Since the beginning of the year, Canadian equities have been on a (relative) tear, outpacing most developed and emerging market equities in Canadian dollar terms…but this recent brush with greatness begs the question: Is this year’s success the beginning of a long-term trend or a brief flash in the pan?
Looking back at data since the 1970s, regional equity markets have indeed experienced extended stretches of market leadership followed by long periods of underperformance, according to data from MSCI. To understand the whims of market leadership, I looked at 5-year and 10-year annualized returns in the U.S., EAFE (Europe, Australasia, Israel and the Far East) and Canada (see the chart below). In the 1980s, EAFE generated the strongest returns but then lost its leadership in the 1990s as the pole position swung to the U.S. and its better economic momentum and growing technology hubs. Canada pulled ahead throughout much of the first decade of the new millennium as commodity prices firmed around a broadening emerging market growth story and then a more muted exposure to the 2008-09 global financial crisis.
Market leadership through the lens of valuation metrics, however, tells a somewhat different story (see the chart below). On the one hand, price-to-book ratios rose steadily when EAFE and the U.S. were in the lead. In other words, part of the reason EAFE outperformed in the 80s – and the U.S. rocketed ahead in the 90s – had to do with expanding multiples and growing enthusiasm for these regional stock markets but Canada’s long window of success came more as a result of contracting multiples and waning enthusiasm in the U.S. and Europe, rather than booming euphoria about the outlook for Canadian stocks. Comparatively speaking, valuations on Canadian equities have been much more steady than has been the case for the U.S. or EAFE.
Up until this year, the U.S. markets had been in the fast lane since the end of the global financial crisis. This is largely because of better profitability and a more sustained increase in valuation multiples. By contrast, Canada’s leg up during 2016 has come more from a snapback in deeply depressed industry sectors, such as energy and materials, as well as better relative performance from Canadian financial institutions.
Valuations between the three regions are not as extreme as in past periods when market leadership made a decisive turn. While Canada may be cheap to the U.S. (and slightly expensive relative to EAFE), profitability is not yet at a point that would justify Canada breaking away from the pack. Improvement in commodity prices and the Canadian economy could permit continued modest outperformance of Canadian equities this year, but this would only represent a short-term tactical opportunity. As for calling this year’s strong start the beginning of a new era of leadership for Canadian stocks, I think it’s still too early.