Canadian equities: facts and future

Last year was marked by massive changes in financial markets the world over. Volatile oil prices, the prevalence of work from home, and travel restrictions were just some the major themes in our daily lives whose effects carried through to the equity markets. Yet despite the objectively negative effects of the global pandemic on the economy, equity markets were shockingly resilient. “The stock market is not the economy” was the standard line used by those who couldn’t reconcile the direction of the economy with that of the stock market.

But even if the stock market doesn’t perfectly correlate to the general direction of the economy on a weekly, monthly, or even yearly basis, the two are inextricably linked, and we saw some of the aforementioned themes affect sector weights in the S&P/TSX Composite Index. Longer term, as the Canadian economy changes, so too will its public companies and the market index to which they belong. With this in mind, we explore what themes and hard facts in Canada’s real economy are likely to affect and alter the future of the Canadian stock market.  

The energy sector was remarkably unremarkable last year. Having been one of the three biggest sectors in the S&P/TSX Composite Index for at least 20 years, late last year it fell into fourth place—surpassed by industrials—as the collapse of the price of oil took its toll. But if we take a longer-term view, what factors might drive this sector’s importance and prominence in Canadian public markets?

Energy in Canada is losing steam as IT picks up the slack
Weights in the S&P/TSX Composite Index by GICS sectors

Undeniably, the ongoing shift to a lower-carbon economy will affect global oil prices and, as a consequence, the Canadian energy sector’s importance to the TSX. That said, it’s also worth mentioning one sobering fact: The timeline to move away from crude oil in any significant manner is likely further off than people think. In fact, consumption of petroleum in the United States—the world’s largest consumer and the destination for 98% of Canadian oil exports in 2019¹—is expected to increase by 16%, from 33.55 quadrillion BTUs in 2020 to 39.08 in 2050. What does this slow transition to the new carbon economy mean for the Canadian energy sector? First, considering that the demand for crude oil and its derivatives is likely to grow even in the long term, we believe that Canadian oil and gas explorers and producers won’t pivot to more sustainable products. In other words, we don’t foresee them shifting focus and capital spending to green energy as some of their larger international peers have done.²

Petroleum isn't likely to go away anytime soon
Forecast petroleum consumption in the United States

Importantly, this doesn’t mean they won’t partake in the shift to a lower-carbon economy. As corporate environmental footprints occupy a larger space in investors’ minds, our view is that those oil companies that are able to improve their environmental practices will be granted the social license to operate that’s necessary to attract conscientious investor capital these days. They’ll also be better positioned to withstand the planned increase of the Canadian federal carbon tax from CAD$30 per tonne of CO₂ in 2020 to CAD$170 by 2030.³ It therefore behooves oil companies to clean up their operations as much as possible from both a capital-attraction and bottom-line standpoint. Still, as polluters by nature, if climate continues to grow in importance—and we expect it will—in the distance future, we may see traditional exploration and production companies in Canada occupy a smaller and smaller place in the TSX.

Who might take up this slack? Ironically, it’s possible that the future of the Canadian energy industry lies in certain names that are technically classified as utilities. The TSX utilities sector is full of renewable energy companies—Boralex, Brookfield Renewable, and Northland Power, just to name a few. Although smaller than their oil-producing peers, many of these companies have assets in international markets. We also consider some of these names to be highly innovative, particularly as it concerns the climate, and so, rather than playing catch-up on the path to help the environment, these companies are industry leaders. With a massive head start over their legacy energy companies in that respect, we see a potential for a growing presence in the years ahead for these innovative companies that, although classified as utilities, may have a large role to play in the future of the Canadian energy industry.  

Financials have almost always been the sector to beat in terms of size in the TSX. With the exception of a few months in 2006 and again during the Global Financial Crisis, the financials sector has been the behemoth of the TSX over the last 20 years. However, in the last 5 years, although financials have been growing in absolute size, their proportional market cap in the S&P/TSX Composite Index has actually been on a slow decline, from 39% in 2015 to about 30% at the end of 2020.

Banks in Canada have plenty going for them. With a highly stable market from a regulatory point of view, banks can easily attract international capital. They also operate in a nonfragmented market: It’s no secret that Canada’s Big 6 banks together have a dominant market share. That isn’t to say there aren’t threats to their positions, including the increasing prominence of fintech firms and the rise of robo advisors. We do consider those to be relatively minor threats, since Canadian banks are so entrenched in Canadians’ everyday lives and provide services well beyond what these young firms currently offer. Still, the overall competitive pressure on fees means banks have to stay nimble and must adapt to their new reality. 

