Industry composition is always a big issue for Canadian equity investors, and the TSX has plenty of exposure to what is working now. The global inflation story is probably the biggest theme out there, led by soaring commodity and raw materials prices. Energy and materials account for a quarter of the index, or more than a third if we include industrials. Indeed, since October, eight of the top ten individual stocks in the TSX are in energy.
In terms of index point contributions, banks make up the top four individual stocks driving the TSX gain since the fall. This stage of the cycle—a steepened yield curve and reopening of smaller businesses in view—along with limited loan losses through the downturn, is clearly favourable for the group. And, capital markets activity is strong, too, with announced global M&A activity in the six months through April 2021 almost US$2.5 trln, the highest in 14 years. Combined, financials, energy and materials make up about 55% of the TSX, so there you have it.
Concern about inflation could also be helping. That said, the historical relationship of relative TSX performance in inflationary environments is decidedly mixed—it really depends on what’s driving it. Negative oil supply shocks have helped, but other demand-led bouts have not been as favourable. The current environment (call it combined negative supply and positive demand shocks) seems about neutral. But Canada is rich with dividend-paying companies that have an ability to maintain pricing power and grow dividends over time at least in line with the rate of inflation, and these sectors have performed very well. When 10-year yields are still less than 1.7% in North America, and there’s a real potential for those returns to be more than fully eroded by inflation, those dividends start to command a premium.
Even though all seems to be going right, on a relative basis, the TSX is actually not outperforming the S&P 500 since last October; and, is barely doing so over the past three months. The reality is that those sectors driving strength in Canada are running even hotter in the U.S. (financials, for example, are up more than 60% in the S&P 500 versus about 40% in the TSX). So, the industry composition that favours Canada is offset by softer actual returns in each industry.
All told, it’s a good time for Canada from an equity market perspective, but it’s still proving tough for the TSX to seriously outperform its U.S. counterpart. Given the longer-term underperformance we’ve become used to, that, in itself, feels like a win.