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U. S. DOLLAR’S BIG RALLY IS LOSING STEAM — HERE’S WHAT INVESTORS SHOULD LOOK AT NEXT.
The past few years have not been very kind to Canadian investors, with the loonie collapsing back down to 2003 levels and the S& P TSX underperforming the S&P 500 by 7.8 per cent per year since the bottom of the financial crisis.
As a result, it wasn’t surprising to see investors chasing these U. S. returns by piling into anything U. S.-dollar- related last year. ETF funds flow data, for example, shows Canadian equity ETFs represented only 7 per cent of the total net inflow compared to 34 per cent into U.S equities.
Given the benefits of diversification, we would normally not complain that Canadians are finally investing abroad. The magnitude and timing of this shift, however, are cause for concern because investors are notorious for making such decisions at the wrong time.
For example, investors were herding into Canadian equities — and especially resources — at the tail end of the commodity bull market that ran from 2001 through the end of 2007. This isn’t surprising as the S&P/TSX composite index delivered a 7.4-percent annual return over this period compared to the S&P 500’s paltry 3.3 per cent.
Eight years later, investors are once again chasing recent returns and selling Canadian equities and moving international, especially south of the border. The S& P 500 is up 11.6 per cent per year over the past five years, while the S& P/ TSX composite is up only 2.1 per cent.
When looking at the factors driving this outperformance, our inner contrarian has us wondering just how sustainable this gap will be going forward. If the latest quarter’s performance is any indication, this trade may already be starting to unwind — the S&P TSX is up 4.5 per cent compared to the S& P 500 that was up 1.35 per cent and a negative 4.9 per cent in Canadian dollar terms.
We are keeping a very close eye on three key factors that could result is this becoming a trend over the remainder of the year.
Firstly, the U. S. equity market has a much smaller resource weighting than Canada, which has been work- ing to its benefit until just recently. In particular, the S& P TSX has a 20-per-cent weighting to energy and 11- per- cent weighting to materials compared to the S& P 500’s much lower 6.8- per- cent and 2.8- per- cent respective weightings.
This is important as we think the commodities market has reached a bottom, having been heavily oversold and vastly under-capitalized for a couple of years now. History has shown that an oil- price bottom precedes an economic recovery and to see the oil price move higher with equity markets is a very encouraging sign.
Secondly, the U. S. Federal Reserve is not happy about the rocketing U.S. dollar that is up 40 per cent from its mid-2013 lows against the loonie and until recently, was setting highs against other major global currencies as well. This large move is no doubt impacting U. S. corporate profitability with S& P 500 companies expected to post an 8.5- per- cent decline in earnings this past quarter, according to Factset data.
We think the Fed is very much aware that most other major central banks are stimulating and is therefore are not keen on inflating the U.S. dollar any further via another rate hike this year. Interestingly, speculators have been hedging their bullish stance a bit on this with the U. S. dollar index (DXY) falling 4.3 per cent in past quarter, while major currencies such as the euro gained 4.8 per cent.
Finally, U. S. equities have benefited from a record amount of share buybacks representing over six times more stock purchased than ETF and mutual fund inflows, according to Bloomberg. This year alone buybacks accounted for a whopping 93 per cent of total net purchases of U. S. stocks, according to Bank of America.
We do not think this is sustainable longer- term, and wonder perhaps what the performance of the S& P 500 would be in absence of financial engineering growth through buybacks.
Therefore, if one happens to be bullish on equities we believe the best opportunities still remain closer to home.