(Runtime: 4 min, 45 sec; size: 53.57 MB)
Craig Jerusalim, senior portfolio manager, Canadian equities at CIBC Asset Management.
Last year at this time I made the prognostication that it’s finally time for Canadian equities to outperform their U.S. peers, but now my confidence is even greater relative to that 2021 call, that this year, 2022, will be another year of outperformance for Canadian equities.
Let’s start by looking at past performance. Prior to this last year, the S&P 500 had outperformed the TSX in nine out of the prior 10 years. During that stretch, the TSX had risen a respectable 115%, but that return was completely overshadowed by the massive tripling of the S&P 500 over that time. To be fair, 2021 was a little bit of a push. The S&P/TSX did outperform the Dow Jones Industrial Average, the Nasdaq and the Russell 2000, but fell a tiny but short of the S&P 500 on a total return basis. But the arguments I put forth last year are much stronger and more supportive today.
Last year this time, we noticed a decidedly wide deviation between the forward price-to-earnings ratio of the TSX and the S&P 500. The TSX was slightly more expensive than its 20-year average level at 16.2 times forward earnings, while the S&P 500 was trading about five multiple turns higher than its long-term average at 21.7 times. Today, there is a similar five multiple turn gap between the S&P 500 and the TSX, except to date, the TSX is close to one standard deviation below its long-term average, while the S&P 500 still looks expensive at 20 times forward P/E.
The second argument is composition of the indices. The S&P 500 is dominated by technology companies and technology-like companies such as Facebook, Amazon, and Google. The big six U.S. bellwethers, Apple, Microsoft, Google, Amazon, Tesla, and formerly, Facebook had essentially powered the past 10 years of growth for the S&P 500, but the law of large numbers and the prospects of rising interest rates make the prior impressive run difficult to sustain.
We’ve already seen some of those pillars start to crack with the likes of Facebook and Tesla experiencing 30% draw downs. Conversely, the TSX is much more cyclically balanced with its three main pillars — financial, energy, and materials — benefiting from rising interest rates and the economic growth we are expecting post the COVID recovery. One of those sectors, energy, has already had an impressive rebound off of its 2020 lows, and we’ve seen oil surge higher in recent weeks, partially due to geopolitical risks. However, there are many reasons to believe in the sustainability of this energy bull run.
Over the past year, we’ve seen global inventory levels be drawn down. DUCs are drilled in uncompleted wells, which are a leading indicator, have fallen to cycle lows all while producers remain disciplined on production growth, even while demand begins to approach pre-COVID levels. More specifically, the Canadian energy producers have already repaired their balance sheets, are generating record free cash flows, and returning more cash to shareholders, yet still trade close to trough valuation. And while some people will criticize the carbon footprint of oil producers, it is important to point out that our Canadian producers are amongst the least carbon intensive and most ESG conscious producers in the world. And providing balance to the energy sector is the relatively high 3% allocation to renewable companies on the TSX that should benefit from the next few decades of renewable growth.
Rounding out some of the tailwinds Canada has over the U.S. in a post COVID world is our thoughtfulness through COVID. Our population has a much greater vaccination rate, a much lower death rate, and that’s contributed to the strong rebound in employment. Canada has recovered almost all of its jobs lost during the pandemic and has seen its participation rate get back above 65%, while the U.S. lags a few percentage points behind. But really one of Canada’s superpowers is its strong immigration policy that will target over 400,000 new Canadians or more than 1% boost to its population. The often highly skilled and educated new Canadians give a boost to growth and stimulate the overall economy, making up for lackluster birthrates problematic in many developed countries.
So, putting everything together, all the tailwinds just mentioned, plus the higher expected EPS growth for the TSX due to a cyclical growth composition, plus the much lower starting valuation, positions the TSX extremely well to outperform U.S. equities in 2022. This won’t be the case every year. Let’s enjoy it while it lasts.