2023-07-31 01:48:20 ET
Summary
- It's been a great year for Canadian stocks.
- But most of the upside has come out of higher valuation rather than earnings.
- With the BoC poised for an extended tightening cycle, the setup for the iShares MSCI Canada ETF isn't as compelling.
Canadian equities have largely shrugged off the Bank of Canada's (BoC) surprise monetary tightening in June (after months of staying neutral) in response to economic developments. From here, the market is pricing in one more hike by year-end before the central bank pivots to rate cuts next year. This seems a tad optimistic to me, given the persistent inflationary pressures, as indicated by the stronger-than-expected June employment report, as well as the accelerated pace of wage growth in the quarterly GDP report (up ~7% annualized in Q1). Further, continued economic growth in Q1 suggests that growth in Canada isn't slowing down anytime soon, leaving the BoC with ample room for precautionary tightening. With Canadian interest rate risks skewed to the upside for the rest of the year and the iShares MSCI Canada ETF ( EWC ) priced at ~13x P/E (vs. ~10% consensus earnings growth next year), the risk/reward seems balanced here.
Fund Overview – Relatively Pricey Exposure to a Diversified Canadian Large-Cap Basket
The US-listed iShares iShares MSCI Canada ETF seeks to track, before fees and expenses, the performance of the MSCI Canada Custom Capped Index, a basket of large-cap Canadian equities subject to concentration limits. The ETF held ~$3.2bn of net assets at the time of writing and charged a 0.5% expense ratio, placing it at the upper end of single-country Canadian options available to US investors. By comparison, key comparables such as the JPMorgan BetaBuilders Canada ETF ( BBCA ) and the Franklin FTSE Canada ETF ( FLCA ) come with ~0.2% and ~0.1% expense ratios, respectively.
The fund is spread across 87 holdings, with the largest sector allocation going to Financials at 35.9%, followed by Energy at 17.3% and Industrials at 12.3%. Other meaningful sector exposures over the 5% threshold include Materials (11.2%) and Information Technology (8.5%). With the top five sectors accounting for ~85% of the total portfolio, EWC is one of the more top-heavy North American ETFs - despite incorporating weighting caps. With the exposure to cyclical sectors counterbalancing the outsized financials allocation, the fund's equity beta is in line with the S&P 500 ( SPY ) at 0.96.
In line with the sector composition, Canada's biggest banks, the Royal Bank of Canada ( RY ) and Toronto-Dominion Bank ( TD ), lead the single-stock allocation at 7.3% and 6.3%, respectively. The non-bank exposure is better spread out, with no single holding >5%. The largest non-bank names in the EWC portfolio are Class I railroad Canadian Pacific Kansas City ( CP ) at 4.2% and e-commerce company Shopify ( SHOP ) at 4.1%. Including energy company Enbridge ( ENB ), the top five holdings account for ~26% of the overall portfolio, keeping the EWC portfolio fairly diversified from a single-stock perspective.
Fund Performance – Demonstrated Track Record of Through-Cycle Capital Growth
On a YTD basis, the ETF has risen by 9.6% and compounded at an impressive +7.8% rate in market price and NAV terms since its inception in 1996. In the last five years, the fund has only seen two years of drawdowns, in 2018 (down low-teens %) and 2022 (down high-teens %). With each negative year swiftly followed by strong rebounds, though, the fund's track record has remained strong through the cycles. In particular, the three-year performance (+13.1% annualized) stands out, pulling up the five (+6.5%) and ten-year returns (5.2%), as well as the overall compounding rate since inception. The fund's exposure to cyclical industries like Energy, Industrials, and Materials means returns generally track the volatility of global cycles, though, so investors will want to be wary of the performance swings.
Helped by its holdings in high-yielding bank names, EWC's income-driven distributions have generally been solid through the cycles (current trailing yield at a solid 2.4%). While the yield provides a nice supplement to the fund's capital gains, the elevated ~12.8x P/E and ~1.9x P/B valuation multiples won't appeal as much to value-focused investors. With EWC's key bank holdings now also trading at a wide premium to book following this year's recovery, the valuation expansion runway seems limited here.
Canadian Rates Peaking but Not Quite There Yet
The BoC surprised markets with a 25bps policy rate hike this month (now at 5.0%) – despite the long pause since the start of the year. While consensus is that the current rate hike cycle is nearing its end, with Governor Macklem confirming as much in the post-meeting statement , there were still several hawkish caveats in the announcement. At the top of the list is the issue of 'sticky' demand, a result of cyclical factors like excess household savings and pent-up services demand countering the impact of the BoC's tightening efforts. But there are also structural factors at play, most notably Canada's population growth surge, which is providing a bigger inflationary (via incremental demand for goods and services) than disinflationary (via labor supply expansion) force right now.
As a result, core inflation has been 'stickier' than expected, with the BoC predicting that a reversion to the 2% target would take 'longer than previously forecast.' Between the July and September meeting, the interim CPI report releases will be key – the most recent consumer inflation print, for instance, showed a YoY deceleration at the headline level, but the more important core inflation metrics haven't followed suit. In the likely event that upcoming data releases, including monthly employment data, inflation, and Q2 GDP, show more of the same, the BoC is likely on track for another 25bps rate hike in September. An extended tightening cycle doesn't bode well for the EWC portfolio's rich valuations, especially with consensus currently assigning a relatively low 21% probability to a September hike (and deep rate cuts from H2 2024). And with the recent wave of negative revisions indicating rates are starting to bite into corporate earnings as well, I would be cautious.
Balanced Risk/Reward on Canadian Equities Ahead of Further Tightening
Having surprised the markets in June with a rate hike, more tightening cannot be ruled out in the coming months, and that will only add to the downside pressure for Canadian equities. Wage inflation is running hot, as shown by a robust June employment report and Q1 GDP report, while growth has also been resilient despite the series of hikes over the last year. In the likely event that the upcoming data releases (July employment and CPI, as well as Q2 GDP) point to continued economic resilience, current market estimates for a September 'skip' could prove too optimistic. In the meantime, Canadian large-caps have re-rated to ~13x P/E despite a slew of negative earnings revisions in recent months. While the EWC fund's portfolio companies could still grow into their valuations over time, the risk/reward seems fairly balanced at current levels, and I don't see a compelling reason to accumulate here.
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EWC: Balanced Risk/Reward On Canadian Equities Ahead Of Further Tightening