Chief Investment Officer at Dixon Mitchell says recent oil surge is just part of the story
While many investors might have only recently started favouring the Canada’s broad equity market over its U.S. counterpart’s, Dixon Mitchell has been making its move over a longer span of time.
“Internally, we've been increasing our Canadian asset allocation over the past nine to 12 months,” said Ken O’Kennedy, Chief Investment Officer at Dixon Mitchell.
Globally, O’Kennedy says that Canada and the U.S. have been showing the best earnings among equity markets across the world. But lately, the Canadian stock market has been outpacing the U.S. as energy and materials, generally the two most economically sensitive sectors, benefit from broad and immediate macro tailwinds.
“Both oil and materials are up over 20% for the year,” he says. “Within materials, outperformance seems to be across the board – gold, copper, you name it.”
Not everything is coming up roses for Canada. Information technology, for example has been a negative detractor for the Great White North so far. O’Kennedy says the sector is undergoing a correction after exuberant investors who vastly overestimated the future prospects of the business pushed it to toppy levels.
However, that same trend of correction has played out in the U.S. stock market, where technology as a sector has a much bigger weighting. With both U.S. and Canada officially taking the first steps on their respective rate-hiking cycles, growth-oriented businesses including tech have taken a hit.
“Clearly, oil is the sector that’s benefiting greatly from a macro trend standpoint,” O’Kennedy says. “With Russia’s invasion of Ukraine, I think there’s some level of geopolitical risk premium in oil today.”
The Cinderella story of Canadian oil isn’t all about the war. Since 2014, he says the industry has endured a “long winter” during which it was starved for capital, which has resulted in a substantial lack of drilling inventory. Today, oil companies are far less able to turn on production as they might have been in the past.
But as lucrative as the oil sector might look at the moment, O’Kennedy finds investing in it challenging simply because it depends so much on the price outlook for crude, which itself is peppered with ifs, ands, or buts.
“If there's a floor of $90 or $100 over the next four or five years, then potentially some Canadian energy companies could look very attractive,” he says, noting that it depends on how fast the world can resolve current supply constraints. There’s also the chance that at some lofty price point, there will be a wave of demand destruction among consumers.
Beyond the current winners, O’Kennedy sees potential in other pockets of the Canadian stock market. While he acknowledges concerns about a growth slowdown as Canada pulls back from its most ambitious experiment in monetary stimulus, he says some businesses with the Canadian small-cap universe are the most inexpensive he’s seen in a long time
“When you go into these periods of tightening liquidity, it's not great for those smaller businesses. So we've seen a lot of multiple contraction there,” O’Kennedy said. “And comparing Canada and the U.S. small-cap segments, we’d say Canadian small-caps are more attractive from a valuation perspective.”
The Canadian discount to the U.S. isn’t just confined to the small-cap space; in fact, O’Kennedy says there’s a valuation gulf between the two markets. But that wasn’t always the case.
“At the end of 2010, we made a fairly big decision to dramatically increase our U.S. asset allocation,” he says. “At that time, the Canadian dollar was at par, and the U.S. and Canadian markets basically stood at the same multiple.”
The U.S. market of 12 years ago, O’Kennedy says, would generally have higher-quality businesses than Canada. With the greenback and the loonie at par, they were able to get higher quality exposure for each Canadian dollar they spent. But since then, he says the U.S. market has gotten too far ahead.
“The valuation gap between Canada and the U.S. is large,” he says. “Given the growth prospects and valuations, Canada looks attractive to us versus the U.S. So we’ve started to move some of that allocation back home.”
