2019 Quarterly Canadian Investment Outlook

A Tale of Two Bull Markets

Big Bull, Little Bull

The Canadian equity bull market, which added yet another quarter of strong performance to the 10-year anniversary milestone of last quarter, bears some stark―and telling―comparisons to its larger US counterpart. The duration of both bull markets is the same; but the magnitude of each market’s advance has been very different. These differences offer valuable insights on where the Canadian equity market stands today in relation to the world’s largest equity market.

US Bull Outpacing Canada

The total return for the S&P 500 Total Return Index from March 9, 2009 to June 30, 2019 amounted to an annualized advance of 17.9% (17.8% in US-dollar terms), or 444.7% unannualized (439.5% unannualized in US-dollar terms). This return far exceeded the gain for the S&P/TSX Composite Total Return Index of 11.0% annualized, or 193.7% unannualized. In a 10-year span that featured low interest rates, tepid economic expansion and a recovery in the state of global financial markets following the Great Financial Crisis (GFC), sector returns for both indices were generally strong, but highly divergent.

Growth versus Value Sectors

Two growth-oriented sectors, Information Technology and Health Care, both heavily weighted in the S&P 500, were among the strongest sectors in terms of index performance. In Canada, these two sectors carry much less weight in the S&P/TSX Composite Index, as shown in the accompanying table. Moreover, the Canadian constituents of these sectors (think RIM/Blackberry and Valeant/Bausch Health) materially underperformed their US counterparts, contributing relatively little to overall Canadian equity market returns.

On the other hand, the Energy and Materials sectors, two value-oriented sectors that are heavily weighted in the S&P/TSX Composite Index and carry much less heft in the S&P 500, were two of the worst-performing sectors, materially weighing on Canadian equity market returns.

But Long-term Returns Are Similar

Over longer periods of 15 and 20 years, the magnitude of Canadian and US equity market returns is more similar. In the prior decade, outperformance by Canadian equities was significant throughout the global commodity super cycle, largely due to the much larger weighting natural resource stocks carry in the Canadian index.

Source: Franklin Templeton and S&P/TSX Composite Index

US Trade Critical for Canada

The similarity in returns between markets comes as no surprise given the economic relationship between the two countries, and the many Canadian-listed equities with significant operations or end markets beyond Canadian borders. From an economic standpoint, the Canadian economy is inextricably linked to the fortunes of the United States. While only 15% of US exports flow into Canada, approximately 75% of Canadian exports are destined for the United States.

Uncertainty Testing Ties

Trade tensions and related uncertainty surrounding the global growth dynamic have damaged sentiment. For example, trade restrictions imposed by China on Canada following the arrest of a senior Huawei executive in Vancouver have affected Canadian export activity. In contrast, the removal of US-imposed steel and aluminum tariffs and prospects for the ratification of the new United States-Mexico-Canada Agreement (USMCA) could offer some relief for exports, sentiment and investment.

Energy, Real Estate Cooling Canadian Economy

Beyond trade, the dampening effects of low energy commodity prices and changes to domestic housing policies have contributed to a cooling economy in Canada. In the case of oil and gas, a lack of export pipeline capacity has led to lower prices for Canadian production and a meaningful reduction in the economic contribution of Canada's natural resource-heavy economy.

Another focus in Canada is the domestic housing sector and its potential effects on the economy and equity markets, including the ever-important Canadian commercial banks. Housing has bounced back recently, but affordability, especially in the larger cities, remains an issue.

Rate and Currency Correlations

Other notable themes include interest rates and the Canadian dollar. Like the trade dynamic between the United States and Canada, the interest-rate environment between the two countries is highly correlated. The direction of interest rates has an enormous influence on the value of equities, and Canada is no exception to the rule. Changes in interest rates have direct implications for the cost of capital and valuations, in addition to impacts on economics and overall profitability of a business.

In response to the changing economic landscape, the Canadian dollar has fallen from a high of US$0.82 in early 2018 to US$0.76 in mid-2019. A weaker Canadian dollar has a direct, positive impact on many Canadian equities, especially companies with non‐Canadian dollar revenues and Canadian dollar expenses, which includes a disproportionate number of domestic materials and energy producers.

Currency weakness also aids Canadian companies with foreign operations, such as the Canadian commercial banks and life insurance companies, where profits translate back into Canadian dollars on more favourable terms.

Momentum Market Redux

We believe that some equity market excesses over the past few years have in part been driven by investor exuberance regarding specific equities’ momentum and potential, rather than the true fundamentals and valuation of the underlying businesses.

