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Written by: Mike Archibald | AGF
The Canadian stock market enjoyed a good start to the year, as the S&P/TSX Composite Index rose about 6% in the first quarter. True, that performance might pale in comparison to the U.S. equity market, where the S&P 500 Index extended its late-2023 rally. But Canadian stocks’ solid gains so far in 2024 should not be overlooked, as there is reason to believe that the market may gain momentum in the months ahead.
As much as investors in Canadian equities aren’t likely to complain about a 5%-plus quarterly gain, they still might look in envy at U.S. markets, where the S&P 500 rose by about 10% in the first quarter, clearly outperforming the Canadian index. There are some pretty clear reasons for the disparity. One is that the S&P 500 is about 30% weighted in technology, including trendy artificial intelligence (AI) stocks, but technology comprises less than 10% of the Canadian index, which is dominated by financial and natural resource companies. As well, on a macro level, higher interest rates have slowed Canada’s GDP growth (~1% in Q4 2023) more dramatically than in the U.S. (3.4% GDP growth in Q4), and a high proportion of S&P/TSX equities, especially financials, are correlated with economic growth. Given those headwinds, the Canadian market’s steady performance so far this year is remarkable in its own right.
Yet the winds may be turning more favorably. Economically, one factor in Canada’s favour is its strong demographic profile. For the past several years, Canada has enjoyed the highest population growth of any developed country, which should provide a boost to economic growth. The challenge is that productivity continues to lag other countries, but that may change once the hangover effects of the COVID-19 pandemic dissipate. Over the medium term—say, the next two to three years—there is a good catch-up story to be told in terms of Canadian economic growth viz-a-viz the U.S.
In the shorter term, the Canadian interest rate environment may become more benign more quickly than many currently expect. It’s a popular assumption that the Bank of Canada will likely move in lockstep with the U.S. Federal Reserve on easing, and markets have priced in approximately the same number of cuts from both central banks this year. But inflation has come down much further and faster in Canada than in the U.S. Along with a more rapidly slowing economy, lower inflation could give Canada’s central bank more leeway to cut sooner than its counterpart in Washington, which would help allay recessionary fears and provide a potential boost to financials.
On the other side of the growth/recession coin, there are strong indications that the macroeconomic backdrop is shifting from a strong growth/falling inflation dynamic (a “goldilocks” environment) to one in which growth remains strong but inflation may stay elevated, and perhaps even rise further. This reflationary dynamic, which is developing in particular in the U.S., has already driven up prices for oil, gold and copper, and is boosting commodity stocks as well. Commodities can provide a potential inflation hedge, and energy and materials—both heavyweights in the Canadian equity market—could outperform in a reflationary environment. So, too, could banks.
Structural changes in the energy sector provide another potential tailwind for Canadian equities. Canada’s oil-and-gas producers have long been constrained by limited access to global markets, but that is about to change. The Trans Mountain Pipeline Expansion (TMX) is poised to begin commercial operation this spring, and it may increase export of Canadian heavy oil to U.S. and Asian markets by potentially hundreds of thousands of barrels. That could shrink the historical differential between Canadian and global oil prices. Further down the road, LNG Canada, a liquefied natural gas export facility in B.C. scheduled to come online in mid-2025, could provide a similar boost for Canadian natural gas producers. It’s worth noting, too, that these developments are unfolding amid already-resilient global energy prices, and the fact that Canadian producers are practising better fiscal discipline than they perhaps have traditionally is a further structural support.
Given all those factors, there’s a case for optimism on Canadian equities going forward. A lot has to go right for this short term trend to turn into something with more duration and certainly there are risks on the horizon which could challenge this thesis: inflation may prove sticky and limit the Bank of Canada’s ability to cut rates; new energy infrastructure like TMX and LNG are big, complex projects, and their long-term impact is still unclear. Still, one doesn’t have to squint too hard to see the potential for an already solid year for Canadian equities to get even better. In the short to medium term, their performance just might go from “good” to “great.”
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