Canada’s Stock Market Is Beating the U.S. How to Play It.

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War in Europe is pushing up commodity prices while interest rates rise as central banks try to curb inflation. The pressures are being felt worldwide as investors price in slower economic growth and lower corporate profitability.

But Canada’s stock market is skating by, outperforming the U.S. and other developed markets. Its secret: financial and energy stocks.

The

iShares MSCI Canada
exchange-traded fund (ticker: EWC) is flat this year. That stands as a win compared with the

S&P 500,
off 10%, or the

Nasdaq Composite
index, down 15%. Canada is also outperforming the

iShares Core MSCI Europe
ETF (IEUR), down 16% through Friday’s close.

Canada is doing better thanks to its heavy exposure to financials and energy, two sectors that benefit from higher interest rates and commodity prices.

Nearly 40% of the MSCI Canada index is in Canadian banks, including

Royal Bank of Canada (RY.TSE),

Toronto Dominion (TD.TSE), and

Bank of Nova Scotia (BNS.TSE). Banks generally benefit from rising rates, which improve their profitability, or net interest margins, on loans.

Annualized inflation in Canada hit a 30-year high of 5.1% in January, more than twice the Bank of Canada’s 2% target. The central bank raised its benchmark rate by a quarter percentage point to 0.5% this past week, with further increases expected to push it to 1.25% by the end of 2022 and 1.75% in 2023, according to credit ratings firm Fitch.

Investors appear to like that setup for Canadian banks. Year to date, Royal Bank of Canada is up 3% on the Toronto Stock Exchange. TD is ahead 1.3%, and Bank of Nova Scotia is up 4%. The stocks also have healthy dividend yields, upward of 3% each. Overall, the MSCI Canada ETF yields 1.9%.

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Another big slug of the Canada ETF is in energy and raw materials, accounting for 28% of its assets. Oil and gas prices have soared since Russia’s invasion of Ukraine. Canada announced a ban on imports of Russian oil last week, and European countries are considering limits on Russian energy exports. Even without direct bans on Russian energy, buyers of energy products are shifting to other oil-and-gas producing countries and non-Russian companies.

“Regular buyers of Russian oil, primarily in Europe, will seek non-Russian alternatives. That will tend to support the price of Brent crude and the broader market,” said Rick Joswick, head of Global Oil Analytics at S&P Global Platts Analytics in a commentary this past week.

Canada’s equity markets also offer exposure to gold miners and other companies linked to commodities demand, including

Canadian Natural Resources (CNQ.TSE) and Canadian National Railway (CNR.TSE).

“You get the benefits of energy, materials, and financials—three sectors likely to benefit from the current and future economic climate,” said Todd Rosenbluth, head of mutual fund and ETF research at CFRA, in an interview.

Canada’s market is also value-oriented with a focus on industrials, banks, and energy. The value style has been outperforming higher-multiple growth. Indeed, value and growth have diverged sharply—the Russell 1000 Value index is down 4% this year versus a 15% decline for the Russell 1000 Growth Index.

Investors can gain exposure to Canadian equities through ETFs like the MSCI Canada fund. Others include the JPMorgan BetaBuilders Canada ETF (BBCA), Sprott Gold Miners ETF (SGDM), and iShares Currency Hedged MSCI Canada ETF (HEWC).

Canada’s tailwinds aren’t necessarily durable; commodity prices could be hitting a peak, poised to fall back with rising supplies and weaker demand as economic growth slows—the traditional cure for high oil prices. A quick end to the fighting in Ukraine could send oil back down below $100 a barrel, pressuring Canadian energy equities.

Rising interest rates are also a double-edged sword for banks. While they can lift banks’ loan profitability, lending volumes could suffer if home buyers and other borrowers scale back on credit as they price in higher financing costs. Canada’s real estate market—a major source of individual asset wealth and revenue for the banks—could also turn down with higher rates.

For now, though, Canada seems to have the right mix of value, exposure to energy, and a hedge against rising rates with its bank stocks. In hockey, they call that a hat trick. Canada seems have scored one.

Write to Daren Fonda at [email protected]