Canadian Equities Show Small Signs of Improvement

By Richard T. Kensington
Richard T. Kensington
Richard T. Kensington
August 28, 2013 Updated: August 28, 2013

Canadian equities are barely in positive territory for 2013 and have recently been lagging behind many major equity markets around the world. 

Economic performance in Canada has been mediocre, but as the economy in the U.S. and, more recently, China appears to find firmer footing, equities in Canada may start to finally benefit.

American equity markets have garnered all the headlines with record-breaking closes earlier in the year, but lately Canada’s Toronto Stock Exchange (TSX) has started to show some outperformance against the S&P 500 in the U.S. 

In a research note, BMO pointed out that the outperformance (3.7 percent) of Canadian equities versus their U.S. counterparts for the one-week period ending Aug. 16 was the greatest “since the week following S&P’s U.S. credit rating downgrade 2 years ago.” The outperformance continued the following week.

But this is merely a small step toward closing the gap between Canadian and U.S. equities. And the bigger picture continues to favour the U.S. in terms of projected economic growth. But as the U.S. goes, so goes Canada to some extent.

The TSX as a broad-based representation of Canadian equities is strongly influenced by financials (34 percent), energy (23 percent), and materials (14 percent).

With the S&P 500, a broad representation of U.S. stocks, earnings from financials lead the way while Canadian banks have not fared nearly as well. The Canadian banks are currently in their second-quarter reporting period. 

S&P 500 banks are up 25.5 percent this year, whereas TSX banks are only up 13.6 percent as of Aug. 23, according to BMO’s Global Equity Weekly publication.

The commodities sectors have been hit hard in 2013 as concerns about the rate of China’s future GDP growth spooked investors earlier this summer. From the more than 9 percent year-over-year growth in 2011, China’s GDP is now growing at a rate much closer to 7 percent. 

But China’s economic performance has improved recently and this should benefit commodities globally, which is positive for Canada. 

Gold’s abject performance (down about 30 percent in the last year) is another drag on the TSX, but with recent weakness in emerging market economies and the rise of geopolitical tensions in Syria, it has started to shine a bit more.

Interest rate-sensitive sectors (dividend-paying stocks) of the TSX have suffered this year with the rise in bond yields. As longer-term interest rates rise, the value today of future dividend payments decrease, thus decreasing the value of the stock. 

In the second quarter, earnings for the utilities and telecoms sectors were down 46 percent and 10 percent respectively from a year earlier, according to a National Bank research note. Real estate investment trusts (REITs) and income trusts also fall into this category of interest-sensitive sectors.

These sectors aren’t likely to see a notable rebound as interest rates are expected to move higher.

Earnings Growth

Equity analysts expect that the materials sector will generate the largest percentage increase of earnings per share (EPS) growth from 2013 to 2014, at 46 percent. 

According to National Bank’s compilation of Institutional Broker Estimate System (IBES) earnings, equity analysts see a 27 percent fall in expected materials EPS for 2013 and a rise of 19 percent in 2014. 

Overall, TSX earnings are expected to rise 13.8 percent from 2013 to 2014, aided by an improving economy globally. 

As one might expect, Canadian equities are not unreasonably valued according to historical price- to-forward earnings ratios. With an index priced at roughly 17 times forward year earnings, the TSX is “cheaper” than it was in 2009 and 2010. And relative to the S&P 500, Canadian stocks are no longer as noticeably expensive by this measure as they were in 2010 and 2011.

National Bank Financial upgraded the weighting of Canadian equities to neutral from underweight in its September Monthly Equity Monitor published Aug. 22.

While international factors would seem to be the biggest driver in the mild improvement in Canadian equities performance, earnings need to ameliorate in order to see more robust gains.

Richard T. Kensington
Richard T. Kensington