2024-01-08 20:04:24 ET
Summary
- The article evaluates the iShares MSCI Canada ETF as an investment option focused on Canadian equities.
- Canada underperformed the US in 2023, opening up some value plays in relative terms. This is especially true for top-heavy sectors like Energy and Financials.
- Population growth and lower interest rates all support Canadian economic growth and higher equity prices.
Main Thesis & Background
The purpose of this article is to evaluate the iShares MSCI Canada ETF ( EWC ) as an investment option at its current market price. This is a fund that is exclusively focused on Canadian equities, with a bias towards large and medium-sized companies.
My followers know that EWC has been a staple in my portfolio for the long term to diversify my American-centric portfolio in a responsible way. Over time it has served me well, including in the short term. As Q4 was getting ready to kick off last year, I reiterated a bullish case and have been rewarded for that outlook as a result:
Fund Performance (Seeking Alpha)
It is clear that EWC has ridden some nice momentum in the short term. This has helped boost my overall portfolio return and caused me to reconsider if I should be taking profits in this idea as we begin the new year. Rather than do that, I actually see an argument for continuing to add, so I can keep my "buy" rating in place for Q1 at the moment.
Concentration Risk Still Elevated In S&P 500
To begin, I will emphasize I am not bearish on US equities nor am I advocating selling off large-tech exposure in this environment. Quite the contrary. My portfolio has always been dominated by large-cap US stocks (which are tilted towards Tech) and that has served me quite well over the past twenty years. I don't see that changing now, or in the near future for that matter.
But just because I am overweight an area doesn't mean I want to be "all in" on an area. Large-cap US stocks (and the S&P 500) are the bell-weather of my portfolio, sure, but even this index is prone to big swings and losses at times.
So the key here is diversification. I like to use commodities/metals, municipal bonds, and non-US developed world stocks to round out my portfolio to give it balance. This is especially true today as it ever has been because the S&P 500 and other large-cap ETFs/CEFs are dominated by the same handful of stocks called the "Mag 7". What used to be "FAANG" has changed, but what hasn't changed is the market's over-reliance on these names for gains. While this is not new, what strikes me is how this dominance has grown over time:
Concentration of S&P 500 (FactSet)
What I see here is an environment where just seven companies are making an ever-increasing share of the "market's" return here in the U.S. - which has reached the highest level in over twenty-five years. This has certainly been rewarding for investors as the fortunes of these companies have improved - but can that always be the case? Probably not, and I see it as central to why I need to remain disciplined and diversified.
The bottom line is that I don't see a strong argument to put new money to work in the S&P 500/large-cap US stocks in early 2024. My portfolio is already skewed towards their performance and, quite frankly, it is getting a bit too much for comfort. To balance out this reality I am looking north of the border, and I will explain why Canada fits in nicely in the following paragraphs.
Inflation and Growth Estimates Give Central Bank Room To Move
Digging into Canada specifically, this is another country that faced some similar issues as the US and Europe. Namely, inflation and a higher interest rate environment that has pressured both companies and consumers. Fortunately, just like in the US and Europe, inflation has begun to moderate. While that often sought-after 2% level has not yet been reached north of the border, CPI figures show Canada is getting close:
Canadian Inflation (Trailing CPI) (Bank of Canada)
This tells me that the central bank will be unlikely to continue on a rate-hiking path in 2024. Just like the Fed, they are close to "mission accomplished" when it comes to inflation and that should give some breathing room for borrowers.
Further, expected economic growth for Canada is expected to moderate. While this may not seem like a "good" thing in normal times - equity investors want to see rate cuts this year. With inflation coming down and economic growth going to be small - but positive - there is a good chance is this occurring:
GDP Growth (Canada) (Bloomberg)
The long and short of it is this will allow the Bank of Canada to begin lowering its key rate in 2024. These figures are in a bit of a "sweet spot" when it comes to supporting a more dovish case. If inflation fell off a cliff or economic growth was going to be sharply negative, then those attributes would outweigh the bullish boost from lower rates in my view. But w ith growth chugging along modestly and inflation coming down, a tailwind of lower rates is attractive for Canadian equities. No, the story isn't perfect, but I see a backdrop I can get behind in a reasonable way. That supports my buy case for EWC.
