Canadian stocks may have just posted their best quarter since early 2014, but gold notched its best quarterly performance in 30 years.
Gold prices rose 16% (9.5% in C$ terms) during the first quarter of 2016, largely on expectations that central bankers will do everything in their power to boost inflation even if that means moving interest rates deeper into negative territory. Even Fed Chair Janet Yellen sounded more dovish than market participants expected last week in her comments to the Economic Club of New York, leaving investors to debate whether the Fed will raise rates at all in 2016.
One of the criticisms of gold is that it doesn’t pay income. However, compared to the bond market where income is paramount, at least investors aren’t guaranteed a loss in gold as they are now with certain bonds carrying negative interest rates if they are held to maturity. Additionally, some would argue that central bankers’ aggressively dovish policy stance reflects deeper worries about the state of the world economy, suggesting gold may offer a better store of value during these volatile times.
Meanwhile, the commodity-heavy S&P/TSX Composite index (see chart below) was one of the glitzier equity markets globally during the first quarter, up 4.5% including dividends compared with the MSCI World index of developed equity markets, which delivered a negative 0.18% total return.
An outsized exposure to resources in Canada
Sector share of selected MSCI country indexes
Source: MSCI, Bloomberg, BlackRock Investment Institute, as of March 30, 2016
This begs the question: how much of this year’s outperformance of Canadian stocks is a function of gold? Well, the materials sector, which makes up roughly 11% of the S&P/TSX Composite Index, vastly outpaced the overall Canadian equity market with a gain of 20% during Q1. The Canadian gold miners, which account for a bit over 5% of the index, delivered a nearly 40% total return during the same time period. In addition to the price of gold, the decision among the gold miners to do a bit of balance sheet repair over the past year by repurchasing some of their outstanding debt has also lent support to the sector.
Correlation is not necessarily cAUsation
However, to suggest that gold has had something of a Midas touch on the Canadian market would be an overstatement. While Canadian equities and gold have generally exhibited a positive, albeit fluctuating, correlation over the past forty years or so, there’s very little evidence that gold prices can explain the direction of the S&P/TSX Composite Index in any meaningful way. This means that investors in Canadian stocks can’t necessarily expect the overall market to move higher if gold continues its ascent. That said, gold mining stocks have both a persistently high correlation with gold prices, and the change in gold prices can explain nearly 45% of the movement in these stocks (using weekly data going back to the late 1980s). This may be stating the obvious, but it’s also interesting to note that there is still a lot more about the swings in gold mining stock prices that gold prices can’t explain.
Since gold doesn’t pan out
While the broad Canadian stock market isn’t simply basking in the glow of rising gold prices, some of the additional factors boosting performance so far this year are:
- It’s not just about the yellow metal; the stabilization of black gold has enabled the energy sector (at 20%, an even larger sector heavyweight than materials within the Canadian Index) to outpace the broader Canadian equity market. While changes in gold prices may not help much in trying to understand swings in Canadian stocks, oil price moves explain more than 20% of the variability in the Index, and the two are also even more highly correlated than gold prices.
- In contrast to the U.S. where bank stocks declined more than 12% during the first quarter, Canadian bank stocks have posted modest gains this year, and at nearly a quarter of the S&P/TSX Composite Index, this matters a lot.
Canada’s stock market looks modestly cheap compared to both its own historical valuation and other developed markets, but these valuations are only attractive on the basis of restored earnings growth and limited loss to book value from writedowns in the resource sector. Sensitivity to the wild swings in resource prices has meant higher realized volatility for Canadian stocks as of late. Importantly, were there to be a renewed turn to lower oil prices on concerns about weaker global economic activity, there would likely be a corresponding move lower in Canadian equities – even if gold continues to shine.