Canadian Stocks Poised to Accelerate Should U.S. Growth Gain Speed
After nearly five years of underperformance, Canadian stocks are poised to outpace most global indices by a healthy margin in 2016, including the S&P 500.
Experts say they’re poised to do so again next year, as earnings have lots of room for improvement and valuations remain attractive. It’s not all about rising oil prices, in other words.
While U.S. equity markets hit new highs on confidence that Donald Trump’s pro-growth policies will give the world’s largest economy it needs to get finally get over the hump of lacklustre growth, investors shouldn’t forget how Canada will also benefit.
Approximately 60 per cent of S&P/TSX Composite index revenues are leveraged to activity outside of Canada, much of that in the United States.
The TSX is heavy in stocks that benefit from steeper yield curves, particularly the banks and insurance companies.
Matt Barasch, Canadian equity strategist at RBC Capital Markets, noted that Canadian banks, which account for nearly a quarter of the weighting in the benchmark equity index, generate approximately half of their average earnings from net interest margins.
Life insurance stocks, meanwhile, make up about five per cent of the composite, and are also poised to capitalize on the balance sheet relief and higher annuity sales that usually come with higher rates.
A stronger U.S. economy will also boost demand for resources, whether that’s in the mining, materials, or energy sectors.
Barasch pointed out that the TSX has been a strong performer, both in absolute and relative terms, in years when oil prices rise 10 per cent or more.
The index has direct and indirect exposure to oil, which RBC, like others, expect to rise throughout 2017 as a result of slowing global supply growth, coupled with consistent demand growth that could get an extra boost from the U.S. economy.
“On the back of recovering oil and commodity prices, not to mention the potential for higher long rates, earnings for the S&P/TSX have the potential to rebound smartly in 2017 and 2018,” the strategist said in a recent report, where he raised his 18-month target for the S&P/TSX to 16,300.
Elsewhere in the commodity space, Barasch highlighted Canadian gold stocks as poised for good year, due to the combination of global macro risks, the potential for higher inflation triggered by renewed global stimulus, and historically low valuations.
For investors that believe the U.S. economy will grow at or near the pace equities south of the border appear to be pricing in, targeting Canadian companies with leverage to U.S. activity is a sensible strategy.
David Doyle, an analyst at Macquarie Capital Markets, prefers companies with a higher share of U.S. revenue than their sector peers.
He highlighted Toronto-Dominion Bank as the strongest way to play U.S. banking exposure through a Canadian name. More than 35 per cent of its income originates in the U.S., and has strong deposit base and asset sensitivity to that market.
On a sector basis, this theme has Doyle favouring pipelines, and midstream energy companies involved in the storage and marketing crude and other petroleum products.
The analyst highlighted Pembina Pipeline Corp. and Keyera Corp., which also playing into the yield stock strategy.
On the back of recovering oil and commodity prices…earnings for the S&P/TSX have the potential to rebound smartly in 2017 and 2018
He recommended other yield-oriented names, such as as TD, Bank of Montreal, Rogers Communications Inc. and Quebecor Inc., while highlighting Manulife Financial Corp., Sun Life Financial Inc., Magna International Inc. and Thomson Reuters Corp. as stocks that should benefit from the macro picture.
“Equities offering a yield component to their return should remain relevant in the years ahead,” Doyle said. “The more growth oriented sectors, however, should provide greater upside as we move into 2017 and beyond. This is because the tailwind of persistently falling sovereign yields will no longer be in place.”
There is, of course, the possibility that Trump’s policies fail, or never get enacted in the first place.
Disappointments in the U.S. could drive more money into Canada, and record levels for U.S. equity indexes may make the move more rapid and dramatic.
One source of stress could come from the U.S. dollar, which recently hit a decade-and-a-half high on a trade-weighted basis.
Derek Holt, senior economist at Scotiabank, warned that a strong greenback will likely weigh on coming earnings seasons as currency translation hurt results. He also noted that U.S. dollar strength will “crush U.S. competitiveness on the export side and make imports more attractive,” as it did when then the currency peaked in the early 2000s.
And it’s not just U.S. indexes like the Dow Jones Industrial Average and the S&P 500 that are at elevated levels, other measures of stock valuations are at or near record highs.
Holt noted that price-to-trailing earnings is hovering above 26x, compared to a long-term average of roughly 15.6x.
“The last time we saw valuations at such heights was during the dot-com era,” the economist said, excluding the depths of the global financial crisis.
He also highlighted Shiller’s cycle-smoothed price-to-earnings ratio, which stands near 28x versus a long-run average of 16.7x.
Meanwhile, the dividend yield on the S&P 500 is about two per cent. That’s below the yield on 10-year treasuries, so the often-cited argument that the income generated from holding stocks is preferred to that offered by bonds, holds far less weight.
“2017 will be an awkward transition year for the U.S. economy that is getting hit by tightened financial conditions from the bond market, the dollar and oil prices before any shovels go into the ground and before any significant cash flow boost that may stem from tax cuts to households,” Holt said. “A more hawkish Fed that risks further dollar strength and higher rates in the context of stretched equity and currency valuations risks imposing downsides on the U.S. economy.”