After prolonged underperformance, Canadian equities look attractive
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Current Insights
When the COVID-19 pandemic began in early 2020, like the rest of the world, Canada's economy suffered. But more than a year later, the outlook for the Canadian economy and corporate earnings looks brighter.
This sentiment is driven by expectations for widespread vaccine availability across the country in the coming months and ongoing policy support as more Canadians get their COVID-19 shots. Over 60% of the country's population has received at least one dose.1
Another reason are factors such as strength in the country's commodities and financial sectors, accelerating business activity, a stabilizing employment picture and a resilient residential real estate market.2
This means that after a period of significant underperformance compared to other markets, Canadian equities - whose valuations are low relative to global market peers - look attractive. This raises expectations for relative outperformance for the S&P/TSX Composite Index.3
So, what are some specific parts of the Canadian stock market that TD Asset Management Inc. currently considers promising, and what are the trends driving them?
Producers of fertilizer benefiting from global potash demand
Canada is the world's largest exporter of potash, a salt used as a fertilizer which is mined from evaporated sea beds and is rich in potassium.
Thus, the country's fertilizer companies stand to benefit from the growing global demand for potash. The demand for potash has been driven by an increase in crop prices, which has encouraged farmers to boost agricultural production and their use of fertilizers.
The largest potash consumer, China, has imported 3.5 million metric tons of the fertilizer year to date as of April 2021, which is 21% higher than the same period of 2020.4 This growth in demand could continue as Chinese import inventory moved down to 2 million metric tons recently, the lowest level in two years.5
Similarly, the second and third largest potash consumers, Brazil and the U.S., are also importing record-high volumes of the fertilizer this year, with growth of about 30% from a year ago.6
Rebound of energy sector
Canada's rebounding energy sector also looks attractive.
Both globally and in Canada, the energy sector was the largest underperformer last year. But now that oil prices have recovered to levels where companies can generate strong profitability, there has been a rotation of capital back into the sector.
After bottoming in March 2020, the valuations of energy companies recovered to pre-pandemic levels recently, and they remain attractive from a long-term perspective. This is due to three reasons: oil prices remain north of $60 a barrel, global oil demand continues to recover, and energy companies have adopted leaner corporate structures as they have slashed expenses and capital expenditures, helping maximize free cash flows.
However, cash flows have yet to recover to pre-pandemic levels, and improving macro dynamics along with leaner business models provide further room for the recovery to run.
Over the next 12 months, we expect that integrated energy companies in particular - which are involved in the exploration, production, refinement and distribution of oil and gas - will be a good investment opportunity, as these companies have exposure to both the production and refining side of the business. While current oil prices promise a long-term upside, we believe that near-term opportunities lie in refining assets, where margins and utilization rates have only recently begun recovering.
Strong banks
Canada's banks are another segment of the market that looks promising.
One way to measure the strength of Canadian banks is to look at the capital they hold on their balance sheet. Canada's Office of the Superintendent of Financial Institutions sets a minimum capital requirement: banks are required to have a minimum Common Equity Tier 1 ratio - the ratio of a bank's core equity capital to its total risk-weighted assets – of 10.5%.
The six big Canadian banks currently hold $50 billion of capital above this minimum requirement, roughly equivalent to 8% of their market cap.7
Another measure is to look at the level of reserves that banks have set aside against potentially bad loans, known as Allowance for Credit Losses (ACL). Over the past 12 months, ACLs as a percentage of loans have increased to 1% of loans outstanding, which is comparable only to peak levels during the Great Financial Crisis of 2008.8 At the same time, we have yet to see any significant deterioration in actual credit performance.
Attractive valuations
Canadian stock prices are currently competitive, with room for them to rise.
The S&P/TSX Composite Index has experienced an extended period of underperformance, which makes it attractively valued when compared to global market peers.
Relative to the U.S., Canadian stocks continue to trade at a discount as measured by forward price-to-earnings multiples, creating potentially appealing opportunities for investors.
1Source: Data from Government of Canada as of June 5, 2021: https://health-infobase.canada.ca/covid-19/vaccination-coverage/
2Source: /ca/en/asset-management/institutional/insights/summary/market_perspectives_q2_2021/
3Source: /ca/en/asset-management/institutional/insights/summary/market_perspectives_q2_2021/
4Calculations made by TD Asset Management Inc., using raw data from Bloomberg and company reports.
5Calculations made by TD Asset Management Inc., using raw data from Bloomberg.
6Calculations made by TD Asset Management Inc., using raw data from Bloomberg.
7Calculations made by TD Asset Management Inc. based on company disclosure for the big six Canadian banks.
8Calculations made by TD Asset Management Inc. based on company disclosure for the big six Canadian banks.
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