by Mike Archibald, CFA®, CMT, CAIA, AGF Management Ltd.
Ever since economist Harold Innis borrowed a biblical phrase to describe Canada as a land of “hewers of wood and drawers of water” back in 1930 – and probably before – the Canadian economy has borne a reputation as being heavily dependent on the nation’s abundant resources. Of course, much has changed over the past 90-plus years (rapid urbanization, the expansion of the manufacturing sector, the rise of the digital economy and so on), but the reality is that resources still loom large on Canada’s economic landscape. And the same goes for its stock market. The combined weighting of Energy and Materials in the S&P/TSX Composite Index sits at close to 30% – just behind the Financials sector and its Big Banks, according to Bloomberg data.
Yet the other reality is that the world is continually growing and evolving in terms of demographic and economic composition, and Canada is no exception. So, in this blog post, we want to highlight some of the unique characteristics of the Canadian market and the potential impacts on the TSX Composite over the long term. Resources still tell an important story about the Canadian market’s performance, but they do not tell the whole story. And they are just one reason the current macro environment is expected to continue to provide a tailwind for both the Canadian economy and Canadian equities.
One pragmatic approach for this analysis (of which all facts and figures – including those noted throughout this blog – were tabulated by Scotiabank using Bloomberg data) is to look at the performance of Canadian stocks against their most obvious counterparts, namely American equities. While over the past six months or so, the TSX Composite has outperformed the benchmark S&P 500 Index in the U.S. on a price return basis excluding dividends, it is over a longer-time horizon dating back to 1990, that several unique differences between the two major North American indexes become clear.
The most obvious confirms, in part, the reality that Canada remains a resource-heavy economy. Driven in large part by the presence of high-flying tech stocks, average returns in the United States have outpaced Canadian returns over the past 30-plus years (8.5% U.S. return vs. 5.4% Canadian return, both in local currency terms). Perhaps more interesting, however, is the fact that the average spread of returns in Canada is significantly higher than in the U.S., in terms of both the average spread of best-to-worst each year and the maximum/minimum spreads over time. Clearly, the resource dependency of the Canadian economy (and stock market) has led to more sectoral volatility over time. As well, in years during which the Canadian market outperforms the U.S., such as 2004 and 2005, Energy and Materials have usually been significant drivers of Canada’s relative advantage.
Our analysis shows how, in the U.S., secular growth sectors have dominated long-term returns, with Information Technology taking first place followed by Healthcare. Those sectors represent bigger components of the S&P 500 benchmark than of the TSX Composite. By contrast, the best-returning sectors in Canada have been Consumer Staples and Financials. That is related in part to the volatility of resource sectors, but also to the macro backdrop and the composition of the Consumer Staples sectors in Canada, which is dominated by a few big (and growing) companies. It is also worth noting that Industrials in both Canada and the United States have acted as nice, steady portfolio diversifiers – never landing as either the best or worst performers in either country, but historically ranking among the Top Five sectors in terms of long-term returns.
How does this affect the way investors might approach the two markets? Traditionally, Canada has been viewed as a beta opportunity, as opposed to the U.S., which has been approached more as an alpha market. That is, Canada may provide a more direct avenue to gain exposure to the global economic cycle than does the more secular U.S., which may be more insulated from global trends. So a higher relative exposure to Canada may offer higher upside when resources are surging and secular growth sectors are consolidating than would likely be the case if the opposite were true. So far in 2022, those conditions have applied, but investors should not forget that the breadth of investable ideas in the U.S. has historically provided more options than the Canadian market has. That’s why a strategy that positions Canadian resource equities as an opportunity to realize upside in a portfolio that still includes the U.S. secular growth sectors may be valuable for some investors.
When we layer macroeconomic conditions onto our sector analysis, however, we see several factors that support a period of continued outperformance for Canadian equities versus their U.S. and global counterparts. For one thing, elevated inflation is putting pressure on many global stock market valuation multiples, but the approximately 30% resource exposure in the TSX Composite could result in much less downside sensitivity to multiple compression. Second, when interest rates start to normalize higher, the U.S. dollar typically weakens, providing further leverage in the form of higher commodity prices (which are generally priced in U.S. dollars) and therefore potentially better cash flows for the resource space.
But could Canada be attractive to investors for reasons that go beyond its heavy resource weighting? We think it might, because of a little-publicized fact that might help explain some tailwinds for the Canadian economy: since 2016, Canada’s population has been growing faster than that of any other G7 nation, according to Statistics Canada data released in February this year. Given Canada’s relatively liberal immigration policies, along with long-tail considerations such as the impact of climate change on global population trends, one could reasonably expect its consumer base – and, correspondingly, domestic consumption – to grow faster than in counterpart economies. Countries with sustained population growth are attractive landing spots for foreign capital looking to invest. Of course, Canada is not yet at the stage where it can shed its reputation as primarily a supplier of “stuff” to the world, but it might be gradually moving there. If it does, then it will likely be an increasingly attractive destination for global dollars – and could be a solid long-term play for investors looking for areas of growth.
Mike Archibald is a Vice-President and Portfolio Manager at AGF Investments Inc. He is a regular contributor to AGF Perspectives.
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This post was first published at the AGF Perspectives Blog.