Canada has a sophisticated developed market economy and equity market, but significant inefficiencies persist. We continue to take advantage of market dislocations while adhering to the focus on fundamentals and valuation that are core elements of our investment style.

When the Bill Comes Due

A New Normal?

Financial markets continued to power ahead in the second quarter of 2019, with fixed income markets generating very strong returns on the back of lower yields and tighter credit spreads.

Following a brief period of “normal”―in terms of the monetary tightening programs undertaken by some global central banks, mainly the US Federal Reserve (Fed)―the current environment is reminiscent of the “new normal” period that followed the Great Financial Crisis of 2008, when bonds and stocks moved in tandem. In some sense, bad news was good news as it meant lower central bank policy rates.

Now for the Good News

Interest rates moved lower during the quarter, despite the Fed and the Bank of Canada (BoC) leaving their overnight rates unchanged at 2.50% and 1.75%, respectively. The Fed intensified its dovish rhetoric, indicating increasing receptiveness to lower interest rates in view of global policy uncertainty and mounting signs of a slowing economy both at home and globally.

Government Policy Uncertainty Eroding Confidence, Growth

Global government policy uncertainty continues to run at multi-decade highs, acting as an overhang on economic activity, especially trade and investment. Inflation expectations showed a sharp decline during the quarter, prompting central banks in most developed markets to lean further toward easing monetary policies. Overall, the downward trend from incoming data confirms that the “bill” for increased interest costs triggered by previous rate hikes and other items has finally come due.

Only in Canada, You Say

Canada is looking like the happy exception, at least for the time being. Inflation of 2% has continued to hug the “magic middle” of the BoC’s 1% to 3% ideal range. Although Canadian economic growth has slowed meaningfully over the past year, it looks poised to bounce near-term on increased activity in the Energy sector and other transitory factors. At the same time, the longer-term outlook remains quite cloudy in view of the structural and cyclical headwinds facing the economy.

Yield Curves Remain Inverted

Yield curves have inverted largely in line with our expectations. Despite the more conciliatory tone from the central banks, global yield curves have remained flat to inverted. In Canada, the yield curve is currently inverted from overnight to 10 years, which signals neutral to tight monetary policy. Given the inflationary backdrop and the lagged effect of higher policy rates, however, it appears that the BoC may be done hiking rates for this cycle. Markets have currently priced a neutral BoC for 2019; but should the BoC feel compelled to raise rates in the current environment, the yield curve would invert further.

The US yield curve also inverted over the quarter, which we expect will continue next quarter. Some European yield curves have inverted as well, even to the extent of being negative through most of the term structure.

Inverted curves don’t necessarily mean recession is inevitable. Historically, however, they have shown a strong predictive ability to highlight policy errors as applied to then-current economic conditions. In general, the longer monetary policy remains tight and the yield curve stays inverted, the higher the probability of a recession.

Kicking and Screaming Toward Lower Rates

Central banks decide when to hike rates, typically dragging fixed income markets, kicking and screaming, with them; but the markets decide when to cut rates. For the past two quarters, markets have priced in a rate cutting cycle. To no one’s surprise, at its final meeting of July, the Fed announced it was lowering its overnight rate by 25 basis points to a band between 2.00% and 2.25%―the first post-crisis cut. Furthermore, the Fed would end its balance sheet reduction program on August 1, two months ahead of schedule.

Corporate Credit Quality Fading

Narrower spreads helped propel strong returns across the Canadian corporate bond space; but in contrast to the previous quarter, the higher-beta names were not the clear outperformers. The chart below shows a similar pattern, with lower-risk sectors like banks and telecommunication companies outperforming higher-risk sectors such as energy and pipeline companies on a risk-adjusted basis. After multiple quarters of “reach-for-yield” investor behaviour, this suggests to us that at least some investors are beginning to take a slightly more cautious stance.

But Provincial Credit Shines

Provincials led performance during the quarter on the strength of the move lower in rates and their longer duration bias.

Although the credit quality of corporates has been deteriorating, provincial credits have been demonstrating fiscal restraint. Provincial issuers have also taken advantage of international investor interest to satisfy their funding requirements outside domestic markets.

Preference for Higher Quality

While we continue to favour corporate bonds, we currently prefer higher-quality credits and continue to upgrade credit quality. As active fixed income managers, we continue to look for ways to reduce risk and upgrade credit quality while capitalizing on trading opportunities presented by any changes in volatility.