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In a note to clients, Bank of America outlined seven reasons it sees Canada as a better investment opportunity in the years ahead.
IT'S NOT ALL ABOUT OIL, BUT CRUDE DOESN'T HURT
While Canada – and its stock exchange – has a reputation as hewers of wood and drawers of water, the recent drop in crude prices hasn’t hampered the TSX as much as it may have been earlier expected. Bank of America says the TSX has somewhat decoupled from the price of oil, in no small part because of the capital discipline of energy companies, which have been earmarking excess funds for share buybacks and dividends, rather than spending more to open the spigots to pump more oil.
“Up until Jackson Hole, the relative performance between the TSX and S&P 500 in 2022 had been all about oil (84 per cent correlation). But since then, TSX/SPX has started to decouple from oil, with the TSX outperforming the S&P 500 by 5ppt despite oil's 6 per cent fall. The recent divergence suggests the TSX vs. S&P 500 trade is more than just oil”.
CASH IS KING, AND THE TSX IS FLUSH
With rising rates eating into savings, Bank of America noted the TSX composite appears to be a better yield play than the S&P 500, offering investors steady payouts that exceed those from its American counterpart. That, to the bank’s eye, should be supportive to valuations over the long term, particularly if rates remain at elevated levels for some time.
“The TSX has a much shorter duration than the S&P 500 (i.e. less sensitive to rates), yielding 2x as much in dividends, the biggest ratio in history. The TSX is also now more cash rich than the S&P 500, adjusted for market cap. A higher-for-longer rate environment is a much bigger headwind for long-duration assets like the S&P 500.”
RECESSION RISK IS ALREADY PRICED INTO THE TSX
With a recession seeming more and more like a “when” rather than an “if” as the path to a soft landing narrows, Bank of America says the valuation on the TSX has essentially priced in such a pullback in economic growth, while U.S. markets have not. As such, BofA thinks there’s less downside risk in the case of a recession for the TSX, while American markets may be in for a rude awakening.
“From the surface, it seems that more damage has been done to the S&P 500 than to the TSX (TSX leading by 11ppt YTD), especially as the TSX has historically lagged during recessions. However, the S&P's underperformance has been almost entirely due to higher rates, not higher [equity risk premium]. In fact, the TSX is pricing in a much higher chance of a recession (80 per cent) vs. just 5 per cent for the S&P 500.”
TSX EARNINGS APPEAR RESILIENT
While the gloomy economic outlook has put a damper on overall earnings growth expectations, Bank of America says the view has darkened considerably more south of the border. BofA also noted that the average earnings beat in Toronto exceeded that in New York over the course of the second quarter.
“Although earnings revisions have weakened overall, they have weakened more for the S&P 500 than for the TSX. Our three-month ratio of above- vs. below-estimate revisions is now 0.8x for TSX vs. 0.7x for the S&P 500. Moreover, the TSX posted a solid 4.5 per cent beat in 2Q, slightly stronger than the S&P 500's beat of 4.0 per cent.”
MACKLEM & CO. MOVED HIGH, AND FAST
Bank of America says the Bank of Canada’s decision to front-load interest rate hikes – essentially moving up interest rate increases to put a shock into the system to quell inflation – should have the domestic economy, and by extension, the equity markets, in better shape than the U.S. The analysts also noted that a lower terminal rate – the point where central banks end their tightening cycle – should be supportive of business conditions.
“The BoC has been very aggressive so far and inflation expectations remain anchored. So far the BoC and the Fed both have hiked 300bp, but the BoC has done it more rapidly. The BoC ended Quantitative Easing (QE) before the Fed and is doing Quantitative tightening (QT) more rapidly.
“Our economists expect the terminal rate at 4.5 per cent in Canada vs. 5.0 per cent in the U.S., with activity remaining more resilient in Canada than in the U.S. A lower discount rate and better economic growth should translate to the TSX outperforming the S&P 500.”
THE LONG VIEW TRUMPS THE SHORT OUTLOOK
While short-term valuations – on a price to earnings basis – are poor predictors of long-term return, Bank of America noted that on a longer-term basis, it has proven to be a good indicator of future returns. On that basis, Bank of America sees excess upside for Canadian stocks against their American counterparts.
“The current normalized P/E [price to earnings ratio] of 16.4x suggests the TSX returning +6.5 per cent per annum over the next 10 years, plus 3.4 per cent in dividends (i.e., 10 per cent/year in total returns). That compares to 8 per cent/yr in total returns expected for the S&P 500.
Moreover, the current normalized P/E of the TSX vs. S&P 500 stands near a record low at 0.8x. Based on the historical relationship between the relative P/E and forward 10-year returns, current valuations imply the TSX outperforming the S&P 500 by 1 [percentage point] per annum over the next 10 years in price returns.”
CANADA’S ADVANTAGE AMID GEOPOLITICAL RISK
With geopolitical risk running hot, between the Russian invasion of Ukraine and concerns over China’s broader ambitions to extend its sphere of influence, Bank of America says Canada’s role as a stable trading partner to the United States, combined with its abundance of resources, should support business activity in the country in the years ahead.
“While the relative outperformance between the TSX and S&P 500 was driven by oil for much of this year, we believe the 2020s will mark a regime shift where energy and food security will gain importance. Canada is uniquely positioned with both energy and food security, as well as political stability, which we believe is critical in the 2020s with increased uncertainty and internal/external conflicts.”