Why Investors Are Running Away From the Fastest-Growing G-7 Economy

  • Canada’s gross domestic product expanded 3.7% in first quarter
  • Country’s stock index, currency are developed-world laggards

Why Investors Are Fleeing the Fastest-Growing G-7 Economy

Canada’s economy is flexing its muscles. Investors are not impressed.

The country’s economy expanded at an annualized 3.7 percent pace in the first quarter, Statistics Canada reported Wednesday, easily tops in the Group of Seven and at the very high end among all large developed economies.

Meanwhile, in a year when stocks are rising everywhere, Canada’s benchmark index is the second-worst-performer in the developed world after Israel, according to Bloomberg data. It’s a similar story in currency and bond markets.

The performance underscores how, even with the improving economic performance, caution prevails. Investors remain concerned about geopolitical risks such as U.S. trade protectionism, the outlook for oil prices and a housing market that some analysts say may be on the verge of a correction

“It is a tad curious to say the least that the Canadian economy arguably has been one of the bigger pleasant surprises in 2017 and meanwhile the equity market has done a belly flop,” said Doug Porter, chief economist at Bank of Montreal, who highlighted the disconnect between Canadian growth and market performance in a May 26 note.

Energy shares are down 10 percent year-to-date, while fears about contagion from a run on deposits at troubled mortgage lender Home Capital Group Inc. have weighed on financial shares, which are down 1.2 percent.

While the benchmark S&P/TSX Composite index is up a slight 0.6 percent, that’s well below returns in other markets. The S&P 500 Index is 7.8 percent higher this year.

Fears Overblown

Ironically, oil and housing are the two key reasons why Canada’s economy is doing better. Crude prices have rebounded from last year’s lows, giving energy producing regions some life. Nominal GDP, which unlike real GDP isn’t adjusted for inflation and provides a better picture of actual output, grew at an annualized pace of more than 8 percent in the first quarter because of higher commodity prices.

Second, a housing boom in Vancouver and Toronto is fueling construction and creating new-found wealth for inhabitants.

In fact, the figures released Wednesday show growth -- at least on the domestic side -- couldn’t be more broad based, including a sharp comeback in business investment, which has been contracting for much of the past two years. All major components of domestic demand posted increases in the first quarter -- the first time that’s happened since 2010.

Canada’s strong economic growth suggests investors’ fears are overblown, said Vincent Delisle, portfolio strategist at Scotia Capital Inc.

“Housing markets do not collapse when the economy is growing at 4 percent,” Delisle said in a phone interview before the gross domestic product figures were released.

Market Disconnect

It’s not just equities that are disconnected from the economy. Canadian government bonds returned 2.1 percent in U.S. dollar terms this year. While better than the 1.7 percent gains of U.S. peers, they lag behind sovereign bonds globally, which are up 4.4 percent, a Bloomberg Barclays Global Treasuries index shows. The Canadian currency meanwhile is the worst-performing major global currency of 2017, declining 0.30 percent against the U.S. dollar.

“That’s a big disconnect,” Delisle said, referring to the loonie’s performance relative to the economy. “The GDP report should shock everybody outside Canada.”

Part of the problem is that Canada’s stock market isn’t totally reflective of the economy, since it’s heavily reliant on energy and financials, Porter said. Those two sectors account for 54 percent of the S&P/TSX Composite Index.

But investors have been taking their cues in part from the Bank of Canada, whose policy makers have for months emphasized the negative, even in the face of improving data.

Nafta Worries

Global political developments aren’t helping, with renegotiation of the North American Free Trade Agreement due to start as early as August and a new spat with the U.S. erupting over aerospace manufacturing.

Already, data suggest investment into the country is cooling. Foreign direct investment in Canada dropped 25 percent to C$8.68 billion in the first quarter, according to separate data released Tuesday. The country relies heavily on foreign funding to finance spending -- totaling C$130 billion over the past two years, according to balance of payment data.

There is also the subdued outlook for oil, which has traded below $50 a barrel since last week, and the temporary feel of the recent growth upturn.

Part of it is the catch-up effect as the economy recovers from the oil price collapse. Continued growth in residential investment -- which was up an annualized 16 percent in the first quarter -- is also likely to fade as the impact of government measures to cool housing markets kick in. 

“There are a lot of factors that have been giving the economy a temporary boost,” Porter said. “Admittedly, this temporary boost has been going on for three quarters now.”

Priced In

There may also be another type of pay back in play, according to Porter. Investors may already have priced in the good news last year, when Canada’s stock index gained 18 percent, one of the world’s best performances.

“Often times the equity market is moving well before the economy does and of course the Canadian equity market had a robust year in 2016,” Porter said. “One could argue that presaged this better performance by the economy.”

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