Andrew Pyle
June 30, 2023
Canada Strong
As tomorrow is Canada Day, I thought it fitting that we spend this week’s commentary looking at how the country is holding up as we turn into the second half of 2023. While both equities and bonds have not been able to keep pace with the broader U.S. markets, the economy has been resilient and fundamentals in the second half may turn in Canada’s favour, relative to our neighbours to the south. That is assuming that the inflation story continues to improve and a pivot in monetary policy, or at least the expectation of one, takes place sooner than in Washington. It also will require a relatively quick absorption of roughly 3.2 million new Canadians into the economy and workforce.
Canadian stocks have definitely lagged behind most major U.S. indices this year, with close to a 3% gain on the TSX composite. This is in line with the Dow Jones, but pales next to the roughly 15% advance in the S&P500 and 30% rise in the NASDAQ. As we have discussed on recent calls, the divergence has stemmed from a relative overweight in underperforming sectors on the TSX (financials and energy) and a relative underweight in overperforming sectors (tech) relative to the U.S. market. The comparison over just six months doesn’t, however, do justice for Canadian stocks. As the chart below shows, if we go back to the end of 2021, the S&P500 still hasn’t caught up with the TSX and is down more than 7% compared to the 6% loss here.
The Bank of Canada and the Federal Reserve began hiking interest rates in March of last year and, even though the Bank was the first to go ultra-aggressive on tightening in the summer, the key overnight rate target (4.75%) is still a half a percent below the Fed funds target ceiling rate. You would think that this would have allowed Canadian bonds to outperform their U.S. counterparts. Using the iShares Core Canadian Universe Bond ETF (XBB) and the iShares Core U.S. Aggregate Bond ETF (AGG), we find that the total return on Canada’s index has been only 1.5% (assuming dividends are reinvested in the index), compared to about 2% for the U.S. Again, if we go back to the end of 2021, Canada’s bond market has still outperformed with a total return loss of 10% versus 11.3% in the U.S.
That being said, there is reason to believe that Canadian bonds could outperform the U.S. over the remainder of the year. Both 2yr government yields are trading within 20 basis points of each other (0.2%); however, the Canadian yield is only 9 basis points below the Bank of Canada rate, whereas US 2yr yields are still 29 basis points below. Canada’s 2yr has already broken above the March 7th high of 4.32%, while the U.S. yield is below the 5.07% high from March 8th.
If we believed that Canadian monetary policy was going to be tighter than the U.S., then this relative value argument would not be as strong. The probability of that happening though is small. On Tuesday, StatsCan reported that Canada’s headline CPI inflation rate fell to 3.4% in May from 4.4% in April. We had anticipated this, given the base effect from April 2022’s jump in the CPI index, but it is still a large move and puts Canada’s inflation rate more than half a percent below the U.S. In other words, the Bank of Canada is now just 1.4% away from reaching its 2% target, whereas the Federal Reserve is looking at an inflation rate that is still double it’s intended outcome. True, this morning’s US personal consumption expenditure (PCE) data showed improvement in May, but the 3.8% year-over-year rate of increase in the headline deflator remains elevated.
As we have discussed before, both countries are dealing with core inflation (especially on the services side) that is sticky and continues to threaten the achievement of inflation targets if inflation expectations become embedded at a higher level than what is consistent with that achievement. And there are continued cost pressures in Canada’s housing sector that could put a halt to further rapid inflation declines.
The other thing that could limit those declines is simply the fact that the economy up here is doing better than what many had predicted. Employment has held up well and increased population growth could diminish some of the labour shortages faced across the country. That is good news from a wage inflation standpoint, but could add to consumer demand at a time when the Bank of Canada would like to see things cooling off.
Business sentiment in Canada is also pretty resilient, compared to the U.S. The above chart shows the Ivey Purchasing Managers’ Index (PMI) for Canada (seasonally adjusted) against the U.S. manufacturing and services PMI indexes. The reason why I include both of the U.S. measures is that Canada’s Ivey index is designed to represent the economy as a whole, including both private and public companies. All three measures were below the breakeven level of 50 at the end of last year and, while Canada’s index has decline in recent months following a bounce in the first quarter, it is still a few points above 50. U.S. manufacturing sentiment has continued to erode and U.S. services sentiment is back down to breakeven.
In our recent meetings with clients, Ally and I have emphasized an overweighting in Canadian equities and bonds as we head into the final six months of the year, in addition to a healthy amount of cash. Even if we experience a North American recession and pullback in equities, we expect the True North to outperform on price, while providing superior growth in dividend income. That, combined with a strong likelihood of fixed income outperformance, should create a better climate in Canada for balanced portfolios. This week we had headlines that were juxtaposed to each other. Alberta reported its largest budget surplus in more than a decade thanks to a boom in oil sector revenues, while news broke on Thursday that Sweden’s Northvolt AB was nearing a deal with Ottawa and Quebec on a $7 billion battery project near Montreal. This is the second company to partner on battery production this year, as Canada competes with the electrification incentives being rolled out in the U.S.
As we head into the Canada Day weekend, there is a lot to be proud of and thankful for. Many parts of our country are dealing with the direct and indirect effects of raging forest fires, which serve as a reminder to us that climate change is going to remain a challenge and a source of opportunity going forward.
On behalf of all of us at the Pyle Group and everyone at CIBC, have a great Canada Day weekend!
Andrew
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