TSX performance relative to other markets hasn’t been impressive, and January results could prove especially disappointing.
“The performance gap of nearly 7% between the TSX and the S&P 500 so far in this young year leaves Toronto on pace for its deepest monthly underperformance in more than 15 years,” says BMO chief economist Douglas Porter, in a weekly economics report. “Even converted to a common currency, the TSX is still more than 5 points south of the U.S. gains.”
In the report, senior economist Robert Kavcic adds: “If Canadian investors still don’t have meaningful U.S. exposure, they’re passing up some of the headiest equity market returns in a generation in exchange for those that look decidedly normal.”
In Canadian dollar terms, the TSX is down relative to all major equity markets, not just the U.S.
“While Canadian investors are hardly losing their shirts (up more than 3% in the past year before dividends), the Nasdaq is up a cool 31%, and still 23% if left unhedged to the loonie,” says Kavcic.
Beyond the usual suspects
A perennial root cause of TSX underperformance is its concentrated exposure in banks, energy and materials.
“The sectors that are really working right now—think technology, consumer discretionary, technology and more technology—are lightweights in Canada,” says Kavcic.
But the performance challenge goes beyond index composition.
“In fact, eight of the 10 major U.S. sectors are outperforming their Canadian peer group, many by a wide margin, with telecom and healthcare the lone exceptions,” says Kavcic.
A contributing factor is policy, with stateside companies benefiting from tax relief and deregulation, while Canadian policy presents downside risk north of the border, with NAFTA uncertainty, rising minimum wages and tougher mortgage rules.
“There are areas in Canada that have benefited from recent policy changes (see the pot stocks), but they’re still a drop in the TSX bucket,” says Kavcic.
He suggests Canadian stocks could be “enduring a repricing of relative valuations as growth prospects shift in favour of the United States.”
For example, forward earnings yield on the TSX is about 6.25%, he says, almost a full percentage point above that for the S&P 500. “While that looks juicy relative to recent norms—it’s actually the widest spread in nine years—it looks less so from a longer historical perspective.”
At the height of the commodities boom in the mid-2000s, the TSX traded at a premium to the S&P on the basis of forward earnings yield, and traded about in-line with the S&P through the middle stages of the current cycle.
Over the last couple of years, that began to change with the tech boom and pro-business policy in the U.S.
And, during the 1990s cycle, the TSX averaged a roughly 1.5 percentage point discount on the basis of forward earnings yield.
Says Kavcic: “At this rate we could very well be headed back there this time around.”
While there are some specific factors at work, “the sluggish market is also sending a signal that broader economic growth is poised to cool, even as the U.S. economy heats up,” says Porter. “While the message can be muddied by a variety of factors, that’s the key takeaway from early-year developments.”
Low volatility can’t last
In a report on the U.S. dollar and U.S. markets, TD chief economists Beata Caranci and James Orlando note the current state of “frothy” U.S. equity markets and record-low equity volatility.
TD’s financial conditions indicator, which shows volatility relative to hiking cycles and financial conditions, reveals that the Fed doesn’t typically inject volatility into the market.
“Rather, it is the removal of rose-colored glasses by investors,” say Caranci and Orlando. “The macro or financial shocks that raise volatility may seem surprising in the moment, but in reality, were building for some time. Nothing goes up forever, and it’s commonplace to see mini-market corrections of roughly 10% in any given year.”