What’s really wrong with the laggard TSX

You have to wonder why Canadians are investing their money outside the country like never before.

Investment in foreign securities hit $29.4 billion in December — largest net outflow of purchases into foreign stocks and bonds on records going back to 1988.

Foreigners also have less appetite for Canadian equities, dumping a record $48.7-billion worth last year.

The easy explanation for the stampede out of Canada would be performance. Last year the S&P 500 beat the S&P/TSX composite index by nearly 13 percentage points. This year the TSX is up about 5 per cent year over year, a far cry from the near 30 per cent gains in its American counterpart.

“On the technical side, the old truth is that Canadian equity indices often just don’t have much exposure to what is working, and that couldn’t be truer today,” wrote Robert Kavcic, senior economist for the Bank of Montreal, i n a note on Friday .

Most of the growth in the S&P 500 has been driven by surges of 30 to 60 per cent in technology, communications services and consumer discretionary. These three sectors make up 50 per cent of the S&P 500, but just 17 per cent of the TSX, he said.

Canada doesn’t have a Nvidia Corp, Microsoft Corp , Amazon.com Inc, Meta Platforms Inc or Apple Inc , the five companies of the socalled Magnificent Seven that alone have racked up almost half of the net 1,200 point increase in the S&P 500 over the past year, he said.

Canada’s market is also more susceptible to the pressures of higher interest rates in sectors like utilities, real estate and telecom services.

But Kavcic argues there are also fundamental forces at play. It’s not just the TSX that is underperforming the S&P 500, it’s Canada’s economy.

While real gross domestic product grew 3.2 per cent in the U.S. over the past year, Canada’s GDP grew by just 1 per cent, he said. The gap between per capita growth was even wider, a “historic” 4.8 per cent.

“Interestingly, serious underperformance of Canadian equities since early 2023 has almost perfectly flagged this relative weakness in the real economy,” he said.

Like the TSX, Canada’s economy is also more rate sensitive than America’s. While Canadians are struggling with higher payments after their five-year mortgage renewed, Americans are still enjoying low rates under their 30-year terms. That’s cutting into consumer spending in Canada which is 1.5 percentage points lower than in the United States, said Kavcic.

Canada’s slowdown is showing up in corporate profits that dropped to 6 per cent of GDP in the past year, while remaining steady in the U.S. Labour costs in Canada are also increasing more than south of the border, squeezing margins.

Then there is our dismal productivity. Over the past five years, productivity in Canada’s business sector has fallen 0.3 per cent, while it has grown 1.7 per cent in the U.S.

On the bright side, Canadian stocks are relatively cheap. Kavcic says the TSX is trading at 14 times forwardyear earnings compared with 21 times for the S&P 500, “about as wide a gap as we’ve seen historically (think end of the late-90s tech boom.)”

“That’s good news if you believe that sentiment toward Canada is in the tank, and these factors will eventually correct themselves, allowing valuations to normalize,” said Kavcic. “It’s less good news if it’s just a value trap reflecting weaker fundamentals going forward.”

The bottom line: “Canada’s poor relative equity market performance is both technical and fundamental; but, it’s always darkest before dawn.”