2023-09-14 03:04:46 ET
Summary
- I, once again, evaluate the iShares MSCI Canada ETF as an investment option focused on Canadian equities.
- Though I acknowledge the recent underperformance of Canadian equities, I continue to believe in the long-term potential for diversification.
- I discuss the rationale for remaining long or buying new positions in EWC.
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.
I have owned and recommended EWC for the long term and generally speaking this has been a reasonably play. However, as we moved in to the second half of 2023 I continued to hold a "bullish" outlook on the fund and, in hindsight, this hasn't worked out short-term. The out-performance of the S&P 500 has been apparent, and Canadian equities have struggled:
Fund Performance (Seeking Alpha)
As we move in to Q4 and start to focus on 2024, I wanted to take the time to reiterate why I believe this is still a reasonable place to look for diversification. While Canadian equities have under-performed recently, I still see merit to holding them and believe performance will balance out in time. I will use this review to discuss the rationale behind remaining long or buying in to new positions at this time.
Tight Oil Supplies A Bullish Driver
One of the primary aspects for using EWC is diversification (in my opinion). I have used the fund to gain some exposure north of the border, but also because the sector allocations differ substantially from the S&P 500 (my primary holding). While the S&P 500 does have some Energy and Financials exposure, it is dominated by the big Tech names. EWC is a contrast from that:
EWC's Sector Weightings (iShares)
In particular what I prefer here is the Energy exposure. At almost one-fifth total assets, this sector is going to drive performance for EWC in a big way.
Fortunately, I see tight oil markets and rising prices to be a significant tailwind for the sector - and EWC by extension. After a slow start to the year, oil futures have rallied consistently over the past few months
Oil Prices (Based on futures market) (Bloomberg)
This has helped EWC deliver positive returns over the past six months, despite being down in total since my last article:
EWC's Share Price (Seeking Alpha)
Of course, this is all in the past. But the reality is we may see a consistent story play out through the fall and winter. In terms of oil prices, while I wouldn't get overly bullish here given the run they have already had, it is difficult to see a scenario where prices decline significantly. This is because oil markets continue to face a supply shortfall, drive by OPEC+ production cuts . These cuts are expected to remain in place going forward, as OPEC+ anticipates a growing supply/demand imbalance through the end of the year (one that is in their favor):
Supply/Demand Imbalance (OPEC+ Forecast) (Yahoo Finance)
The takeaway from all this for me is that oil markets are favoring the companies that extract, produce, and distribute this commodity. This doesn't bode well for global consumers, but it does signal the potential for more gains for the investors who own shares in the company. Readers can accomplish this through a number of different ways, and EWC is one of them.
S&P 500 Seeing Few Names Lead The Way
A second reason for keeping my Canadian exposure in place has to do with my growing concern about the sustainability of the US equity markets. Namely - the S&P 500, as that makes up the bulk of my portfolio. Of course, 2023 has been great for this index, and I have been a happy camper. But what concerns me is that just a handful of names are driving returns. That doesn't bode well for overall market health or the sustainability of the gains we have seen YTD.
Followers of this index would likely suggest that top Tech names generally drive returns for the S&P 500. And they would be right, so in isolation this may not seem to be anything to worry about. But even with that understanding, I have concerns given the size of the gains from these names just this year. For context, readers should note that 2023 is far above the norm in this regard:
Top 10 Stocks Driving S&P 500 Gains (Fidelity)
This is not meant to be alarmist. I remain long the S&P 500 and will continue to do so for the foreseeable future. But it should serve as a reminder that investors should stay diversified. The S&P 500 is top heavy and its performance is driven by a handful of names in a historically unusual fashion. This, at the very least, suggests there is merit to diversifying and/or buying some hedges. While EWC is not really a "hedge" given how global equity markets are correlated, it does check the diversification piece quite well. That supports my continued ownership of the fund heading in to 2024.
Dividend Growth Impresses
My next topic is a short and simple one - but important nonetheless. This relates to dividend growth, which is a definite reason for considering Canadian equities. While EWC is not really a high yield play, its underlying holdings (namely Financials and Energy) have performed well enough this year to return cash to shareholders. After a difficult 2022, the fund has seen a sharp increase in the distribution paid (EWC pays a semi-annual distribution, not quarterly like many US-based ETFs):
June 2022 Distribution | June 2023 Distribution | YOY Growth |
$.276/share | $.346/share | 25% |
Source: iShares
The conclusion I draw here is there is underlying health within the companies EWC holds - enough that they could pump out extra cash for investors. As a "dividend seeker", I am pleased with this development.
There Are Concerns To Be Aware Of
While I have illustrated a couple of positive attributes for EWC so far, I must now shift to some risks. I try to do this for every stock/fund/sector/idea I have, and EWC is no exception. Despite a favorable backdrop - in my view - EWC has struggled of late and we should examine why that is. There is no investment out there that is a "sure thing", and Canadian equities are no exception.
One item in particular to be aware of is slowing GDP growth. This is undoubtedly due to inflation and central bank hikes, along with generally pressure on the global economy that is impacting the developed world. Narrowing in to Canada specifically, after a strong mid-year, Q3 saw negative GDP growth and that is not an encouraging headline:
As you can see, the Canadian economy contracted last quarter and that is a metric we have to hope reverses in Q4. There are some signs that suggest a reversal is in the cards. The economy saw both wage and job growth climb last month, indicating a resilience that is similar to the US:
Labor Market News (Canada) (TD Bank Securities)
What I am seeing here is a bit of a push-pull. The labor market is showing some signs of strength, but general economic growth is cooling. In this environment we have to have a bit of a wait-and-see approach. We can hope for the best, but plan for the worst in taking measured and calculated positions. This doesn't mean flying all-in to funds like EWC, but it doesn't mean outright avoiding them either.
US Dollar Strength Another Headwind
A final point to consider is that EWC is a non-US fund. It trades on the US stock exchange but the companies are based on Canada and are predominately domestic. The Energy, Industrials, and Materials exposure offers a more global and diversified list, but the Financials weighting (at almost 35%) shows that this fund is very focused on what is going on inside Canada's borders.
In this vein, readers should be aware of the pressure the US dollar can put on this type of ETF. When The USD appreciates versus the Loonie, that can make the revenues and profits earned by those Canadian firms worth less in real terms to US-based investors (like myself). As the Fed has kept up its rate hiking path in the second half of the year, the USD has rallied, and that is part of the reason for EWC's weakness of late:
US Dollar Index (Charles Schwab)
The good news is that this presents an opportunity for investors if the Fed is done - or near done - with its rate hike plans. With treasury yields at their highest levels in over a decade, it is not really much of a stretch to think the Fed is nearing the end of its tightening cycle (with respect to raising its benchmark rate):
2-Year Treasury Yield (Federal Reserve)
What I am suggesting here is that the USD's rally could be cooling in the months ahead. This would be a net benefit to investors in foreign shares - whether Canadian or otherwise. But for now, the USD's strength is a definitive headwind and I would urge my followers to keep this in mind before deciding whether or not this exposure is right for them.
Bottom-line
EWC has not been a winner of late but I am not letting that deter me. The Canadian economy has held up reasonably well over the past year despite negative growth last quarter. Oil prices are helping the underlying shares in this fund and consumers are seeing job and wage gains that will help them cope with higher energy prices (for now). Finally, US markets are getting a bit over-concentrated in just a handful of names that tells me staying long my foreign exposure makes a lot of sense. As a result, I will be keeping my "buy" rating for EWC in place going forward and suggest my followers give the fund some consideration.
For further details see:
EWC: Reasons Why I Remain Long Canadian Equities