For the last two years, the Toronto Stock Exchange (TSX) has been under fire for its underperformance if compared with U.S benchmarks, such as the DOW or the S&P 500. At the time of writing the TSX had a mere 3.29% increase in a 2-year period, whereas the DOW index is climbing 39.45% and the S&P 500 28.69%.
The purpose of this article is to address the concerns surrounding the TSX’s shortfall. In brief, the main problems are summarized as follows:
• The United States economic position
• Rising interest rates
• Federal Liberal Government
• Overconcentration – TSX not reflecting Canada’s economic performance
United States Economy
In financial terms, we can think of an “index” as an average of the performance of all the stocks represented by it. In particular, the TSX index has been limping around the break-even level for the last two years. In January 2018 was the month where the bulk of U.S indexes began their climbs, whereas the TSX has taken its own route [1]. Inquisitively, the climbs begin precisely when Donald Trump was sworn in as the 45th president of the United States. Immediate promises on tax cuts, deregulation and infrastructure investment fuelled the market’s perception of government spending.
Graph 1: DOW vs. S&P 500 vs. TSX Performance
Trump elected President
Source: Yahoo Finance
President Trump’s promised corporate tax cuts made the Canadian tax system less competitive by comparison, and this effect was fuelled by the President’s intention to revise business regulations. By providing corporate tax incentives, and easing policies in the form of deregulation, it is far more attractive for businesses to set up their operations in the US rather than in Canada. In the next 10 years, President Trump’s tax plan is expected to cut over $5.5 Trillion in all sectors of the American economy [2]. An example of these tax cuts in action can be seen in the large, commercial banks. Canada’s six largest banks collectively increased profits by 10% to a whopping $11.7 billion at the end of the 3rd quarter of 2018. These tax cuts have, in essence, made American banks more competitive, after Trump’s corporate tax cut of 35% to 21%. In addition, these will also help end the offshoring of corporate money by transitioning the country to a territorial system of corporate taxation enforced by anti-abuse rules for multinationals that shift profits offshore. As stated by Tony Scherrer, director of research and portfolio management at Seattle-based Smead Capital Management:
Canadian banks are run well and everything, but where they’re sitting in our view is not as attractive as where our U.S. banks are in terms of opportunity.
Trump’s proposed lower tax rates are expected to generate excess $10 Billion in annual profits for Wall Street’s largest banks. In addition, the tax cuts have also helped the Investment Banks to roll out more than $29 Billion in net profit in Q1 and Q2 of 2018, which in return make investment opportunities far more interesting in the United States than in Canada [3]. These tax incentives have also guaranteed more than 3.5 million American workers across more than 300 companies additional bonuses and raise. Many companies have also announced new investments and new hiring, building on America’s economic momentum [4].
Rising Interest Rates
In July of 2017, the Bank of Canada raised interest rates in an attempt to boost their confidence in the Canadian economy [5]. A second increase was followed in September of 2017. The reason this lead to a market drop is simple. In general, interest rates increase to justify a surge in inflation. However, Canada’s economy is very vulnerable to rising interest rates given how much debt has been accumulated.
Graph 2: Canadian Federal Debt as a % of GDP
Source: TradingEconomics [6]
What does the rise in these interest rates mean for the TSX performance and investor’s portfolios? This question is dependent mostly on the weighing of each sector of Canada’s economy on the TSX. The biggest ones are commodities, housing and principally, financials. On balance, these sectors are much more exposed to interest rates than other sectors whereas in the US technology and consumer goods are predominantly larger in the index. In essence, these sectors are less exposed to interest rates, and react slower – if anything at all, to adjustments. The Bank of Canada is essentially increasing the cost of borrowing for investors, and as a consequence, the cost of investing for margin accounts – these are accounts offered by brokerage firms that allow customers to borrow money to invest in securities or any other asset class.
In the short-term, investors who hold stocks are likely to sell after interest rates increase, lowering the stock’s value, but if economic growth also pushes the market into increasing returns, then the change in the stock’s value is barely noticeable and the TSX remains uniform.
Nonetheless, the Bank of Canada’s actions can be beneficial for investors in the long-term, because new investments in bonds can be made at higher interest rates so they will yield more in, for example, a 10-year Canadian bond. However, higher interest rates have broader implications on how asset classes are priced. By increasing rates, investments in the country look worse by comparison, especially for high-dividend paying stocks such as Enbridge Inc (TSX: ENB) or TransAlta Corporation (TSX: TA), both listed in the NYSE and the TSX [7].
Federal Liberal Government
Justin Trudeau has been an impeding force against foreign investment in Canada. Referred to as “the Trudeau effect”, the leader of the federal liberal government has enforced policies that aim to make workers more important than shareholders. The liberal government favours taxing corporations and the wealthy, adding more regulatory impediments to business operations, and is a supporter of income redistribution. In Trudeau’s view, the idea is for companies to adhere to the liberal government’s social views and economic philosophies [8].
In this context, economic performance could be looked into instead of the stock market to justify the liberal government’s views. However, we need to quantify how successful the economic performance has been since surely it is correlated with the stock market.
Graph 3: iShares S&P/TSX 60 ETF in Canada vs. SPDR S&P 500 ETF in the US
Source: Yahoo Finance
Trudeau’s government was elected on October 19, 2015. The graph above shows two large-cap, and highly liquid ETF’s. These two Exchange Traded Fund devices are designed to track the performance of the S&P500 (in red) and the TSX (in blue) for the period of January 2016 until October 2018 in terms of percentage return. Between January 1st, 2016 and January 1st, 2017, the TSX ETF (in red) had a mere return of 15.3% against the S&P 500’s 22.3%. In addition, between January 1st, 2017 and December 31st, 2017, the TSX ETF reported a disappointing 6.8% against S&P’s impressive 26.3% return. More recently from July 2018 until the end of September 2018, the U.S market has outperformed Canada’s TSX by 28.8%.
The graph illustrates the increase in the underperformance of the TSX in a technical manner since the beginning of 2016. The graph also indicates that there has been a fundamental change in the Canadian economy in the last two years. Investors in Canadian equities originally gave the benefit of the doubt to the Trudeau government, but since the federal Liberal government’s policies were put into practice, the Canadian TSX began underperforming.
Final Thoughts – Overconcentration
In addition to the evaluation made of the TSX underperformance, I believe that there is one important element to add in this equation. In the TSX, financials account for 35.3%, energy at 20.1% and materials at 11.8% [9], indicating that the problem may also be overconcentration.
Financials make up a third of the index, and the sector has dropped by 1%. Although this isn’t a significant drop, the three sectors make up nearly two-thirds of the index. This means that technology for example, which only has a 3.2% weighting in the index is nearly insignificant. Tech stocks seem to be the ones with the highest investment potentials. In fact, one statistic shows that in the US markets, tech stocks account for 102% of total return – indicating another reason why the S&P500 has outperformed Canada’s TSX. Canada has some great tech companies such as Shopify and Constellation Software, but their contribution and profit do not seem to have enough weighing in the TSX.
One could argue that giving each sector a different weighting in the basket would solve the problem. However, the composition is actually substantially reflective of Canada’s current economic position, suggesting that the root cause of the problem may lie in the need to diversify and be more competitive at a global level.
[1] https://www.cbc.ca/news/business/canada-stock-market-performance-laggard-1.4526473
[6] https://ideas.nationalbank.ca/how-an-interest-rate-increase-will-affect-your-portfolio/
[7] https://tradingeconomics.com/canada/government-debt-to-gdp
[8] https://ca.finance.yahoo.com/news/5-reasons-why-tsx-composite-132606500.html
Master in Finance student at Imperial College London
