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Energy Inflows May Give Spark to Languishing Canada Stock Market

August 13, 2017


It hasn’t been a pretty year for Canadian stocks but signs are growing that the S&P/TSX Composite Index may be set for a rebound — if investors can move past geopolitical tensions and focus on the fundamentals.

After gaining 18 percent in 2016 and hitting a record in February, the S&P/TSX has been one of the worst-performing benchmarks in the developed world with a decline of 1.7 percent year-to-date, second only to Israel’s 7.3 percent drop.

“You’ve seen the unwind, and clearly you can blame energy for that,” Brian Belski, chief investment strategist at BMO Capital Markets, said in a phone interview.

The energy index has been the worst performer on the S&P/TSX this year with a decline of 15 percent, outpacing about 9 percent drop in West Texas Intermediate crude prices. Energy stocks account for 20 percent of the benchmark’s weight.

However, it’s not all doom and gloom for Canadian investors. Of the 143 index members that have reported second-quarter earnings, 64 percent have beat analyst estimates and 30 percent have missed, according to data compiled by Bloomberg. This is a significant improvement from the first quarter, when 49 percent beat and 43 percent missed, and an indication that corporate fundamentals are improving.

“Investors are finally going to come to grips with Canadian growth and earnings growth is a little bit better than everybody thought so that’s where you can get more upside,” Belski said.

An upbeat earnings season hasn’t had much impact on valuations yet. The gap in forward price-to-earnings between the S&P/TSX and the S&P 500 Index is the biggest it’s been since 2008. Several strategists and investors say a gap this big can’t last and will either be narrowed by declines in the U.S. or gains in Canada.

“There’s a good case to be made for the bout of serious underperformance in Canada to subside,” Robert Kavcic, senior economist at BMO Capital Markets, wrote in a recent note.

Any recovery in the S&P/TSX will need energy stocks behind it, given their importance to the benchmark. Although there are plenty of unknowns for oil prices — including OPEC’s commitment to production cuts and U.S. shale producers’ ability to fill the gap — there are also signals that investors are getting more bullish on energy.

Traders invested C$42 million in the iShares S&P/TSX Capped Energy Index ETF in July, the biggest exchange traded fund tracking Canada’s energy index, according to data compiled by Bloomberg. That inflow was the largest since September 2016, a month when oil prices rose 7.9 percent and energy stocks gained 3.5 percent.

Canadian oil producers are also more resilient than they were before the downturn following significant cost-cutting efforts. Meanwhile, the price discount between Western Canada Select and WTI has narrowed to about $10, the smallest in more than two years and down from a high of more than $40 a barrel in 2013 — another positive sign for the Canadian oil patch.

A rebound in Canadian stocks also won’t get far without the help of financials, which account for 34 percent of the S&P/TSX. Financials have lost 0.5 percent this year as concern about overheated housing markets weighed on shares of the big banks.

Belski said that will change as investors look for dividend growth as an alternative to bonds in a rising-rate environment. Canada’s five largest banks have averaged dividend growth of 64 percent since 2008 compared with 32 percent for the five top utilities stocks on the S&P/TSX over the same period.

“We still believe that most investors are under-exposed financials,” he said. “Over the next three to five years in equity investing around the world, one of the biggest secular themes is going to be dividend growth and Canadian financials are among the best dividend growers in the world.”

John Aiken, financials analyst at Barclays Capital, said he expects bank valuations to continue to rise in the back half of the year as stocks are buoyed by a steady domestic economy, the strongest employment landscape since the financial crisis and rising interest rates, which will boost net interest margins.

“Further, we believe strengthening commodity prices, most notably WTI, could be the fuel that drives further upside to bank valuations,” Aiken wrote.

Not everyone is bullish on Canadian equities. David Doyle, market strategist at Macquarie Capital Markets Canada Ltd. called Canada, its equity market and the loonie “maximum underweights” in a recent note, citing the Bank of Canada’s recent interest-rate hike.

“Even a modest rate-hike cycle introduces downside risks to our base case for a prolonged period of subdued 1 percent real GDP growth,” Doyle wrote. “A ‘made in Canada’ recession has moved from being an interesting outlier scenario to worthy of serious consideration.”

And a new wrinkle has presented itself in growing tensions between the U.S. and North Korea, which pushed Canadian stocks to their biggest weekly decline since June.

But the economy’s growth of well over 3 percent in the first half of 2017 — the fastest among the Group of Seven — will give equities the chance to climb out of the doldrums, Belski said. He has a 16,000 target on the S&P/TSX, which would be up 6.4 percent from Friday’s close.

“What you’re going to see is an improving Canadian economy,” he said. “I think there’s a nice opportunity for a game of catch-up in Canadian stocks, especially considering that U.S. stocks are sitting near all-time highs.”

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