The overall competitive pressure on fees means banks have to stay nimble and must adapt to their new reality.

We believe Canadian banks are facing these challenges well and tackling the threats head on. The country’s largest banks have collectively spent nearly CAD$100 billion on technology since 2009, making it their second-largest expense in that period.⁴ Those investments appear to be paying off—transactions that needed to take place in person just a few years ago (e.g., mortgage renewals and cheque deposits) were seamlessly transitioned to primarily digital, meaning pandemic-induced lockdowns were far less detrimental to banking customers than they could have been. The spend on technology means banks are well ahead of the game in terms of their ability to face competitive pressure on fees, as the technological investment gives them the flexibility to reduce costs in other areas. In short, while it may not be the most interesting sector in the country, the fact is that their behind-the-scenes adoption of technology will likely help banks maintain their position as the TSX’s dominant sector for the foreseeable future.   

Although the materials sector in Canada is the second largest in the S&P/TSX Composite Index, it’s 12% weight is a far cry from the more than 25% share it had in 2011. Most of the materials names in Canada are in the gold mining and exploration field; those 26 companies make up about 57% of the materials sector by market cap.⁵ But while gold is the most prominent metal in the Canadian mining universe, there are others that are important to the future of the TSX—and to the planet.

Copper, for example, is having its day in the sun, having recently reached its highest price in nearly a decade, at over US$9,600 per metric tonne. Because it’s a highly efficient conductor of electricity, copper is used extensively in multiple types of renewable energy systems, including solar, hydroelectric, thermal, and wind sources, and is a key component in the power grid. It’s also heavily in use in the electric vehicle (EV) market; EVs require two to four times more copper than internal-combustion vehicles.⁶ Nickel is another interesting metal that’s seeing interest increase, thanks to the green revolution, as it’s a key component in rechargeable batteries. Again, EVs are the most obvious demand driver for batteries and the metals inside them. If forecast increases of EV sales come to fruition—from 2.7% of global sales in 2020 to nearly 60% by 2040, by some estimates⁷—demand for these metals is likely to benefit.

Canada is one of the leaders in nickel
Nickel reserves and production

Given the likely increase in demand for metals that are key to a lower-carbon future, we’d expect at least some of the six diversified metals and mining and copper companies that trade on the TSX to see a more prominent weight in the index in the future. Specifically, Indonesia, the world’s largest exporter of nickel in 2019, banned exports of the metal in 2020. As the fifth-largest exporter of nickel and with the eighth-largest reserves, Canada is well placed to take advantage of any potential increase in demand for the metal.⁸ Moreover, given that Canadian markets have historically been friendly to mining companies, it would make sense for mining companies abroad to have more of a Canadian presence.

We do caveat that although their products may help advance the green revolution, pressure will be on these companies to mine sustainably; although a decreasing dependence on carbon is undeniably a good thing, it can’t come at the cost of stripping the planet bare. Like their peers in the energy sector, mining companies will face heavy environmental, social, and governance scrutiny, and those able to prove that their operations are sustainable from both a financial and planetary point of view will be the true winners.

We’d be remiss if we didn’t mention the Canadian technology sector, which, like its peers in the United States and abroad, impressed last year: The S&P/TSX Capped Information Technology Index gained over 57% in 2020. That performance, combined with declines in the energy sector, contributed to a significant increase in tech’s presence in the S&P/TSX Composite Index, from about 5.7% at the end of 2019 to 10.3% at the end of 2020. But we note that while 2020 was certainly an outlier, technology companies have steadily been increasing their prominence in the TSX since their low point of barely over 1% in 2012.

For Canadian tech firms, what we believe will be key is their ability to grow their international reach and exposure. Situated in a fairly small market, Canadian tech firms need to look beyond our borders in order to expand; luckily, they’re aware of this. Of the 13 S&P/TSX Capped Information Technology Index companies that disclose their revenues by domestic (Canadian) versus international exposure, an average (weighted by revenues) of about 89% of their sales stem from outside of Canada.⁹ To be clear, these figures aren’t skewed by just a few major players with massive international exposure—only two of the firms examined reported international exposure of under 85%. These numbers give us the confidence to say that technology companies in Canada are well placed to expand beyond our borders and gain market share internationally.

