It has been an uneventful few weeks, with volatility near the lows for the year. Government bond yields have remained in a tight range for the past few months, which stands in contrast to the larger swings witnessed earlier this year. Inflation concerns have calmed down, for now, but they remain out there, with investors continuing to debate the levels of job growth needed before central banks begin to shift their ultra-accommodative policies. Meanwhile, on the equity front, some markets have continued their slow and steady grind higher. This includes the Canadian stock market, which we discuss below.
Canadian equities leading the way
The Canadian equity market has been one of the best performing this year. In Canadian dollar terms, the market is up by an even bigger margin than many of its global counterparts, driven by the strength of the loonie relative to most currencies. We’ll save the discussion on the Canadian dollar for another day, and focus instead on what’s been driving the market and its outlook going forward.
Most of the strength in Canadian equities can be attributed to the cyclical nature of our market. Nearly 60% of Canada’s stock market is tied to sectors such as financials, industrials, and non-precious metal commodities, all of whose earnings are heavily influenced by levels of domestic and global economic activity. An accelerating growth outlook acts as a meaningful tailwind, while a decelerating outlook or stagnant one can act as a headwind. Since the second half of 2020, global growth has been on the upswing, fuelling an earnings recovery and higher stock prices, particularly in the cyclical sectors.
The other issue worth mentioning has been the Canadian market’s resilience in the face of higher government bond yields. It has by no means been immune, but it has faced less pressure compared to others. High growth industries such as technology and alternative energy sectors for example have been notably vulnerable to the move higher in bond yields this year. This has presented a meaningful challenge to markets like the U.S. and China, which have substantial exposure. While Canada’s technology sector has grown meaningfully in size in recent years, it is still not big enough to present a headwind for the broader market.
Over the past twenty years, Canadian stocks have traded at a discount to their U.S. counterparts. More specifically, on a price to projected earnings basis, Canadian stocks have traded just below their U.S. peers. There have been periods over the past few decades when Canadian equities have traded meaningfully higher. For example, in the commodity boom of the 2000s and the period immediately following the great financial crisis. But since then, Canadian stocks have seen their premium turn into a discount that reached an extreme late last year. Recently, this has started to reverse, but it still has a long way to go to return to a more normal range.
The backdrop is favourable for Canadian equities, driven by a global economy that should continue to improve in the months to come and a relative valuation that remains reasonable. But, it’s impossible to know exactly what will transpire in the months to come. Moreover, it’s too short-term sighted. Most importantly, the outperformance of Canadian stocks this year after a few years of underperformance relative to global peers serves as a reminder of the need to have a well-diversified asset mix to ensure that a portfolio has exposure to asset classes that can carry the burden of generating returns when other parts of the portfolio inevitably run into some challenges.
Have a great weekend.