It is interesting to see the performance gap between the U.S. and Canada begin to narrow in recent weeks.
The U.S. is a growth stock market, while Canada is deep value. Late-cycle investing means rotating towards value. Canadian stock market valuations and equity risk premiums are among the most compelling at the moment.
The Fed is tightening by raising rates and unwinding its massive balance sheet. The Bank of Canada is on hold and since it never embarked on QE, it does not have to resort to QT. And being relatively commodity-sensitive, the Canadian market is a much more effective hedge against inflationary pressures, which is why Canada always outperforms the U.S. late in the investment cycle.
So the answer is yes, Canadian equities can rally as the U.S. market falters or even heads into recession — and there is precedence for this “decoupling,” believe it or not.
For example, from August 2007 to August 2008 — a full year — the TSX rose 80 basis points while the S&P 500 sagged 13 per cent. The reason? Oil prices surged 56 per cent and that helped the TSX energy sector advance 16 per cent. The spillover to materials was notable too — up 15 per cent even as the U.S. economy went into recession (Asia, being the marginal buyer of commodities, is far more important).
There was also a hiccup in the U.S. stock market in 2005 — the S&P 500 was off around 40 basis points for the first ten months of that year, while the TSX rose more than 12 per cent. Again, because of oil prices, as they surged 38 per cent back then and the TSX energy space jumped 45 per cent.
The U.S. endured a double-dip downturn in the first half of 2002 as well, with the S&P 500 sagging six per cent and the TSX advancing more than three per cent. What do you know? Crude oil soared 30 per cent, yet again, and Canadian energy shares ran up 20 per cent and were the clear reason for the ‘delta’ in overall performance between the two countries.
And as the dotcom bubble burst in 2000, the “growthy” U.S. stock market slumped nine per cent while the TSX increased a healthy 13 per cent. Once again oil rose 106 per cent and the TSX energy space soared by 97 per cent. And in that 1994 period when the Fed began the mother of all tightening cycles, U.S. financials really took it on the chin and the S&P 500 dipped one per cent while the TSX firmed up 3.5 per cent — and as a final exclamation point, oil prices were up 19 per cent and this helped the TSX energy complex to a 10.5 per cent gain.
This whole discussion seems to raise some eyebrows, as many are surprised that the Canadian stock market can indeed generate a positive return and minimally protect capital as the U.S. heads into a bear market and/or recession. But this is not an opinion, it is a fact — it has happened in the past, and for periods longer than six months too, not merely six weeks.
It is, however, a case where the circumstances must fit, as in when oil and commodities, generally speaking, are in rally mode. You see, commodity prices are more influenced by China than by the U.S. — the former is still so “goods-driven” while the latter is “services driven.”
For example, the correlation between the Chinese economy and the CRB Index is over 80 per cent whereas the correlation with the U.S. economy is 68 per cent. So when China is growing just enough or when we get supply discipline from global producers to such an extent that commodity inflation comes to the surface, the Fed generally tightens policy. All the more so when we are late in the cycle. So actually, the commodity bounce is often at the root of the rate hikes that generate the U.S. recession. As for those who don’t believe in “decoupling,” Canada did not incur an official recession in 2001 during the tech wreck and the U.S. recession that began in late 2007 only became a problem for Canada nine months later when the Lehman and AIG collapse caused a near-global depression.
The Canadian stock market, given its global nature, is actually only 68 per cent correlated with Canadian GDP, but guess what? Given its still-high commodity exposure, it is 84 per cent correlated to the Chinese economy! That is even higher than the 78 per cent correlation that Canadian stocks have with the U.S. economy, but take note that even the U.S. economy is more of a dominant force on Canadian equities than Canadian GDP! Do you not see all those comfy green TD couches along the entire U.S. east coast?
But what is really special about these periods of late-cycle U.S. market and economic behaviour, is that the best place to hide traditionally is the Canadian energy sector. This part of the Canadian equity space has the lowest correlation of all to the U.S. stock market — just a 34 per cent relationship (not to mention just a 23 per cent correlation to U.S. GDP). For the broader material sector, the correlation to the SPX is a mere 18 per cent (by way of comparison, TSX Industrials have a 95 per cent correlation to the SPX, and the Canadian Consumer stocks are not far behind; Financials have an 80 per cent correlation).
David Rosenberg is chief economist and strategist at Gluskin Sheff + Associates Inc. and author of the daily economic report, Breakfast with Dave.
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