Canadian tech firms are truly global
Revenues from outside of Canada for the S&P/TSX Capped Information Technology Index (%)

Source: Latest corporate annual reports, TMX Money, Manulife Investment Management, as of March 25, 2021. As of this date, the S&P/TSX Capped Information Technology Index had 19 members, of which 13 disclosed their revenues by Canada versus ex-Canada. 

Beyond pure tech firms, we note that innovation is a key component to the non-tech firms as well. As mentioned, Canadian banks are investing heavily in technology to adapt to today’s new realities, while mining and energy companies’ future will be affected by their ability to leverage new environmental innovations to reduce their carbon footprint. But Canadian corporations may also soon benefit from another cutting-edge technology: artificial intelligence (AI). In 2017, Canada became the first country to launch a national AI strategy, promising CAD$125 million in funding for the Pan-Canadian Artificial Intelligence Strategy.¹⁰ This initiative is already paying off: Canada ranked fourth globally for its level of investment, innovation, and implementation of AI,¹¹ while the AI sector has attracted CAD$3 billion in new investment and created 50,000 jobs over the last decade.¹² Interestingly, one private Canadian AI firm that’s partially funded by the Canadian government was among the first in the world to identify the emerging risk from COVID-19, doing so nine days before the World Health Organization alerted the public to the emerging coronavirus, and the federal government is using its technology to monitor and respond to the pandemic.¹³

Canada is one of the world leaders in AI
Tortoise Media Global AI Index

This impressive progress notwithstanding, we don’t necessarily expect AI-based companies to be heavyweights in Canadian public markets in the near future. However, we do believe that Canadian companies could benefit from AI’s ability to enhance the so-called world’s most valuable resource: data. The TSX has no shortage of companies that are inherently data intensive and can monetize this resource. The TMX Group, for example, may be a financial services company and Thomson Reuters may be a media conglomerate, but we’d argue that, considering the mountains of data on which their companies rely, they’re at least in part data firms. Yet data needs to be properly analyzed in order to be valuable. Companies that can leverage AI’s ability to enhance data capabilities—whether that data is to enhance their own business practices or to sell (within ethical responsibilities)—would have an advantage over those that don’t. We’ll be closely monitoring the AI space and its use by the quasi-data firms in Canada.  

At first glance, the TSX of the future may not look drastically different from how it looks today, as it will likely continue to be dominated by a few legacy sectors. But below the surface, we believe that changes that reflect our shifting economy are taking place. In our view, the companies that make up Canadian public markets will be greener and more technologically focused as they adapt to new investor demands and market realities. Finally, innovation and the ability to expand beyond our borders will also be key as Canadian public companies seek to take their rightful place in the economy of the future. 

1 Natural Resources Canada, www.nrcan.gc.ca/science-data/data-analysis/energy-data-analysis/energy-facts/crude-oil-facts/20064. 2 The CEO of Royal Dutch Shell, for example, has said that it’s no longer an oil and gas company, but rather an “energy transition company.” 3 "Canada to increase carbon taxes by 467%," Norton Rose Fulbright, December 15, 2020.  4 www.bloomberg.com/news/articles/2020-04-22/canadian-banks-71-billion-for-tech-pays-off-during-pandemic. 5 Data is based off GICS sectors and subsectors, retrieved through Macrobond, as of March 12, 2021. 6 www.nrcan.gc.ca/our-natural-resources/minerals-mining/minerals-metals-facts/copper-facts/20506. 7 about.bnef.com/electric-vehicle-outlook/. 8 Natural Resources Canada, www.nrcan.gc.ca/our-natural-resources/minerals-mining/minerals-metals-facts/nickel-facts/20519. 9 Manulife Investment Management, latest corporate annual reports. Of the 19 companies in the S&P/TSX Capped Information Technology Index, 13 report their revenues on a Canada versus ex-Canada basis. These 13 companies are listed here and used for our calculations. A USD/CAD exchange rate of 1.2600 was applied for those companies that report their revenues in U.S. dollars for the purposes of calculating a weighed average revenue exposure. 10 www.newswire.ca/news-releases/canada-funds-125-million-pan-canadian-artificial-intelligence-strategy-616876434.html. 11 www.tortoisemedia.com/intelligence/global-ai/. 12 "Canada’s AI ecosystem: government investment propels private sector growth," University of Toronto. 13 www.cnbc.com/2020/03/03/bluedot-used-artificial-intelligence-to-predict-coronavirus-spread.html.