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Canada may not want Americans up north, keeping its border closed, but that’s no reason to shun Canadian stocks.
The Canadian stock market has been performing well, up an average 22% this year for U.S. investors. It’s still looking cheap, and could outperform the U.S. market as a cyclical recovery gains momentum.
While the
has gotten pricey at 21 times forward earnings, the S&P/
Composite, a broad index of Canadian stocks, trades at 17 times earnings. That’s below the average valuation difference between the two markets, and it’s the steepest discount to the U.S. since the tech bubble, according to Bank of America strategists Ohsung Kwon and Savita Subramanian.
When Canadian stocks have been this cheap, they have outperformed the S&P 500 by an average of 8.4 percentage points, beating the U.S. 63% of the time, BofA says.
Canada’s equity market tilts heavily to cyclical sectors such as commodities, energy, materials, and financials. Cyclicals account for 70% of the Canadian market, compared with 25% of the S&P 500. Financials comprise about 36% of the Toronto Stock Exchange (TSX), followed by energy stocks at 14%, tech at 13%, and materials at 11%.
The cyclicality in Canada’s market can work both ways. The market up north is highly sensitive to commodity prices and cyclical trends—getting a lift when economic growth is looking up and falling hard in downturns. It’s also sensitive to U.S. demand; over 30% of sales for companies on the TSX are derived in the U.S.
Canada exports more than 30% of its gross domestic product annually and much of it winds up in the U.S., which is Canada’s largest trading partner.
There’s also currency risk, though it has been positive lately. The Canadian dollar, known as the loonie, is up about 10% over the past year versus the U.S. dollar. That might be tough on Canadian exporters, but it has lifted returns for U.S. investors in Canadian equities. While the S&P/TSX has gained 30% in the last year, U.S.-listed exchange-traded funds that focus on the Canadian market have jumped about 47%.
A stronger Canadian dollar historically lifts the multiple of its stock market, too. BofA estimates that the Canadian market could rerate 20% higher relative to the U.S., if historical patterns hold.
The Canadian dollar has been rallying with commodity prices, gaining more than 3% against the U.S. dollar this year, making it a top performing currency.
Canada’s economy could also perk up as the country catches up on vaccinations and gradually reopens, lifting services and other sectors.
One big headwind, of course, is the pandemic: The government of Prime Minister
Justin Trudeau
has been far more cautious in reopening the country to tourists than Europe. Ongoing border closures could prolong an economic downturn.
The Canadian dollar and economy are also sensitive to U.S. interest-rate policy. The loonie weakened recently as the Federal Reserve struck a slightly more hawkish tone. If U.S. rates head up in a meaningful way, it could strengthen the U.S. dollar and weigh on the TSX, BofA notes.
Nonetheless, investors looking for a less expensive way to play a cyclical recovery should consider Canada-focused ETFs.
Some of the larger and more liquid ETFs include
(ticker: BBCA),
ETF (EWC), and
ETF (FLCA). The ETFs are up about 22% on average, this year. The
iShares Currency Hedged MSCI Canada ETF
(HEWC) aims to eliminate the currency risk, though it is trailing its non-hedged rivals by about 3 percentage points this year.
If Canada ever does open its border, allowing vaccinated Americans in, it could be like the gravy on poutine.
Write to Daren Fonda at daren.fonda@barrons.com
