When<br /> two countries are as interconnected as Canada and the US, it is often<br /> the case that their respective economic circumstances are at least<br /> somewhat similar. For these two North American neighbors, however,<br /> their economies and stock markets have diverged considerably over<br /> recent months. This shouldn’t come as too much of a surprise, as we had<br /> indicated in our last newsletter that leading economic indicators of<br /> each economy were already signaling a slow down in Canada’s economy and<br /> a much awaited resurgence of the US.<br />
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Canada & the USA, a Tale of Two Economies
Canada Out-of-Step With the US
When two countries are as interconnected as Canada and the US, it is often the case that their respective economic circumstances are at least somewhat similar. For these two North American neighbors, however, their economies and stock markets have diverged considerably over recent months. This shouldn’t come as too much of a surprise, as we had indicated in our last newsletter that leading economic indicators of each economy were already signaling a slow down in Canada’s economy and a much awaited resurgence of the US.
It is important to point out that stock markets are only a partial reflection of the overall economy. And despite ebbs between the performance of Canadian and US economies, historically their two stock markets have been highly correlated. More recently, however, a pronounced divergence has emerged with Canadian stock markets remaining relatively flat over the last year as US stocks marched higher. This disconnect is illustrated below.
If one were to search for an explanation for this divergence then the fundamentals of the Canadian economy and slowing global commodity prices are a great place to start. One of the biggest reasons for this underperformance has to do with the makeup of the two countries’ markets. Approximately 40% of the Canadian stock market is made up of natural resource stocks – more than double the 15% resource exposure of the S&P 500 (US Stocks).
Canada’s Decade of Success
For much of the last decade, rising commodity prices were a strong tailwind to Canadian equities. The world was knocking on Canada’s door. The allure of the riches of the Canadian oil sands, robust commodity consumption from China and an appreciating Canadian dollar made Canadian equities attractive assets. As this went on, the capital inflows into Canada from around the world made Canadian equities even more attractive.
The Energy Sector
The Canadian energy sector, which comprises over 25% of the S&P/TSX index, has in large part acted as an anchor on Canadian equities.
While the price of oil has stayed relatively high, Canadian oil companies have not been able to benefit as much as their US counterparts. In fact, for much of 2012, Canadian oil companies were receiving up to $20/barrel less for oil shipped to the US. This was due to limited US refinery capacity, pipeline constraints, and rising US oil production that combined to create a glut of oil.
Profits for the Canadian energy sector declined by more than 50% in 2012, to a little more than $7 billion which is on par with 1999 levels. As the sixth largest oil producing nation in the world, the discount that Canadian oil companies receive on their crude production has an economic impact. Estimates indicate losses due to the discount in pricing to be upwards of $15 billion to $18 billion per year.
This issue will likely continue to confront our oil producers for some time as pipeline capacity will continue to be constrained even if the Keystone XL pipeline wins approval later this year from the Obama Administration. The 830,000 barrel/day pipeline would not start moving oil until late 2014 at the earliest. The chart below illustrates its proposed route from Hardisty Alberta to Cushing Oklahoma.
Chart source: Canadian Association of Petroleum Producers (www.capp.ca)
As investor confidence has been jarred by the developments in the Canadian oil sector, it has left many of the largest oil producers in Canada trading at very cheap valuations – rivalling the levels reached during the recession. These valuations plus their strong track records of dividend growth has made them very attractive investments. After releasing first quarter 2013 earnings, Canadian energy giants, Suncor and Canadian Natural Resources raised their dividends by 54% and 21% respectively.
The catalyst to unlock this value and move stock prices higher will come from the approval of new pipelines that will move Canadian crude faster to the US Gulf Coast, Eastern Canada and to the Pacific Coast where Canadian oil companies will be able to access Asian markets. The access to Asia is especially important as US energy production continues to rise and China assumes its expected title of world’s largest oil importer. According to the International Energy Agency, US production of oil will help to lower US oil imports from 10 million barrels/day in 2010 to about six million/day by 2035. As of the end of April 2013, US oil production stands at 7.3 million barrels/day which is up nearly 20% from a year ago.
Commodities Sector
Another drag on the Canadian stock market has been the sharp drop in agricultural and base metal prices. Commodity stocks represent almost 20% of the Canadian stock market while they are less than 1% of the US S&P 500.
Copper has earned the nickname of “Dr. Copper” for its reputed ability to call turning points in the economy. Oftentimes, copper prices have turned higher or lower in anticipation of the economy’s turning points. Copper prices have fallen by about 5% over the last two years. A large part of the reason for the decline in copper prices is likely due to fears about the Chinese economy.
China’s leadership has made a central plank of its policies the intention to make the Chinese economy less reliant on construction and capital investment. The excessive reliance on construction and capital investment has led to fears of a bubble in property and overinvestment in various industrial sectors. In addition, the European Union is the second largest consumer of copper and it is mired in recession which has hindered copper demand further. Offsetting this weakness is the budding rebound in US construction.
Financial Sector
When the Great Recession ended in 2009, Canadian banks were trading at a significant premium to banks in most countries. Gradually, the rise in the stock prices of US banks has helped to narrow the valuation gap between Canadian and US banks. In recent quarters, investor fears about Canadian consumer debt and elevated house prices have made investors cautious on Canada’s banks. The fear arises from the distinct possibility that a decline in Canadian real estate will impact banks through rising mortgage defaults and a made-in-Canada debt-reduction process.
North American Economic Landscape
When the Great Recession ended in 2009, one of the most repeated predictions was that the US savings rate would rise to match the levels of the 1960s and 1970s. The thought was that consumers had undergone a generational change in mindset towards spending and saving as a result of the economic turmoil that had enveloped the global economy. After a brief rise in the immediate aftermath of the Great Recession, the personal savings rate in the US has fallen once again to 2.3%. While this has helped the US economy achieve one of the best economic growth records amongst the advanced economies, the low savings rate is a function of poor wage growth. In fact, wages as a percent of the US economy are at a record low.
Stagnant wage growth has helped to propel US corporate profits and they are now at a record level as a percentage of the US economy. As Ron Perelman, the chairman and CEO of Revlon stated recently in an interview:
“Unfortunately what is good news for American industry…is bad news for those looking for work …We’ve rationalized our businesses over the last five years… those people that we laid off in 2008-2009, there’s no need for us to hire back … We’ve gotten more efficient and we’ve gotten more productive.”
– CEO of Revlon
As the current economic recovery has been sub-par by historical standards, corporations have struggled to maintain revenue growth so they have been focusing on cost controls to help meet profit expectations. Corporate profit growth in the US was lower in 2012 than 2011 but the US market has been able to overcome slowing profits because investors have given the economy the benefit of the doubt. The Price-to-Earnings (P/E) ratio has risen to about 16 – meaning investors are willing to pay $16 for each dollar of corporate profits. This has allowed the market to continue higher as central banks around the world are going to remain ultra-accommodative and help to ensure liquidity is well supplied to the markets. Though economic data has been disappointing in recent weeks, investor confidence is strong and the demand for equities has been resilient.
Pacifica Partners Capital Management Inc.
This report is for information purposes only and is neither a solicitation for the purchase of securities nor an offer of securities. The information contained in this report has been compiled from sources we believe to be reliable, however, we make no guarantee, representation or warranty, expressed or implied, as to such information’s accuracy or completeness. All opinions and estimates contained in this report, whether or not our own, are based on assumptions we believe to be reasonable as of the date of the report and are subject to change without notice. Past performance is not indicative of future performance. Please note that, as at the date of this report, our firm may hold positions in some of the companies mentioned.
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