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What's behind the billion-dollar move into Canadian stocks?

Canadian Border

Whether or not you're an American planning a move to Canada after the election, there's good reason to embrace the northern neighbor of the United States right now: Its stock market is soaring.

Since January the S&P/TSX Composite Index has climbed 14 percent, according to S&P Global Market Intelligence, more than double the S&P 500's 6 percent year-to-date gain. That's made the country a favorite destination for investors. With near-$1 billion in net inflows, the iShares MSCI Canada ETF (EWC) has received the most new money of any non-U.S. country fund so far this year.

Some might hope these gains are thanks to Justin Trudeau, Canada's recently installed easy-on-the-eyes prime minister, but domestic issues don't tend to drive the Canadian market. Those caught up in the U.S. presidential election may wonder if it's a "what if Trump wins" preemptive move. But there's a more obvious, nonpolitical explanation.

Don't blame — or credit — Trump

Ups and downs in the Canadian stock market and economy are typically caused by the price of oil and other commodities.

When China's slowdown started and demand for commodities decreased, the country's mining and minerals sector, which make up about 13 percent of its stock market, tanked. When crude oil prices crashed, so did Canada's energy sector, which makes up about 20 percent of the market. Since July 2014 the S&P/TSX Capped Energy Index has plummeted 40 percent in local currency terms, while last year the entire market was down by nearly 12 percent.

Now that oil prices have stabilized and have even climbed about 30 percent year-to-date, according to S&P, the Canadian stock market has rebounded. Gold, another big industry in Canada, has also seen a 24 percent gain in its price. "Canada is very tied to commodities, and this year is one of the better environments for those sectors," said Stephen Lingard, a portfolio manager with Franklin Templeton Solutions.

Top Canadian equity funds

Name
YTD return (%)
1-yr return (%)
3-yr return (%)
RBC Canadian Mid-Cap Equity Class Adv 26.7 24 7
DFA Canadian Vector Equity Class A 23.5 24 3.2
Galileo High Income Plus Class A 23 17.6 1
PH&N Small Float 22.8 23.3 14.4
Fidelity Canadian Opportunities Sr A 22 17 9.6
Marquest Small Companies 20 11.5 -0.95
DFA Canadian Core Equity A 20 19.1 5.1

(Source: Morningstar, 9/26/16)

A similar stock rebound has been taking place in other hard-hit commodity economies, including Brazil and Russia, which have posted year-to-date returns ever greater than Canada. Peru, a base-metals economy, is second to Brazil this year in country stock market performance.

Last week the news of an OPEC deal to cut production — the first notable agreement since the oil price collapse of 2014 and first production cut since 2008 — buoyed crude prices. But doubts remain about follow-through on the deal from OPEC members, as well as the extent to which a production cut would propel further oil price gains. Goldman Sachs said it was making no change to its oil price forecast through 2017 — $43 through the end of this year and $53 a barrel in 2017.

Rising oil prices also impact Canada's currency, which after a couple years of declines has strengthened considerably against the U.S. dollar. Since the start of the year, the greenback has fallen by more than 5 percent against the loonie, which means that even if the Canadian market was flat, you'd still make money off that currency movement. "The Canadian dollar has bounced off the bottom," Lingard said. It's a currency move that has benefited a broad Canadian stock fund like EWC, which is up 19 percent this year — its total return without the currency move is roughly 13 percent.

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As good as these gains have been, why would an American want to invest in Canadian stocks? One reason is that, as commodity-driven economies go, Canada is a much safer place to invest in than other commodity-rich countries, such as Brazil and Russia. While both of those nations have seen bigger market gains this year, they're much more volatile than Canada. And while Canada is, of course, not an emerging market, people do lump the country in with these developing countries because of its oil and materials exposure. If you do want that commodity exposure, it makes a lot of sense to buy Canadian.

"If you're investing in a commodity-heavy index, downside risk is very important," said Risteard Hogan, lead manager on the Fidelity Canada Fund. "In Canada there's a rule of law; there's corporate governance. In emerging markets there's not an immaterial chance of getting an asset appropriated. Investing in Canada is a much higher-quality way of owning these businesses."

Hogan understands why people compare Canada to emerging markets, stating that the country has a lot more to offer than oil. There are a number of high-quality companies, similar to what you might find in the United States, but structurally may be even more attractive. The telecom space, for instance, is an oligopoly, where three big players generate most of the revenue. Canada also has century-old rail companies — Canadian Pacific and Canadian National — both of which are reliable and well-run operations that do a lot of business in the states, too.

"I focus on areas with good market structure, and there are a number of sectors in Canada that over time have demonstrated an ability to create value," Hogan said. "Grocery stores, insurance companies, railways — these are some areas where the industry structure is supportive of longer-term pricing power and value creation."

Top country ETFs

ETF
YTD performance (%)
1-year performance
3-year performance
iShares MSCI Brazil Small Cap 72 68 (-43)
VanEck Vectors Russia Small Cap 68 77 (-20)
iShares MSCI All Peru Capped 66 51 6
Global X Brazil Consumer 66 73 (-22)
iShares MSCI Brazil Capped 66 58 (-24)
VanEck Vectors Brazil Small Cap 63 66 (-44)
First Trust Brazil AlphaDEX 57 59 23
Global X Brazil Mid Cap 55 57 (-23)
IQ Canada Small-Cap 45 36 (-16)
Guggenheim Canada Energy Income 33 23 -34
Global X MSCI Argentina 32 51 22
iShares MSCI Russia Capped 31 27 (-27)

(Source: XTF.com, 09/30/16)

There are some risks to investing in Canada. If oil prices decline again, then the market could experience loses and see its currency fall, but it also has what many think is an overheated housing market. The Bank of Canada itself says that housing is about 30 percent overvalued. If the market does indeed crash, then that could impact the banking sector, which makes up about a third of the market, Lingard said. He thinks hot housing markets in Vancouver and Toronto might cool but will muddle along rather than crash.

Longer-term, Hogan said Canada will still make gains. It usually does well when the United States does well, in part because the United States is Canada's largest trading partner, so as long as this country keeps chugging along, the Great White North should do fine. It also has a strong resource base, with plenty of oil and gas reserves, its debt-to-GDP ratio is low, and demographics trends are favorable with continued immigration.

"There are good companies to own that compound value," Hogan said. "You can do very well without taking on a lot of volatility risk."

By Bryan Borzykowski, special to CNBC.com