Due to falling commodity prices, the TSX grossly underperformed most major benchmarks in 2015, especially in comparison to its U.S. peers. 2015 was also a wildly turbulent year for the Canadian index, which saw large swings in net fund and equity flows. That being said, with a well-diversified economy and a new Prime Minister ready to pursue infrastructure spending to boost the economy, the Canadian market seems like the perfect value investment. However, contrarians be warned: Canada presents its own challenges and risks that must first be addressed.
Ex1: The TSX trailed leading benchmarks and U.S. indices in 2015 (author-generated using data from CIBC)
Ex2: 2015 was a volatile year for Canadian equity markets (author generated using data from StatsCan)
(See also: (EWC, FCAN, CNDA) 3 Best Canada ETFs for 2016)
Northern Values
The end result of the TSX’s underperformance last year is a heavily discounted price-to-earnings ratio this year. From a first glance, TSX presents an excellent contrarian opportunity to play a rebound in the oil and commodity space. Currently the TSX is trading at roughly 15.1x trailing earnings, while the S&P, Dow Jones Industrial Average and the NASDAQ are trading at 21.4, 16.9 and 20.85 times their trailing earnings respectively. Moreover, Canada’s E&P sector is in survival mode, characterized by liquidity and leverage concerns, along with widespread dividend slashes. However, even within this battered sector, shining stars such as Vermillion Energy Inc. (VET) and non-dividend paying names such as Spartan Energy Corp. (TSX:SPE). are expected to weather the storm, and offer some great value oil plays. (See also: Is Now the Right Time to Buy Canadian Stocks?)
Exhibit 3: Comps of some Canadian oil names (generated by Thomson Reuters)
Secondly, recently elected PM Justin Trudeau has promised that he intends to diversify away from an economic reliance on the resource sector, and he has voiced his support for Canada’s growing technology space, along with plans for expansionary fiscal policy. The new PM will present his budget plans in March, but the Liberal government is expected to propose deficit spending on major infrastructure projects to boost the economy.
Finally, Canada’s finance minister Stephen Poloz has made it clear in the past that he is willing to break the zero bound if it will jump-start Canada’s economy. With inflation expected to be well within the Bank of Canada’s 2 percent band, the risk of a stimulus overshoot remains subdued.
Ex 4: Low inflation means more wiggle room for monetary stimulus (BoC)
(See also: Why Canada's Interest Rates Won't Rise Anytime Soon & Oil Prices' Impact On Canada's Oil Transportation Industry)
Buyer Beware: Canada Comes with Its Own Challenges
Despite its apparent discounted nature, it is worth nothing that the Canadian economy presents its own set of risks that must be addressed. After all, the stock market’s underperformance is, by and large, a corollary of Canada’s underlying economic problems.
Firstly, while the effects of the commodity sell-off have been relatively contained to the resource-rich provinces, spillover effects have seeped out to slowly raise the unemployment rate for the rest of Canada. As Canada is a net exporter of commodities, low-priced commodities can present a drag on Canada in terms of trade, wealth and income levels. The aforementioned spillover to the non-commodity-producing provinces involves reduced demand for mobile labor. Currently as the oil-and-gas and metals-and-mining sectors account for $257 billion in outstanding bonds and make up 26 percent of the TSX’s market cap, prolonged weakness in commodity prices can exert downward pressure on Canadian equities and upward pressure on credit spreads. Thus, it remains to be seen how Canada’s well-diversified economy will be able to handle a lower-for-longer oil environment.
Ex 5: Commodity spillover (BoC)
Ex 6: Skyrocketing unemployment rate in Alberta (StatsCan)
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Canada is also experiencing wildly diverging home prices in Toronto and Vancouver versus the rest of Canada. Led by an influx of foreign investors, the median home prices in these metropolitan areas have soared, thus leading to a worrisome increase in household debt levels. Recently, the Canadian Housing and Mortgage Corporation (CMHC) has tightened mortgage regulations by raising the minimum downpayment levels required to secure a loan.
Ex 7: Housing bubbles in Toronto and Vancouver have led to price divergences in the RE market (BoC)
Ex 8: RE divergences are also creating upwards pressure in debt levels (BoC)
Thirdly, a hard landing in China or an implosion in highly leveraged emerging market economies, caused by weak commodity prices and continued dollar strength, can have a moderately negative impact on the Canadian economy. According to the Bank of Canada, recent spillovers from China and other EMs to Canadian financial markets suggest that the transmission channels may be stronger than originally anticipated. Future disturbances could prove quite costly, as lower commodity prices would reduce Canada’s terms of trade and incomes, while slowing down demand for Canadian goods overseas.
Ex 9: Emerging markets have continued to take on leverage, even in the face of falling commodity prices (BoC)
The Bottom Line
Canada’s main equity index, the S&P/TSX, has grossly underperformed its international peers due to the commodity sell-off. However, despite the doom and gloom, investments north of the 49th parallel present some excellent contrarian opportunities. That said, investors should take note of the risks inherent in the Canadian economy, such as a continued weakness in oil, a hard landing in the Chinese economy, continued rise of the USD and its adverse impact on commodity prices and reluctance from the BoC to cut interest rates.
