Canadian Q2 Market Review and Outlook: Stocks Tread Water Despite BoC Rate Cut

The greatest headwind facing Canadian markets right now may be the idea that the Bank of Canada’s fight against inflation isn’t over.

“After four consecutive positive CPI reports in Canada, the May print landed with a thud,” said Robert Kavcic, Senior Economist at the Bank of Montreal, in a note on June 26. “Headline inflation accelerated to 2.9% year-over-year, and the various core measures picked up as well, disappointing expectations across the board.”

Canadian stocks struggled in the second quarter. It’s been a development “exacerbated by the lack of interest from foreign investors,” said a June note from Stéfane Marion, chief economist and strategist and team at National Bank of Canada. “According to the latest data, foreigners have dumped $37 billion worth of Canadian equities over the past 12 months, a trend that has been in place since the start of 2023 and is normally observed during a recession.”

Canadian Materials Stocks Bouy Market in Q2

Basic materials stocks helped the Canadian stock market stay afloat with an 8.09% return quartering the second quarter.  That gain contributed 0.87 percentage points to the Morningstar Canada index’s performance. That sector’s returns were followed by consumer defensives, up 10.92%, which contributed 0.36 percentage points to the performance of the index. Among the top contributing stocks, Dollarama added 0.18 percentage points to the index return thanks to a 19.29% rally in the quarter. Royal Bank stock returned 7.02% and contributed 0.44 percentage points to the index. The rise in RBC stock ran contrary to the overall decline in the wider Canadian financial sector, which was a leading detractor over the period.

Financial services detracted 0.60 percentage points from the Canada index’s return last quarter. This was largely due to the sector’s weight at 31.83% of the index, as Canadian financial stocks only fell 1.85% last quarter. The Canadian technology sector, meanwhile, fell 6.54%, detracting 0.58 percentage points. Shopify led the decline in the Canadian tech sector, down 14.17% and detracting 0.56 percentage points from the index. Shopify was followed by Bank of Montreal and Toronto Dominion Bank, down 11.47% and 7.16%.

The prospect of a pause in the interest rate cuts in the short term may have investors hedging equity market volatility with materials while avoiding financial services due to interest rate risks related to high Canadian consumer debt levels.

Canadian Real Estate Sector Can’t Raise Rent

While prices accelerated across the board in Canada, especially in services, rents “surged” in May says Boudreau. “This uptick is a headache for the Bank of Canada. Rent is salient, politically sensitive, and has a massive weight in the consumer basket.” The effect of higher interest rates for longer is also critical for Canadian REIT investors, with an impact on high operating costs pulling down the Morningstar Canada REIT index 6.42% last quarter, and down 10.69% year-to-date.

Canadian Bonds Hit an Inflection Point

The CPI report was a bit of a hit to Canadian bond investors. The Morningstar Canada Core Bond index fell from a yearly high in mid-June, ending the quarter up 1.73%. “Canadian 5-year yields jumped 10 bps in the wake of the CPI report, perhaps stalling some further mortgage rate relief, for now,” said Kavcic.

The mortgage rate relief may not be soon enough for markets, however. “Despite the start of monetary easing in some parts of the world, we expect monetary policy to remain restrictive for the foreseeable future, a situation that is likely to trigger financial market stress,” said Marion and team. “We maintain our defensive asset allocation.”

Could Canadian Equities be Set for a Comeback?

Vanguard’s outlook on Canadian equities is “relatively optimistic” says Ashish Dewan, Senior Investment Strategist for Vanguard Canada: “Canadian equities have a value bias relative to the U.S., and value stocks are well positioned to outperform amidst a higher structural interest rate environment.”

“In the near term, we expect below-trend economic growth in Canada for the rest of 2024 in the range of 1.25-1.5% amid potent monetary policy transmission,” predicts Dewan. “We foresee additional Bank of Canada rate cuts by an additional 25-50 bps this year which should provide some relief to the Canadian economy, particularly to homeowners, that could also positively impact Canadian equities overall.”

The murky Canadian interest rate outlook has markets “going back to the data grind,” wrote Bank of Montreal’s Kavcic. “At this point, the market has (appropriately) scaled back July rate-cut odds, and our call for a September move remains intact for now.” Jules Boudreau, Senior Economist at Mackenzie Investments agrees: “Today’s inflation data shows that Canada’s path to 2% will be a bumpy road but doesn’t rule out multiple rate cuts in the rest of 2024.”