CA - Why Canadian Markets May Be Worth A Closer Look In The Second Half

2023-07-27 16:11:00 ET

Summary

• U.S. markets have outperformed Canada for a few reasons.
• Potential reasons for caution in the markets going forward.
• Canada may be looking better than U.S. on valuation basis.

While the big U.S. indices have outperformed the TSX so far this year, Michael O'Brien, Portfolio Manager at TD Asset Management, tells MoneyTalk's Anthony Okolie that the Canadian market may be worth a closer look for investors going forward.

Transcript

Anthony Okolie: Why don't you just give us a recap of the Canadian markets, so what they've done so far and how they've stacked up against the US.

Michael O'Brien: Sure. So it hasn't been lost on anybody -- the US has really been the story of 2023. Fantastic start to the year. I think as we sit here today, the S&P is up about 20% year to date -- a great start. NASDAQ even stronger, obviously, with those big tech heavyweights.

Canada, like you say, it hasn't had a bad year. I think we're up, on a total return basis, we're up 7% or 8% year to date, which is respectable. But obviously, we look south of the border, and we're a little envious of that performance.

I think a lot of the same trends, both north and south of the border, but Canada has had a few of the bigger components of our market. The banks have been a little bit of a laggard. Some of the energy stocks have lagged a bit. Some of the big telcos have lagged a bit.

But all in all, a very strong start to the year. And you think about it relative to where we were back last fall when markets were at their lows, a lot of concern around inflation. And there was a view that in order to bring inflation back to more acceptable levels, central bankers, policymakers, would have to inflict some pain on the economy.

Instead, what we've got so far is we've had inflation come down very nicely, at least as quickly as most people expected, but we haven't seen that pain in the economy. The first half of the year, both the US and Canadian economies performed pretty well.

Anthony Okolie: And the job markets also --

Michael O'Brien: And the job markets have held up very well. So I think that explains the strength that we've seen, which I don't think a lot of people were calling for back in November, December.

Anthony Okolie: Now, you also said it's hard to get too bullish about big gains in the back half of the year. And a lot of that has to do with what markets seem to be pricing in. What are you seeing right now?

Michael O'Brien: Well, I guess my point on that would simply be we've, particularly in the US market, but more broadly speaking, it's been almost a perfect scenario this year. Like I described, Economics 101 tells you that you're not supposed to have your cake and eat it too. And yet, we've seen inflation recede without that impact on the job market, without that impact on the economy.

And so consumption has been pretty strong. Really, the only weakness we've seen has been sort of in the commodity complex, which has actually helped bring inflation down. So I guess where I'm at now is it's been a very smooth ride so far. But for the central bankers -- the Fed, the Bank of Canada -- to achieve this soft landing or the no landing scenario that some people are calling for, it's still going to be a really tough act to pull off.

And so I think it's all about what's priced into markets today? What's priced into markets today when you look at where valuations are -- the S&P, for example, is close to 20 times earnings, which is quite elevated. It's telling you that investors expect a soft landing.

Whereas if you go back to some market history, you would say the odds of a soft landing are not as favorable as the markets are implying. So from the starting point, it's a little bit of a challenge with what's been priced into the markets.

The other part of it, too, is even if inflation continues to behave pretty well, I think the central bankers have made it very clear that they intend to keep leaning on the economy. If the economy continues to hold up, they aren't going to be in a rush to cut rates, which means even if we do achieve a soft landing, it's hard to picture an environment where earnings growth is going to re-accelerate in a substantial manner because the policymakers are going to continue to keep things tight.

On the other hand, if all these recessionary signals that we were looking at, inverted yield curves and whatnot, if they aren't giving a false signal, if that's where we're heading, then, obviously, the economic environments over the next 9 to 12 months is going to be much more difficult. So either way you slice it, I don't see a big rebound in earnings growth over the next two, three quarters. So that makes me a little bit cautious because I'm not betting on further multiple expansions from what we've already seen.

Anthony Okolie: Now, you talked about some of the indicators. There are also some lagging economic indicators that you'll be keeping an eye on going forward.

Michael O'Brien: Yeah. You look at the whole panoply there to try to triangulate what's happening. But when you think about -- you and I both just said, the job market's held up very well -- it has. That tends to be more of a coincident or a lagging indicator. It's sort of an inflation -- we said how inflation has come down.

Those tend to be sort of coincident or lagging indicators. All the classic lead indicators, things like your purchasing managers indexes that people watch, those types of things, or, like I mentioned, the inverted yield curve, those tend to be leading indicators. And they've been flashing red for some time. So we're really at this turning point.

And so it's this age-old question of, is it different this time? And when we get to this point in the cycle, the tendency is for us to say it's different this time. It's going to be a better outcome. The odds are that it's probably not.

And so I'm just trying to be sober and realistic about the odds of achieving this perfect economic scenario. History would tell us it probably won't happen. Markets are already pricing in a pretty positive outcome. So I'm just being cautious. I'm just being cautious.

Anthony Okolie: Now, you also said that Canada is not looking too bad compared to the US markets right now. Why is that?

Michael O'Brien: Well, I think, like I mentioned earlier, there are a couple big pockets, very important components of the Canadian market that have been laggards. They haven't seen that 30%, 40%, 50% return that we've seen out of a lot of these other stocks, specifically the banks. The Canadian banks got caught up in the controversy around, or the problems with some of the US regional banks -- remember Silicon Valley Bank failing, a couple of the other ones, a lot of pressure on deposits, concern about loan losses.

That dragged the Canadian banks down too. They've started to stabilize here. I think we've seen better deposit trends. We haven't seen that deposit flight that really sparked the problems in these US regionals. I think we've all realized that lending margins are probably going to be a little bit pressured here for the next couple of quarters.

So that's kind of in the price. And so far, the credit concerns -- the loan books have held up pretty well so far. So I think at this point, the banks have kind of stabilized. They're not expensive stocks. They've still got these headwinds that they're going to have to deal with, but they're not expensive.

Anthony Okolie: What about energy?

Michael O'Brien: And I was going to say, another big important part of the Canadian market is the energy space. And, again there, commodities struggled in the early parts of the year. I think people had hoped that the Chinese reopening story would really drive the commodity complex in the first half of the year. It's kind of underwhelmed.

Chinese oil demand has been good, but it hasn't really pushed that whole commodity complex higher. And so instead of seeing oil prices in the $80 to $90 level, you are looking at $60 to $70. So, again, that's another part of the market.

But now, you're seeing oil prices have started to strengthen a little bit. And valuations again, and expectations, are quite reasonable for that group of companies. So if you get a scenario in the back half of the year where the banks and the energy stocks start to work, that could be a really nice tailwind for the TSX, the Canadian composite.

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