Summary
- EWC is a large-cap focused portfolio with limited churn.
- Gauging the Canadian central bank’s intentions on March 8 is a tricky proposition considering some of the conflicting data floating around.
- Loan growth of Canadian banks may remain subdued, but these banks also appear to be well-positioned to cope with asset quality challenges.
- The earnings-to-valuation matrix of EWC is not great, and the risk-reward on the charts is not compelling enough.
ETF Snapshot
The iShares MSCI Canada ETF ( EWC ) is a financial product that tracks the MSCI Canada Custom Capped Index, which in turn covers a universe of 88 large-and-mid-cap Canadian stocks (EWC is tilted towards large-caps which account for 87% of the portfolio). One of the hallmarks of EWC is the stability of its portfolio; typically, only 5% of its holdings get churned every year, 6x lower than the average annual turnover rate of all ETFs. A yield of 2.25% isn't pulling up any trees, but this is an ETF that has grown its dividends at a little over mid-single-digits both on a 3-year basis and a 5-year basis.
Macro Conditions
It's fair to say that quite unlike the US, monetary policy transmission in Canada has been a little more effective. Since March last year, the Central Bank of Canada had raised its benchmark lending rate through the year from 0.25% to 4.5% and this has left a mark on the growth and inflation trajectories of the nation. In effect, Q4 GDP growth came in flat , coming in well below street expectations of a 1.5% increase (annualized), and the bank's own estimate of 1.3%.
Inflation, on the other hand, has come off quite significantly over the last two months, dropping to 5.9% in January (below street estimates of 6.1%), and with the steep base effect kicking in from March, we could see further downside pressure here.
Given the underlying conditions with growth and inflation, one could have felt relatively confident that we were going to get a pause with rate hikes, more so, as last month, the Central Bank Governor had touched upon the prospect of a conditional pause. However, it's not as though all the pivotal macro metrics are heading south. The labor market, if anything, still continues to remain quite resilient. In January, the country had a whopping 150k net new jobs, well above consensus estimates of only 15k jobs! Meanwhile, wage growth in Canada of 4.5% is still above the Canadian Central Bank's inflation target of 1-3% , which suggests that the labor market-related inflationary pressures could still spill over. Also note that conditions in the manufacturing space are solid enough, with the most recent PMI hitting its highest point since May.
Nonetheless, given these inherent conflicts across some of the key macro metrics, it would be difficult to ascertain the central bank's positioning with benchmark interest rates at the next meeting due to take place on March 8.
Banking Sector Conditions
The fortunes of Canadian banking stocks will be pivotal to any potential alpha that EWC could generate as these entities account for 38% of the total portfolio in aggregate, more than 2x as much as the second-biggest sector (energy stocks).
With the economy slowing the way it is, one does wonder if there will be ample appetite for credit this year. Already, as of December 2022, loan growth in Canada has dropped to 5.9% YoY, below the 50-year average of 7.6% . Even if one were to assume a resumption of credit appetite (if the Canadian central bank pauses rates), I feel that Canadian households are already overleveraged and this could only add to systemic risks further down the line. The image below shows that debt levels continue to overshadow disposable incomes by very uncomfortable margins (184%), even as household savings rates have plummeted from the 15% levels seen in Q2-21 to the mid-single-digit levels.
Whilst credit costs could rise compared to recent years as the economy worsens, I don't believe Canadian banks would be subject to a drastic decline in asset quality, as they appear to be exercising some prudence and control in disbursing mortgage loans. Besides as you can see from the image below, compared to the subdued level of loan loss provisions seen in late 2021/early 2022, the provisions levels in Q1-23 have been trending up for a few quarters now, reflecting a good degree of foresight.
Nonetheless, even if the large Canadian banks wanted to pursue aggressive loan growth, things could be hamstrung on account of greater capital requirement thresholds that would have kicked in from February 1, 2023. Basically, since the turn of last month, the domestic stability buffer (DSB) which was previously at 2.5% increased to 3%, thus pushing the overall CET1 minimum requirements from 10.5% to 11% (essentially, a base capital ratio of 8% of risk-weighted assets plus the new DSB of 3%).
Closing Thoughts
When we consider EWC's valuation and technical backdrop, we don't see compelling evidence to turn bullish on the fund.
YCharts data suggests that EWC's constituents could likely only deliver 5-year earnings growth of ~8% , 200bps lower than what the constituents of the diversified Vanguard FTSE Developed Markets ETF ( VEA ) could deliver. Despite the unfavorable earnings variance, EWC also trades at a slight ~3% forward P/E premium (12.9x) to VEA's corresponding multiple.
EWC's sub-par earnings to valuation equation could see funds flow to other developed markets. Interestingly enough, do note that over the last three months, EWC's AUM is already down by -10%, even as VEA's assets have grown by ~3%
Relative to its developed market peers, EWC could have been an attractive mean-reversion candidate when the pandemic first hit, as the relative strength ratio of Canadian equities and developed market equities looked oversold. However, the ratio rebounded to the 0.87 levels, and even though there's once again been a pullback below the mid-point of the long-term range, the gap isn't sizeable enough to justify a rotation to EWC.
Finally, we switch to the dynamics on EWC's weekly chart and here we can see that since May last year, EWC has been trading within a tight range of $30-$36. If we were to use those boundaries as pivot guidelines, it doesn't make a great deal of sense to enter EWC at this juncture as the reward-to-risk equation is less than 0.5x.
For further details see:
iShares MSCI Canada ETF: Not Too Compelling At This Juncture