3 reasons why Canadian stocks may get their groove back

Kurt explores the prospects of the country’s equity market outperforming global counterparts over the balance of 2017.

The S&P/TSX Composite Index could be set for a comeback in the back half of 2017 after underperforming the S&P 500 by roughly 10 percentage points during the first six months of the year, according to Bloomberg data. But any turnaround in the weeks ahead may depend on a reversal of fortune in three of the very same factors that led to the sharply weaker performance in the first half: Valuations, oil prices, and sector exposures.

Valuations

Canadian stocks started the year with unforgiving valuations in both absolute and relative terms. Not only were stocks looking modestly expensive versus history, valuations were also full relative to international markets, including the U.S. (see the chart below). Since the start of the year, 12-month forward price-to-earnings ratios for Canadian stocks have turned lower and now rest at a healthier discount relative to the U.S. market. Moreover, much of the weakness in energy prices has already been reflected in downward revisions to Canadian earnings, implying less pressure on forward-looking multiples.

iSH Blog Cheap stocks Jul17.1

Interestingly, when the relative valuations between the U.S. and Canada fall to these levels (using data since 1987), we find that Canadian stocks have tended to hold up pretty well relative to U.S. stocks over the following year (see the chart below). Of course, there is no guarantee that Canadian stocks won’t cheapen further from here, and admittedly we only have a handful of valuation cycles to use in our analysis. That said, over the past thirty years, Canadian stocks have tended to outperform when they reach these levels, suggesting the past underperformance may have run its course.

iSH Blog Underperformance Jul17.2

Oil prices

When the year began, many investors anticipated strong earnings growth mostly coming from the energy sector, and many oil analysts had targeted crude prices in the upper US$50s to low US$60/barrel range over the course of 2017. Instead, we have oil prices now trending in the mid US$40 barrel range, according to Bloomberg data, and an outlook for oil prices that is generally lower and already reflected in earnings estimates. To the extent that oil represents less of a headwind for the energy sector, then the prospects for Canadian stocks should brighten somewhat, in our view.

Sector exposures

As the year unfolded it became increasingly apparent that the S&P/TSX Composite Index offered investors outsized exposure to the laggards, such as energy, but also too little exposure to the leaders, such as the secular growth themes of technology and healthcare. While we currently favour global exposure to the technology sector and selected opportunities within healthcare, we’re also positive on financials – another giant within the Canadian market cap that we believe registers as fairly valued with the potential for decent earnings growth amid a synchronized and sustained global economic expansion.

Kurt Reiman is BlackRock’s Chief Investment Strategist for Canada and is a regular contributor to The Blog in Canada.

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