expensive on earnings metrics. However, the sector sports accelerating earnings growth that ameliorates these concerns. Consumer Discretionary (at just 4% of the index) is a mixed bag of reasonable to slightly expensive valuations with sluggish return on equity, but earnings growth is above average and re-accelerating – not an overly concerning sector.
The good news is the Financials, Energy and Health Care sectors have attractive valuations with the first two (making up 49% of the index) being poised to benefit from our improving 2020 scenario.
- Financials – The Financial sector continues to suffer from recession fears and concerns over Canadian household and corporate indebtedness. An improving 2020 scenario staves off any recession or ‘day of reckoning’ for these concerns and they should continue to be buoyed by a Canadian employment market that’s pumping out considerable jobs and wage growth. Add-in robust population growth that continues to sustain the Canadian bank’s domestic lending franchises. The banks (and insurers) will benefit from a steeper yield curve and modestly higher bond yields. The 33% index weight of the Canadian Financials sector doesn’t need to perform any Herculean feats: an estimated 2020 dividend yield of 4.5% and a further 5 to 7% price appreciation is all that’s needed to nudge total return into the low double-digits. That kind of price appreciation is a low bar given the starting point of below-average valuations.
- Energy – The Energy sector is extremely cheap, raising the question of whether or not it’s a classic value trap. Can the Energy sector re-rate back anywhere close to its average valuation of the past? Global investor sentiment is weighing on the sector and considerable uncertainty remains around whether the sector has passed the point of no return regarding environmental concerns and/or alternative fuel technological pressures. It feels like ‘Big Oil’ is becoming like ‘Big Tobacco’ of the 1980s. What we know is thirty years later, tobacco companies are still around. If everyone quit smoking tomorrow, the companies would be gone and the world (as we know it) wouldn’t change. The same cannot be said about energy – the world continues to need fossil fuels (the recent CN rail strike reminded many Canadians of this fact). So the question is whether Energy sector share prices (that are at very low levels given where the commodity price sits) respond the way they have traditionally done to a pro-growth scenario? While the Energy sector isn’t trading at the rock-bottom lows associated with sub-$30 oil prices (nor are oil prices sub-$30, they are nearly twice that level), it’s trading well below much higher price levels witnessed just in the last four years (see Exhibit 3.2 – U.S. WTI Crude Oil Prices). In that time, the sector has mounted three charges higher with returns ranging between 20% and 50% in periods of multiple months, not quarters. We think the risk-reward here is compelling to warrant exposure.
- Health Care – The trials and tribulations of the cannabis industry has this sector now relegated to a 1% weight (it was never more than 3%). We continue to see the risks and uncertainty of this sector outweighing the opportunities as we know them, but for a deep-dive on the subject, read GLC Insights: The Green Rush - Exploring Canada's Cannabis Industry.
The Bottom Line:
Canadian equities continue to trade at a wide valuation discount to their U.S. counterparts. The index has a sector composition favourable to a scenario of modestly improving global growth and waning trade uncertainty, including the prospect of a ratified USMCA. The swing factor for outperformance does rest heavily on the Energy sector, where uncertainty and volatility bring a risk profile that warrants some caution. Weighing the various factors we maintain our neutral recommendation with a base-case scenario for the S&P/TSX Composite of a 7% price return; when coupled with an estimated annual dividend yield of 3%, we expect a total return of 10% for 2020.
We hold a neutral view on non-North American, developed market equities, commonly benchmarked against the MSCI Europe, Australasia and the Far East Index (MSCI EAFE Index). In aggregate, we don’t expect EAFE equities to outperform Canadian and emerging market (EM) equities. However, two geopolitical hot topics affect our outlook on international equities in 2020.
- Any détente in trade frictions benefits EAFE equities (not just with U.S./China, but the U.S. versus everybody). We believe the U.S. has a desire to change its trading relationship with most of the world, and certainly with China and Europe, who sport the largest trade imbalances with the U.S. However, with 2020 being an election year and U.S. businesses and the public already suffering from trade war fatigue, we believe the clock has run out for the current U.S. administration to escalate trade frictions until after November 2020.
- A resolution of Brexit concerns should help release pent-up business investment. As much as this likely leads to an appreciation of European currencies (a negative for corporate Europe, which lowers earnings due to foreign exchange translation and dampens export competitiveness), holders of euro- and Sterling-denominated assets stand to benefit from the currency appreciation.
While EAFE equities are heavily influenced by global factors, there are domestic factors as well. The most notable is the Financials sector where we see the potential for this embattled sector to see some relief (the sector remains an 18.5% weight in the EAFE Index and shares of European banks remain more than 40% below levels that prevailed in 2015, when they had just recovered from Europe’s homegrown banking crisis). European economic growth is already showing signs of bottoming, but it is the negative interest rate environments in Europe and Japan that have been especially painful for lenders. While central banks in Europe and Japan (ECB and BoJ) have extended their forward guidance into 2020 to keep rates below zero, they’re increasingly becoming concerned with the negative consequences of these policies on their banking sectors. In fact, the ECB has already taken steps to provide some relief to the banking system by adopting a tiered interest rate structure. More broadly, expectations of firmer economic growth conditions are seeing global bond yields retreating from their depths of mid-2019, which in turn is leading to steepening yield curves in many parts of the world – a further welcomed development for the Financials sector.
Bottom Line: We hold a neutral view toward EAFE equities. Weighed against Europe and Japan’s longer-term structural issues, heavily export-oriented EAFE corporations have an opportunity to benefit from a pick-up in growth and a trade détente. The group offers reasonable valuations and decent earnings growth potential, along with a high dividend yield.
Table of Contents:
- Executive Summary
- World at Large
- U.S. Equity
- Canadian and International Equities
- Emerging Markets
- Fixed Income
Copyright 2019 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.