Equity markets rebounded this week as Greece voted to pass the austerity measures necessary to secure another bailout from the EU/IMF. The S&P 500 rallied 2.9% led by banks and cyclicals, though all sectors rang up healthy gains. Meantime, the TSX rose 2.5% as the energy sector was fuelled by a rebound in oil prices. Thus concludes the first half of 2011, with major global equity markets posting low single-digit gains, not at all out of whack with our expectations going into the year.
Canadian stocks, however, have lost some lustre relative to their global peers, particularly those in the U.S. The TSX was among the worst performing major global equity indices in the first half of the year, falling nearly 2% and trailing the S&P 500 by a wide margin, threatening to end a run of seven straight years of Canadian outperformance. Stock-specific issues, the cyclical nature of the TSX, tightening in China and the strong Canadian dollar all appear to have played a role in the recent underperformance.
One reason for the sluggish performance in Canada this year has been the action at the sector level, particularly in materials and technology. Part of these sector disparities can be attributed to company-specific factors or plain bad luck—RIM, Cameco and Sino Forest, for example, have accounted for a combined 210 of the 520 points lost by the TSX this year. However, the more lasting issue is the highly cyclical sector makeup of the TSX, especially when compared to the S&P 500. Deep cyclicals (i.e., energy, materials and industrials) now account for 55% of the TSX market cap, up from about 35% after the 2002 bear market, while defensives (i.e., health care, staples, telecom and utilities) make up less than 10%. Conversely, the S&P 500 is much more evenly balanced with about an even 28% split. In other words, when markets begin to sniff out an economic soft patch, as seen in recent months, Canadian stocks are at a serious disadvantage. Growth prospects in China are a related factor, which have a significant impact on commodity prices and the performance of cyclicals. Indeed, aside from Australia, which wins thanks to geographic proximity, the TSX has seen the strongest positive correlation with the CSI 300 over the past year, while U.S. indices have seen the least correlation.
The strong Canadian dollar has also had at least some impact as it can negatively impact earnings through a variety of channels—lower export demand, margin compression for those producing in Canada but selling into the U.S. market, and lower C$ per-share earnings for those reporting in US$ but trading on the TSX. On the flip side, large S&P 500 companies generate nearly half of their revenues overseas, and are reaping the benefits of the flagging U.S. dollar.
That said, valuations are far from stretched versus those in the U.S., even after 7 years of outperformance. In fact, that run largely reflects a renormalization from a period in the early 2000s that saw U.S. equity valuations stretched far beyond those in Canada. By the simplest measure, the ratio of the TSX to the S&P 500 is now bang on its long-run average, while other valuation metrics actually still favour the TSX. The 2.6% dividend yield weighs in at 60 bps higher than in the U.S. (a full standard deviation better than normal), while the TSX is again substantially cheaper on a price-to-trend earnings ratio basis.
Note: A full report can be found on our website: http://www.bmonesbittburns.com/economics/focus/20110630/feature.pdf
About BMO Financial Group:
Established in 1817 as Bank of Montreal, BMO Financial Group (TSX, NYSE: BMO) is a highly diversified financial services organization. With total assets of $412 billion as of October 31, 2010, and 38,000 employees, BMO provides a broad range of retail banking, wealth management and investment banking products and solutions.
We serve Canadian clients through BMO Bank of Montreal®, our personal and commercial banking business, BMO Nesbitt Burns®*, one of Canada’s leading wealth management firms, and BMO Capital MarketsTM, our North American investment and corporate banking division.
In the United States, clients are served through Harris, a major U.S. Midwest financial services organization with a network of community banks in the Chicago area and wealth management offices across the United States, as well as BMO Capital MarketsTM, our North American investment and corporate banking division.
We help our customers make money make sense by delivering the broadest range of financial services through a single point of contact. Our financial service professionals provide access to any services our customers require across the entire enterprise.
BMO Financial Group is made up of three operating groups: