Posthaste: What does the TSX’s record run say about the economy? Maybe not as much as you’d hope

The TSX hit a record high this month, but is it a good bellwether for the economy? Photo by The Canadian Press

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Canada’s stock market has been on a tear lately.

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Since just before the United States election in November, the S&P/TSX composite index has outperformed both the S&P 500 and the EAFE (Europe, Australasia, and the Far East), according to BMO Capital Markets, and hit a record high this month.

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So is this a good omen for the Canadian economy?

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BMO senior economist Robert Kavcic looked at the reasons behind the rally in a recent note entitled “Is the TSX Glitter Economic Gold?”

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BMO Capital Markets

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Tariff trouble?

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Investors don’t like uncertainty and the turmoil thrown up by U.S. President Donald Trump’s trade war has been huge. The first thing to remember, though, is markets are always looking at least three to six months ahead. Kavcic said the worst-case scenario for tariffs was arguably priced in months ago and since then Canada’s exemptions under the Canada-United-States-Mexico Agreement and a relative pass on Liberation Day has signalled that the tariff bark could be worse than its bite.

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The direct hit of tariffs on the country has been narrow, he said. Steel and aluminium producers face hefty 50 per cent duties, and some auto parts have been penalized, but these industries represent only about 1 per cent of the TSX index.

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Get ’em while they’re cheap

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Before the trade war broke out, the TSX’s forward earnings multiple was around 15x, compared with above 22x for the S&P 500, “a wide gap from a historical perspective,” said Kavcic.

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Bank of Canada beats the crowd

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Canada’s central bank cut earlier and deeper than most other advanced economies, leaving its policy rate at a much more neutral level than the Federal Reserve’s.

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“The 225 bps of easing in the past year could be taking the brakes off the economy (with a six-to-12-month lag) just when it needs some help, and the TSX could be reflecting that,” he said.

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What our market is made of

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Over the past 25 years, the correlation between TSX performance and economic growth has been positive, but not as strong as in the United States, where the S&P 500 proves a better bellwether, said Kavcic.

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This comes down to composition. The TSX is dominated by financials and energy/materials. While the former picks up on economic conditions, the latter has less sway in the economy than it used to, he said.

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Case in point are gold stocks which were five of the top 10 contributors to the TSX’s increase this year, and account for about a third of the gain year to date.

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The big guns of the economy, industrials, consumer spending and real estate represent only 12 per cent, 7 per cent and 2 per cent of the index, respectively.

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“The TSX is notoriously not a perfect reflection of the underlying Canadian economy given its composition,” said Kavcic.

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The bottom line

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While the resilience of the Canada’s equity market in this tumultuous time is impressive, Kavcic said BMO would be cautious in passing that strength into the economic outlook.