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Canadian equities: Hitching a ride on a strong U.S. economy and a rebounding China


This article appears as published in the Globe and Mail.

Climbing to new highs, the S&P/TSX Composite Index continues to shrug off negative news – weaker economic data, resurfacing USMCA chatter, depressed oil prices and housing concerns to name a few. How is the index doing this and can it continue?

In the portfolios my team and I oversee, we were tactically underweight Canadian equities for 21 months reflecting our pro-cyclical regional view at the time. Markets in the U.S., Europe and Japan appeared relatively more attractive as the Bank of Canada (BoC) was on a clear hiking path and oil prices were below profitable levels for Canadian producers.

We closed this position in January as we now expect the TSX to perform better with a mid-to-high single digit return over the next 12 months.

Why? U.S. growth, although slowing, should be positive and lead global expansion. Next, China is showing signs of a rebound and growth looks to be stabilizing. All of which is supportive of Canadian equities.

Canada is tied to the U.S. Right now, that’s good for Canadian equities

In the BoC’s Spring Business Outlook Survey, the overall indicator declined from the last reading and has been falling since the second quarter of 2018. It turned negative for the first time since 2016 – major concerns continue to be a weaker energy sector due to pipeline uncertainties and production cuts, as well as global trade headwinds and geopolitical tension.

Despite this, surveyed firms anticipate input and output price growth to stabilize despite cost increases born directly or indirectly from tariffs. Additionally, sales are expected to be positive over the next 12 months as we see signs of recovery in international markets. Respondents are clearly not anticipating a U.S. recession over the next 12 months and I agree with them – our own U.S. bear market indicator is also signalling a low probability.

The U.S. is by far our largest trading partner, roughly accounting for 75 per cent of exports. Concerns over NAFTA/USMCA appear to be overblown. While there is a slim chance that the U.S. pulls out of both, it appears unlikely due to the upcoming U.S. election, highly integrated supply chains and the large trade flows between the three countries.

Improving Chinese conditions is always good news

China’s deleveraging campaign was largely responsible for the slowdown in Chinese and global growth last year. The slower than expected growth paired with U.S. trade tensions led them to put deleveraging on pause to let credit growth accelerate.

The good news is that U.S.-China trade tensions are easing, and Chinese growth appears to be picking up as is market sentiment. Companies on the S&P 500 with large revenue exposure to China have outperformed the broader index posting double-digit returns year-to-date. Recent Chinese data was broadly positive with industrial production, retail sales and GDP all coming in at or higher than expectations. China’s presence has grown to about 27 per cent of global growth – similar to how China slowing has had a negative effect, their recent policy easing will likely boost domestic and global activity in 2019.

Other positives

A major headwind facing Canada was falling oil prices and production cutbacks. However, oil prices have modestly recovered over a short period of time and I expect prices to be range-bound through 2019. Production cuts continue to be a drag on growth in the Prairies but otherwise Canada is in a good position going forward.

Canadian banks rank higher relative to other developed markets in our models due to favourable interest rates and earnings, and housing risks remaining contained.

Recent rate hikes are still making their way through the economy, but employment growth is healthy, and unemployment is low which will support wage growth and help the consumer with higher interest rates. On Wednesday, the Bank of Canada removed any bias for hikes this year – in line with central bankers globally. GDP estimates for 2019 were downgraded, as expected, but remain positive. Whether the central bank stays put or cut rates over the next 12 months, it’s a plus for Canadian equities.

The Canadian dollar started 2018 around 80 cents US and has weakened to about 75 cents US. I expect it to move higher from here, but the lagged effects of a weaker Canadian dollar throughout 2018 will provide a boost in 2019.

All things considered, there’s a few tailwinds supporting Canadian equities in the early part of 2019. For the next 12 months, I expect robust returns from Canadian equities—in fact, the TSX has recently set new highs, which can’t be said for most major indices in Europe and Japan—bolstered by our strong ties to a leading U.S. economy and the widespread benefits of a stabilizing China.

Rachael Moir is a Quantitative Investment Analyst with the Investment Management and Strategy team at MD Financial Management. She is responsible for supporting strategic and tactical asset allocation and alternative investment mandates.