It was a stellar year for Canadian markets, with the S&P/TSX Composite Index producing a total return of 20% in 2016. But has the market climbed too fast, too soon? That's what several Canadian fund managers are worried about, though many still think there are opportunities to be had. We spoke to five investment experts about where they think the market is headed in 2017.
Tim Caulfield, manager of Franklin Bissett Canadian Equity
Morningstar Analyst Rating: Silver
We've seen a big rebound in markets coming into 2017, and while we all like strong markets, the unfortunate truth is that if returns are going to outpace growth in the underlying value of the business, then that tempers our enthusiasm about absolute returns. We still think there are opportunities for active managers who can take advantage of the continued dislocation in the Canadian equity market. So while we're cautiously optimistic about absolute returns we think there's a great opportunity to generate strong relative returns.
We're watching how rising interest rates will impact the market. Rates have declined for such a long time that it's hard for anybody -- investors and executives -- to remember what it's like to have significantly higher rates. It's akin to being in a gravity-free environment, where astronauts have been sitting in space and gradually losing muscle because they haven't had to work against gravity for quite some time. If we do see higher rates over time, we're going to see what a lot of these companies are made of. We've seen companies do a lot of M&A [mergers and acquisitions] and increase debt on balance sheets, and it will be interesting to see what happens.
Jeff Mo, manager of Mawer New Canada
Morningstar Analyst Rating: Silver
We're cautiously optimistic for 2017. The Canadian economy appears poised to repeat another year of slow but positive economic growth, and there's optimism that the price of oil and the U.S. economy post-election are both trending up. At Mawer, though, we focus on fundamental data, and while the underlying numbers are positive, much expectation has been built into the market. A modest positive return would be considered a good year for our small-cap clients.
The biggest risk we foresee is the expectations built into high stock prices. Oil stocks are pricing in higher oil prices, while stocks that follow the general economy have higher-than-average valuation multiples and operate in a lower-than-average economic growth environment. Stocks that have benefitted from expectations of increased infrastructure spending in the U.S. may also find it hard to deliver on those expectations as infrastructure spending tends to take longer to come through than some investors expect.
Look where others are not. Interest-rate-sensitive sectors such as real estate and utilities have fallen out of favour. Some companies in these sectors have growth runways, currently trade at less demanding valuations and may be able to offset rising yields with growth projects. As well, some technology companies that performed well in 2015 have fallen out of favour in 2016.
Marian Hoffman, co-manager of Sionna Canadian Equity
Morningstar Analyst Rating: Bronze
This year ended with an upswing partly due to the rebound in energy and some pick up in materials. Coming off that upswing, we have more muted expectations [for 2017] and we wouldn't be surprised if we saw more volatility and potentially a pullback this year. A lot of what's happened has been more sentiment-driven, and that gives us more pause than if we saw fundamentals driving things. We've had an overweight in energy the last couple of years and we think it has more room to run based on where oil prices are. We haven't yet seen the impact of the improvement in oil prices in company results. I don't think it's as attractive as it has been, but I do think it can move more.
One thing we're watching is the continued tensions between active and passive management. Collectively, active managers haven't been able to differentiate themselves in recent years. There are early signs that 2016 was a time when active managers were better able to prove their worth, so maybe we'll see more of a recognition that the market needs active managers. But they have to prove their worth and prove their fee structures.
Brandon Snow, manager of CI Cambridge Canadian Equity Corporate Class
Morningstar Analyst Rating: Bronze
We expect a return of volatility in 2017. The rally that's occurred since Donald Trump's election has been supported by stronger economic data, but I'm not convinced it will continue, and expectations have become too high. While we don't find the index attractive, we are finding more specific areas to invest in.
One risk is that there is uncertainty with what the Trump administration will do on a trade basis. There could be significant impacts to specific products and companies that will be difficult to price in ahead of time. The other big concern we have is on China. The structural issues there have not been fixed, and the pressures on liquidity domestically and on the currency through outflows continue to pick up. We worry about the potential for a significant devaluation of the renminbi.
We're finding more opportunities today in lower-risk areas such as health care and staples, though in selective stocks, while at the same time secular growth stories in technology have become more attractively valued. Patience and prudence will be the name of the game next year. We continue to see a lot of speculation driving violent moves in the market. We will stay disciplined to our bottom-up process and use those periods of volatility to benefit clients.
Mike Leonard, chief equity strategist, Morningstar Canada
The price-to-book value for the median Canadian stock is almost always between 1.4 times and 2 times. Between 1985 and 2015, the only two times the median P/B has fallen below 1.4 times were the 1990 to 1992 recession and the 2008 financial crisis. The median P/B value in Canada is now 1.52 times, which means most stocks in Canada are relatively inexpensive versus the valuations seen over the past 32 years.
Return on equity (ROE) for the median stock in Canada declined from March 2015 to July 2016, primarily due to declining resource prices. Since July, the median ROE has increased. If Canadian equity analysts' earnings estimates for 2017 are realized, or mostly realized, corporate ROEs will be among the highest seen in Canada in the past 30-plus years.
Between May 2015 and July 2016, median year-over-year earnings growth for Canadian companies was negative, so more than half of Canadian companies were seeing declining earnings. This value became positive in August and now stands at 3%. If analysts' estimates come true for the fourth quarter, year-over-year earnings growth will rise to 5.8%, which bodes well for continued improvement in corporate ROEs. Rising earnings growth is providing fuel for these improved ROEs. These are very good conditions to be investing in Canadian equities.
