Why Canada is well-positioned to benefit from reflation trade

Canada has many reasons to gloat. From its cosmopolitan cities, sense of social justice and innate politeness, the country has a lot going for it.

When compared to its southern neighbours, that can turn into a feeling of superior smugness. However, reflections on Canada’s equity market swiftly turns that smile upside down. Despite more than doubling in value since 2009, the S&P/TSX Composite Index has vastly underperformed the S&P 500 Index and many of its global counterparts.

This has shown no sign of abating, with investors ploughing capital back into stocks following the pandemic-induced bear market selloff this time last year.

Mike Archibald, VP and portfolio manager at AGF Investments, believes we could be at the start of a shift, with the macroeconomic story for Canadian stocks dramatically improving.

He said: “As unprecedented levels of fiscal and monetary stimulus continue around the world to fight the effects of the COVID pandemic, the structure of the Canadian market should offer investors an attractive opportunity in the years ahead. The primary reason? The S&P/TSX Composite is heavily skewed towards economically sensitive sectors that benefit from policy stimulus, rising interest rates and higher inflation.

“We know the first condition already applies; the second and third are now widely considered possible, and perhaps even likely, for the first time in many years.”

Archibald added that when you examine the Canadian index, it’s pretty easy to see why it’s one of the most economically sensitive global indexes in the world. In total, cyclical and/or inflation-sensitive sectors comprise 73% of the TSX composite weight, compared with less than 40% of the S&P 500, which is geared much more towards secular growth sectors such as technology and health care.

Of the six economically sensitive sectors – financials, materials, industrials, energy, real estate and consumer discretionary – five make up a bigger part of the Canadian index than they do in its U.S. counterpart, with consumer discretionary the exception. On the TSX, financials alone account for nearly 30% of market weight, while on the S&P 500, they comprise only about 10%.

“If reflation truly is the economic story going forward, then the long-term underperformance of Canadian equities might also offer the potential for an attractive turnaround given the TSX composite has lagged the S&P 500 – the global market leader – for so long,” Archibald said.

He added: “For those cyclical, inflation-sensitive stocks on the TSX, the sweet spot of economic fundamentals is coming into focus, as cyclical sector earnings should rebound sharply from the lows of 2020. This offers investors the potential for massive earnings increases in 2021 at much cheaper valuations than they will find in other markets.”

Bloomberg data shows that current consensus earnings estimates for the TSX composite sit at $1,043 a share, which would represent a “staggering” 35% improvement over expected 2020 earnings. That earnings potential is available at a relatively modest price. Bloomberg indicates that the price-earnings ratio of the TSX composite is still under 18 on a forward 12-month basis, which represents a significant discount to both global and North American markets.

Archibald added: “To be clear, we are not suggesting investors should ‘buy Canada’ at the expense of U.S. stock exposures. Those amazing earnings estimates for Canadian stocks are based on the expectation of an upswing in all cyclical sectors.

“Commodity prices will need to remain firm, consumer spending will have to rebound, and bank lending and earnings will have to normalize over the next year. In other words, a lot of things will have to go right. Meanwhile, the framework for an economic rebound in the United States is well in place, which should continue to favour its equity market at least through the early stages of the recovery.

“Yet we believe that Canadian equities might soon be worth a deeper look from investors, as the reflationary themes being laid by governments and central banks should provide a much better backdrop.”