The Canadian stock market has long been a laggard globally, but it reached record highs last week and outperformed the S&P 500 by 3 percent in the second quarter.

The Canadian economy is starting to behave more like the U.S. economy and the Bank of Canada raised interest rates four times in the last year. Over this period, the Toronto Stock Exchange (TSX) is up 9 percent.

This run flies in the face of the varied threats facing the Canadian economy including trade tensions, a teetering housing market, and a lack of competitiveness relative to the United States for business.

“Canada’s performance can be said to be waking up to fundamentals,” said Brian G. Belski, BMO’s chief investment strategist, in an interview. “Our view all along: As America goes so goes Canada.”

He added that NAFTA uncertainty and tariffs have been more about fear and rhetoric rather than fundamentals.

Certainly, the BoC hasn’t veered from its stance that higher interest rates are warranted by the current state of the trade tensions.

“The market is just saying ‘We don’t care,’” said Raymond Kerzérho, director of research at wealth management firm PWL Capital, about the record highs. “The market is telling you it doesn’t really believe the economy is in danger.”

Source: BMO Investment Strategy Group, Bloomberg, FactSet, IBES

Of course, the rise in oil prices helps Canada’s stock market, as 20 percent of it is the energy sector. By the end of the second quarter, the energy sector had spiked above its 200-day moving average.

In addition, Belski said other reasons for the strength in equities are that the Canadian banks continue to be excellent stewards of capital, the housing market has not collapsed, and Canadian consumer staples have outperformed their U.S. counterparts.

Technology makes up a very small percentage of the TSX, but the sector is up over 30 percent in 2018 and nearly 40 percent in the last year.

BMO research notes that earnings-per-share estimates are now 3 percent higher than at the start of the year, mostly due to the energy sector.

The Indexer’s View

While Canadian stocks haven’t routinely hit record highs like U.S. stocks have recently, as a long-term passive investor, Kerzérho said the best thing to do about short-term fluctuations, outperformance, or volatility is to ignore them.

“For us, the short-term fluctuations and changing [investment] strategies … in most instances I’m fairly sure they’re subtracting value and not adding value,” he said. PWL Capital prefers to stick to a plan to achieve its client’s long-term investment goals.

But he would act to the extent a portfolio drifts too far away from its target allocations. About 10 stocks have driven the Canadian stock market’s rise, according to his estimates.

To a large extent, Canada takes its cues from the United States. Its equity market makes up only about 3.5 percent of the MSCI World Index of large- and mid-cap stocks.

Belski remains upbeat on U.S. stocks and nixes talk of the bull market being late in its cycle.

Consensus is fixating on a reduction of the difference between the 10-year and 2-year bond yields—a flattening yield curve—and the long length of the U.S. bull market for stocks as harbingers for a recession.

“With everybody calling the end of the cycle, it can’t possibly be correct,” Belski said. He questions what many term a lengthy bull market starting in March 2009 as possibly consisting of a few shorter cycles.

“Ultimately Canada’s longer-term fortunes are likely to mirror the accelerating growth in the U.S.,” according to a BMO research note. The correlation between the S&P 500 and TSX has been steadily increasing since a low at the time of the U.S. election, meaning the two stock markets are rising much more synchronously.

BMO sees another year of positive returns for Canadian stocks, which could be even higher if it weren’t for NAFTA headwinds, oil pipeline approvals, and the softening housing market.

The firm’s year-end base-case target for the TSX is 17,600. This represents upside of 6.5 percent from the July 17 close and a price-to-earnings multiple of 18.

Mixed Signals

The bond market and the stock market have reacted very differently over the last two months. The Canadian 10-year bond yield has fallen roughly 0.30 percent. Such a drop tends to suggest the bond market is at odds with the optimism of the stock market.

“I actually think that the bond market has it wrong and we’ve got it right,” Belski said.

Kerzérho says Canadian stocks are still fairly valued while U.S. stocks are expensive. On a price-to-book basis, Canadian stocks are still cheap relative to U.S. stocks.

“The TSX has a fits-and-starts type of recovery,” Belski said. “I think we’re in the phase of starting to outperform the United States again.” He is more positive on the outlook for energy, financials, and industrials going forward and less positive about health care, real estate, and utilities.

Follow Rahul on Twitter @RV_ETBiz


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