A Big Play On Banks
Digging into EWC more specifically, readers should remember this is a top-heavy play on the Financials/Banking sector. While this makes it good from a diversification perspective (for those, like me, who are long the S&P 500), it carries its own set of unique risks and opportunities:
EWC's Sector Exposure (iShares)
At over 1/3 of total fund assets, one would definitely want to be bullish on this sector before buying in or holding this ETF.
Personally, I like this sector because it is not expensive compared to the US market and it is supported by an above-average dividend yield. So there are perks to owning exposure to Canadian financials. Further, if the economy is able to stave off a recession and/or keep delinquency rates contained, then there is plenty of upside at these levels.
But there are certainly risks to be aware of. With elevated interest rates, there is more pressure on borrowers across the board. While "good" for lenders to have higher rates, if debt does not get repaid, it wasn't "good" after all. So keep a close eye on delinquencies up north as 2024 gets underway.
But the largest banks (which are included in EWC's portfolio) are already taking proactive steps to manage a more difficult macro-environment. This has included a keen focus on expenses, with major job cut announcements coming from the Toronto-Dominion Bank ( TD ) and the other top players in the sector:
Job Cuts (Canadian Banks) (Reuters)
At the same time, the largest six banks in Canada have been preparing for a weaker economy and more loan defaults. This means these institutions are well capitalized to the point where they can absorb these losses (if they do occur). While it won't be great to hear that losses tick up and banks have to dig into their savings, in the interim it relieves some of the stress of wondering if the banks can survive higher delinquency rates. After regional bank failures in the US in 2023, this is an important point, and the net result is large Canadian banks are prepared for such a scenario:
Loan Loss Provisions at Big 6 (Aggregate) (Reuters)
I view this as a sign that management, collectively, has taken serious steps across the banking industry to ensure their companies can ride out any storm. Further, with interest rates remaining elevated for the time being, these credit loss provisions can earn a relatively high yield in short-term deposits and securities, which is where they will be housed. Protecting this cash, while also earning a reasonable return, is a smart way to diversify when credit conditions have been weakening in commercial lending areas.
Population Keeps Growing
Another tailwind for Canada’s economy has been the ever-increasing population growth throughout much of the territory. This is coming from immigration and long-term student visas, supporting consumers, construction, and other cyclical areas of the economy.
Now, we can debate the good and the bad of this policy. A growing population has costs and other net negatives under certain circumstances. I am not suggesting otherwise, but for the topic of this review - which is investing, I have to consider the growth a "good" thing for funds like EWC. And to put it in perspective, Canada's population growth rate is higher than it has been in almost seventy-five years:
Canada's Population Growth (Yahoo Finance)
Looking ahead, there are a couple of reasons to be optimistic about this fact from the point of view of a Canadian equity investor. One is the consumer demand side, which I noted already above.
The second is that more people mean a larger demand for things like housing, retail shops, roads, schools, hospitals, and many other necessities of life. This suggests to me that broader government spending on infrastructure is going to increase not just this year, but for the foreseeable future as migration to Canada remains high. While political pressure is likely to result in some restrictions going forward, limiting the growth, it is still going to be high on a historical basis and compared to other developed world peers in Europe and Japan. What this adds up to is a multi-year tailwind supporting Canadian economic growth and rising equity share prices. Both are beneficial for funds like EWC.
Bottom-line
EWC has been a winner recently and I'm optimistic that can continue. Canada has a few things going for it that support this optimism. One, the population has been increasing at a steady clip, keeping demand for goods and services high. Two, inflation has been slowing, giving the Bank of Canada a case for cutting rates this year. If that occurs, economic growth could come in more than forecasted. Three, US equities continue to be dominated by the Mag 7, which tells me many investors are going to be looking for ways to diversify.
For American investors, Canadian equities are familiar, close to home, and come with less geo-political risk than other countries across the globe. Buying in now gives readers an opportunity to front-run larger-scale buying as more investors wake up to this reality. This means I will be staying long and adding to my position in EWC, and I suggest to my followers that they give this idea some consideration going forward into 2024.
For further details see:
EWC: Reasons For Upping My Canadian Exposure In 2024