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CANADA OUTLOOK
Canada has benefited from strong growth in the U.S. However, household spending trends remain a key watchpoint as rising mortgage-related costs consume a greater portion of disposable income. Canadian equities, meanwhile, remain a better value than in the U.S. Unfortunately, domestic equities continue to underperform as resource concentration has yet to be rewarded.

Diverging growth trends: external vs. internal

There are several uncertainties clouding the outlook for Canadian growth. Trade negotiations with the U.S. are ongoing (as of this writing), high household indebtedness and the generally wide and volatile discount of Canadian crude oil prices relative to global benchmarks are few prime examples. Despite these challenges, the economy has shown a certain level of “resilience”, as Bank of Canada (BoC) Senior Deputy Governor Carolyn Wilkins remarked in a recent speech. Case in point was second quarter Gross Domestic Product (GDP) rebounding convincingly at a 2.9% annualized rate, making up for a weak first quarter. Additionally, external conditions have underpinned this resiliency. As Figure 1 highlights, since the start of 2018, external and internal trends have diverged. Export strength, (a proxy for external conditions) has improved, while retail trade, (a proxy for internal conditions), has decelerated. However, as higher interest rates lead to increasing household debt service obligations, consumption trends will be adversely impacted. As well, consumption will be further tested if the disappointing August employment report, where wage growth decelerated and the unemployment rate ticked up, turns out to be more than a temporary setback.

Looking ahead, there are reasons to be cautious. While U.S. economic conditions remain firm, the beneficial impact of tax reform and fiscal stimulus may fade over the subsequent year, potentially leading to softening U.S. demand. This of course has direct implications for Canadian exports going south of the border. Moreover, both the U.S. Federal Reserve and the Bank of Canada are projecting “gradual” normalization of their policy rates. Therefore, over the next 12 months we anticipate these headwinds continuing to manifest. For the balance of this year, however, U.S. strength may remain a pillar of support as Canadian households are tested with higher interest rates.

Canadian equity outlook: waiting for a sustained sentiment shift

Last quarter we pointed to early signs of a potential shift in sentiment. Although Canadian equities lagged in January as global equities rallied, with more downside volatility over the subsequent two months, Canadian equities demonstrated “defensive” characteristics compared to the U.S. From February to June of this year, Canadian equities outperformed their U.S. counterparts in local currency terms. (See Figure 2). As it turns out, it was a fleeting moment for domestic equities. As the U.S. equity bull market regained vigour starting in July, the domestic outperformance has vanished. We look to our investment decision-making building blocks of cycle, valuation, and sentiment to assess the current state of Canadian equities:

Cycle: Over the immediate horizon, U.S. economic strength may provide the necessary buffer as consumption trends continue to moderate. While year-over-year economic growth has clearly decelerated from 4% levels a year ago, it is settling into a more reasonable 1.5-2% level for the balance of this year. Monetary policy is a key watch point. Headline inflation at 3% levels should not be too alarming. We believe certain transitory effects will fade as inflation settles back towards 2% early next year. That said, the BoC is gearing to raise rates once more, possibly as soon as its October meeting. However additional hikes must be “gradual” or risk over tightening financial conditions. The business cycle overall is modestly positive.

Value: Based on Thomson Reuters data as of September 5, 2018, trailing price-to-earnings (PE) ratio for the S&P/TSX Composite Index at 16.1x is below its longer-term average of 17.7x, while the forward PE ratio is near its longer-term average of 14.5x and a respectable dividend yield of 3%. Among sectors, we find relative activeness in energy and pockets of cheapness in materials, notably gold. Collectively, valuation is neutral to modestly positive.

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