January 27, 2023
Composing this outlook during the Christmas season, having watched a variety of shows inspired by A Christmas Carol, I have a Dickensian framework toward the markets, integrating the lessons of the past, the ability to act in the present, and the opportunities and risks of the future. (In thinking about market gains, I’d also cite Oliver Twist’s “Please Sir, may I have some more?”)
To further extend the literary analogy, I’m tempted to cite the opening line from A Tale of Two Cities when thinking about Canadian markets heading in to 2023: “It was the best of times, it was the worst of times.” While the disappointing performance of global markets in 2022 is easily viewed as “the worst of times,” the opportunity to buy quality companies at discounted valuations also makes the beginning of 2023 closer to “the best of times.”
About 2022, I will briefly note that - mathematically speaking – the TSX missed expectations, recording a decline of -5.8%, versus a long run annual average return of 8.7% since 1980. The decline came as war, inflation, quantitative tightening, high tech valuations, and interest rate increases caused investors to revalue their equity holdings amid concerns that each of these risks would reduce economic growth and corporate profitability. The annual return belies the fact that TSX earnings grew approximately 8.5% over the year. However, the P/E multiple put on those earnings fell to its lowest since the depths of the global financial crisis. For investors worried about buying stocks “at the top” or at stretched valuations, 2022 has given us a wonderful opportunity, and we believe that we have already passed the highest level of interest rate pressure on stock market valuations.
Despite its negative returns, the TSX performed reasonably well on a relative basis, outperforming major U.S. indices by a wide margin and performing in-line with global markets in general. Canada has been helped by the strength of our natural resources companies (particularly energy), and a view that our interest rate increases appear to be closer to the end of their cycle than those of the United States and Europe. While Canada has its challenges, particularly with personal indebtedness related to our
housing market, our financial system is well capitalized, our citizens have a high level of savings to support consumption and debt reduction, and at its ~12x price/earnings ratio, the TSX is trading at a very moderate level of valuation relative to other markets.
While the Canadian economy will need to adjust to higher interest rates, the question for investors is not whether a particular event will happen, but it is whether the markets have over- or under-priced its occurrence. To cite a key example, the Canadian financial sector index is down approximately 12%, as investors believe that loan losses will hurt Canadian bank earnings substantially. We recognize this is possible, however we see this view as overly pessimistic and we expect loan losses to remain moderate. Key Canadian funds have been overweight and adding to this sector, and certain banks are trading near valuation levels seen at the depth of the pandemic drawdown in March 2020. This backdrop makes us think that risks are overly priced into Canadian bank stocks.
Additionally, with geopolitical challenges governing the present and political risks likely to be higher in the future, we Canadians may overlook Canada’s clear internal advantages. As a net exporter of agricultural products, energy, and metals, as well as having one of the best demographic profiles in developed markets, Canada is well placed to withstand, and perhaps even benefit from geopolitical factors that challenge other major markets.
It was Yogi Berra (rarely confused with Charles Dickens) who stated, “it’s tough to make predictions, especially about the future.” I agree, but historical precedents give some cause for optimism in Canadian markets heading in to 2023. The first is the long-term fact that stocks tend to go up, and that since 2000, Canadian markets have only once recorded back-to-back losing years, when a cocktail of war, recession, and technology overvaluation sent the index down in both 2001 and 2002.
Although we expect a deceleration of global growth in the world economy, policy changes in China around its re-opening offer up hope that commodity companies across both energy and metals will see a positive backdrop in 2023. While other sectors may see earnings pressure as some Canadians dial back spending due to higher housing costs, if financials, energy, and materials companies (almost 60% of our index combined) have reasonable operating backdrops in addition to their positive valuation backdrops, aggregate Canadian stocks are looking at a much better 2023.
In the past, as long as deceleration in global growth has been cause for rising interest rates to reverse or moderate, the Canadian stock market has done reasonably well. To cite a recent example, after a difficult 2018 in the markets, when global growth slowed but interest rate pressures also eased, the TSX recorded returns close to 22.9%. While we believe economic slowing is likely to occur in 2023, stock market valuations have already factored this into their thinking and, in my view, offer up a greater chance of a positive surprise than a negative one.
Overall, we are constructive on Canadian equities for 2023, particularly on a relative basis versus other developed markets. In their personal and financial lives, we wish all of our clients a joyful and successful 2023.
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